There are many questions around the implications of Silicon Valley Bank’s (SVB) collapse that won’t be answered for a long time. But there’s one question that many startups and investors are hoping will get answered sooner rather than later: What happens to venture debt?
SVB was one of the larger, if not the largest, providers of venture debt to U.S.-based startups. Now that First Republic Bank has also gone under, that question has spiraled, growing ever more complex.
Many startups rely on venture debt: It’s both a cheaper alternative to raising equity and can serve as a capital tool that helps companies build in ways that equity isn’t great for. For some companies in capital-intensive areas like climate, fintech and defense, access to debt is often the only avenue to growth or scale.
Thankfully, venture capitalists aren’t too worried about the impact of SVB’s collapse on venture debt as a whole.
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TechCrunch+ surveyed five investors, all active across different fund sizes, stages and focus areas, to get the inside line on the state of venture debt. All of them feel that even amidst the turmoil, venture debt will still make its way to the companies that are looking for it — it just might be a little harder for some to get it.
“With the fall of industry stalwarts like SVB and FRB, we suspect access to venture debt to be harder to come by and more expensive, as partners historically considered as “fringe” are not as flexible around factors like scale, or impose stricter covenants. We will see how Stifel, HSBC and JPMorgan (with FRB) and First Citizens will act in the market,” said Simon Wu, a partner at Cathay Innovation.
Sophie Bakalar, a partner at Collab Fund, said that while the process and planning needed to raise venture debt will change, it is still a fantastic resource for growing companies.
“Venture debt has its advantages, more so than ever before,” Bakalar said. “It encourages founders to build rather than grow, which is a good thing when we think about the innovation that can last for decades.”
But the process and underlying business fundamentals needed to get venture debt are likely to change, several investors believe.
“Our prediction is that venture debt lenders will begin to rely less heavily on what the ‘loan to value’ of a business is, and instead start to focus on capital efficiency, ability to become profitable, etc.,” said Ali Hamed, general partner at Crossbeam Venture Partners.
Read on to learn how the rising cost of capital is affecting venture debt, what investors are doing to educate their startups about raising debt and which kinds of startups are best suited to this form of financing.
We spoke with:
- Sophie Bakalar, partner, Collab Fund
- Ali Hamed, general partner, Crossbeam Venture Partners
- Simon Wu, partner, Cathay Innovation
- Peter Hébert, co-founder and managing partner, Lux Capital
- Melody Koh, partner, NextView
Sophie Bakalar, partner, Collab Fund
How have lending standards changed for startups looking to raise venture debt? (ARR growth, minimum cash balances, etc.)
The immediate answer is that our ongoing economic uncertainty has drastically changed today’s lending market, particularly for early-stage startups looking to raise venture debt, in terms of lending standards and the cost of the debt.
In terms of lending standards, there has been a focus on revenue growth and profitability. Lenders are looking for startups with a track record of consistent revenue growth as well as a clear path to profitability. For unprofitable companies, this also means scrutiny of unit economics, as lenders want to make sure the capital is used for value-accretive investment.
This means that startups with strong annual recurring revenue (ARR) growth rates and high gross margins are more likely to be approved for venture debt no matter the market condition. We have a saying in venture that good startups will always get funded, so there’s always an exception to this rule.
Secondly, we’re seeing lenders place more emphasis on minimum cash balances. Startups are expected to have a certain amount of cash on hand, typically enough to cover several months of operating expenses, to demonstrate their ability to weather any financial storms that may arise.
Today, this several-month emphasis is more like one-year-plus. In addition, in the prior “risk on” market, lenders were more likely to approve “covenant light” structures; in today’s environment, we expect and have seen lenders require stricter covenants.
Lastly, we’re seeing lenders take extreme caution to evaluate startups for venture debt based on the strength of their leadership team. Startups with experienced, proven management teams are seen as less risky than those with less experienced leadership, particularly in a market where there is so much uncertainty. A strong leadership team can vastly reduce [the impact of] a crisis if and when it arises.
In light of new market conditions, are there certain genres of startups that are no longer a fit for venture debt?
Venture debt has its advantages — more now than ever before. It encourages founders to build rather than grow, which is a good thing when we think about the innovation that can last for decades.
As far as market conditions and genres of startups, no one should be immune to it. Everyone should think carefully about how this financing model will help their company execute. The first piece of information a bank and/or regulator typically looks at is whether the company is generating income and represents low compliance risk. Fintechs are likely to have a harder challenge here.
We’re still actively investing in climate tech startups that have been focused on execution and solving problems. A few of these include startups that have implemented a venture-debt model.
In today’s environment, the cost of debt has increased significantly with the rise in interest rates. That’s an important factor for cash-burning startups to consider as they think about monthly interest payments and amortization of their debt over time relative to their income and other expenses.
How do you ensure startups feel confident about venture debt? How much education do present-day founders need regarding venture debt to make an intelligent choice for their startup? Is that more or less than in recent years?
For most startups, education and resources around this type of debt financing is always valuable, especially in today’s market. Founders whose financing plan includes venture debt should start modeling scenarios that assume they lose access to this debt. Even if that risk seems remote, it’s always good to be prepared.
In addition, we try to help founders sensitize and sanity-check their forecasts in light of the covenants and downside protections that lenders request. For example, if revenue doesn’t grow as quickly or margins are lower, we want founders to understand the potential downside scenarios and make sure they have an adequate buffer.
Venture debt can be a great extender for a growing, near-profitable startup, but it can be a drag on high cash-burning startups, especially if they perform below plan.
In a more conservative equity investing market, will tighter lending standards and more expensive debt be enough to limit startup dependence on loaned capital?
In addition to tighter lending standards, it is more likely in this environment that lenders will take more time to make decisions and evaluate startups. While lenders are leaning into the void in the market left by SVB, there is likely to be less capital available and, therefore, lenders will be able to more readily pick and choose at a slower, more deliberate manner than in 2020 and 2021.
What should companies look for when evaluating the terms and costs associated with a potential venture debt deal? What should they avoid?
We advise our companies to only take venture debt if they can afford it in a downside scenario. Venture debt comes with lots of covenants and protections to help ensure lenders are repaid. Lenders will very often restrict a company’s ability to spend cash outside of normal expenses and seek governance controls, limiting capital expenditures, acquisitions or other investments.
It’s important that companies understand the nuances of these controls that are outside of just the loan size, interest rate, warrants and amortization schedule.
Finally, has the cost of capital in venture debt reached its peak or should founders expect this form of capital to continue to rise in price?
Capital markets are certainly changing, so founders should expect this form of capital to rise in price as economic trends increase and the supply and demand dynamics in the market change drastically. We’re telling founders that they should be prepared for the possibility of higher cost of capital now and in the foreseeable future.
Interest rates for venture debt tend to have a variable component. Often, that rate can float up, but it won’t go down, so it’s important for founders to take that into consideration. In general, we wouldn’t advise a company to take on venture debt today in the hopes that it will come down in cost.
Ali Hamed, general partner, Crossbeam Venture Partners
How have lending standards changed for startups looking to raise venture debt? (ARR growth, minimum cash balances, etc.)
I think it’s yet to be seen. The SVB collapse happened quickly and recently. The companies borrowing from them (that we have seen) have not seen their lines pulled, or any dramatic event that would cause a forced refinancing that would move the market or turn this into a major liquidity crunch.
That said, we have started to see pricing go up. Our prediction is that venture debt lenders will begin to rely less heavily on what the “loan to value” of a business is, and instead start to focus on capital efficiency, ability to become profitable, etc.
We will see which VC funds were backing enduring companies and which ones weren’t. I think venture debt funds will have to reassess the sponsors they rely on most when this is all over.
On one hand, this should be an excellent time for venture debt funds to originate new loans at better prices. But the ones who will succeed are the ones who can spend as much time doing this as opposed to getting bogged down managing older positions.
I’m sure many firms wish they were doing a lot of originations right now but have neither the human bandwidth nor the dry powder to do so. Plus, I bet a lot of new deals are being compared with adding capital to existing deals — that will create a bottleneck for net new names trying to get funded.
Venture debt lenders also have a weird challenge in that they are relationship-based lenders, which means they don’t like to upset borrowers or the sponsors they work with. But they are going to need to force sales or take action where necessary with companies that can’t raise more capital or cannot get to profitability.
Which companies succeed and which ones don’t will be encoded into the brain of venture debt lenders and how they lend for a long time.
In light of new market conditions, are there certain genres of startups that are no longer a fit for venture debt?
In the last cycle, a lot of companies were able to rely on signals, raise capital on narratives and take bets that required long feedback loops. Companies that sell to large enterprises or build deep tech and take years to see financial traction were viable businesses to fund over the last few years. There will still be a limited number of firms that I’m sure will keep backing those companies (Khosla, Founders Fund, Lux, etc.).
However, I think venture debt lenders will certainly get more conservative regarding how they think about companies that rely heavily on capital markets to be successful or companies that will wait for more than a couple of years to see financial traction catch up to a narrative.
How do you ensure startups feel confident about venture debt? How much education do present-day founders need regarding venture debt to make an intelligent choice for their startup? Is that more or less than in recent years?
We’re always surprised at how long it takes to see the real ripple effects play out through private markets. It took early-stage founders and investors about one-and-a-half to two years after the public markets started falling to begin taking this downturn seriously (seed rounds are still priced too high and are more resilient than growth rounds).
I’d expect it to take some time for the effects of SVB to be known and for the realization to cycle through the system — maybe even up to a couple of years. Call me back in 2025 and I bet that is when we’ll be feeling the biggest after effects.
It’s unclear how venture debt lenders are going to react. Which ones will pile on to their winners? Which ones will be aggressive and force sales or foreclosures? Which ones will amend and extend? Which ones have tons of dry powder and will knock the cover off the ball? I think we’ll need to see how these questions are answered before a VC fund can give advice to founders on which firms to work with.
I think VCs and founders always needed to be educated on how debt financings work. However, a lot of them probably skipped the grunt work or read terms and assumed that they didn’t matter because everything would “get figured out later.” They’re now realizing that’s not always true.
In a more conservative equity investing market, will tighter lending standards and more expensive debt be enough to limit startup dependence on loaned capital?
Maybe. It certainly will force companies to focus on capital efficiency in a way they hadn’t before. However, I don’t think that’s related to venture debt specifically.
What should companies look for when evaluating the terms and costs associated with a potential venture debt deal? What should they avoid?
Companies shouldn’t care about cost (within reason). Venture debt is so cheap compared to equity financing that it almost always makes sense to take as long as the other terms are flexible enough.
All companies should rely more on the flexibility of debt terms, how long duration the term is itself (to ensure they have enough time), and they should pay more interest to avoid things like performance covenants, liquidity covenants or other “gotchas” that they could trip, which could force them to come to the table with their lender.
Finally, has the cost of capital in venture debt reached its peak or should founders expect this form of capital to continue to rise in price?
I’m not sure, but when I’m not sure, I tend to assume the worst. Our advice to companies and our actions are more oriented around “in case things get worse” and less so around “hoping things get better.”
I think most of the tech world underestimates how bad things can actually get, and I’m surprised by how much hubris I still see in the market.
Almost everyone I meet says some version of: “We were definitely in a bubble, and everyone else was wrong except for us. Luckily, we were more prudent than normal, and so we’re well positioned for this environment.”
It drives me crazy any time someone says this, because it can’t be true for everyone. Clearly, people are still lying to themselves, which means the pain is probably yet to come. Overall, it seems like things should keep getting worse.
The flipside of that is: It’s easier to sound smart while being negative than to sound smart by being positive. Time will tell.
Simon Wu, partner, Cathay Innovation
How have lending standards changed for startups looking to raise venture debt? (ARR growth, minimum cash balances, etc.)
Lending standards for startups overall have not changed. For banks that do provide venture debt, the best time to raise is still following an equity round. The most common elements that will be scrutinized are durability of the business model, burn rate and the likelihood of reaching the next stage of development.
However, it’s less about lending standards changing and more about the remaining banks on the market that are willing to underwrite “risky” startups. Historically, venture debt has not been profitable and in many cases has been a loss leader for banks.
With the fall of industry stalwarts like SVB and FRB, we suspect access to venture debt to be harder to come by and more expensive, as partners historically considered as “fringe” are not as flexible around factors like scale or impose stricter covenants. We will see how Stifel, HSBC and JPMorgan (with FRB) and First Citizens will act in the market.
Overall, there are collectively fewer dollars to lend. Many regional banks’ deposits have shifted to larger banks, and lending has become less profitable (given the higher cost of capital), so startups need to get capital elsewhere or stomach higher costs. In addition, banks have to maintain a ratio of deposits to loans with a combination of fleeting deposits and an increased likelihood that regulatory standards could change.
What this all means is that startups have to be more thoughtful about taking on venture debt.
In light of new market conditions, are there certain genres of startups that are no longer a fit for venture debt?
Consumer startups may no longer be a fit, as there will be more scrutiny on unit economics. Structured equity or private credit could come in to fill the gap as an alternative to venture debt.
How do you ensure startups feel confident about venture debt? How much education do present-day founders need regarding venture debt to make an intelligent choice for their startup? Is that more or less than in recent years?
More education is needed. Given the rising cost of debt, combined with the rising cost of equity, it’s not obvious that these expensive “insurance policies” (which was how venture debt was thought of historically) still make sense.
With cash sweep products that help protect deposits above the $250,000 FDIC limit, banks still expect the majority of a company’s deposits to be with the same bank. That might be an issue for certain startup founders/boards from a treasury risk management standpoint.
Some boards might not be comfortable with deposits at regional banks as well, given the suspected banking contagion. While these regional banks are technically sound, because of recent events, people could be hesitant to trust them, which is a sentiment that is hard to overcome.
In a more conservative equity investing market, will tighter lending standards and more expensive debt be enough to limit startup dependence on loaned capital?
First and foremost, loaned capital should never be used by founders who don’t have a repeatable business model or know how they will pay it back. Given the rising cost of equity that continues to play out in the private market, it’s likely that debt will still be cheaper to use to scale businesses, assuming there is a repeatable motion.
However, it will be on a case-by-case basis given how expensive debt will be going forward. The recent rise of fintechs focused on B2B lending, plus new structured equity products that private equity funds are offering, have come in to fill the gap where mezzanine debt falls off, as that could still be cheaper than equity dollars in this market.
What should companies look for when evaluating the terms and costs associated with a potential venture debt deal? What should they avoid?
Startups should always look at duration, price, covenants and the timing of repayments. That hasn’t changed. However, given the uncertainty in the macro environment, covenant levels set by banks might be too onerous to build a business around.
Interestingly, we’re hearing banks are still expecting the majority of the company’s deposits to be with the same bank when taking venture debt, which might be an issue for some CFOs and board members, as mentioned earlier.
Finally, has the cost of capital in venture debt reached its peak or should founders expect this form of capital to continue to rise in price?
The cost of capital is still in flux due to rising interest rates. Since most venture debt products are prime/SOFR (Secured Overnight Financing Rate) rate, plus margin, there is likely still room for costs to increase.
Banks need to ensure they are making money, as venture debt was historically a lead-generation product (and a loss leader). With affordable sources of capital declining (e.g., fleeting deposit base), we need more time for the system to flush itself out, as there are still many effects of the low-interest rate environment playing out — such as commercial real estate.
I suspect we’ll see prices rise more before they fall.
Peter Hébert, co-founder and managing partner, Lux Capital
How have lending standards changed for startups looking to raise venture debt? (ARR growth, minimum cash balances, etc.)
Credit availability has tightened aggressively across the board, far beyond just the world of venture backed-startups. Historically, the model was, in essence, “underwriting the underwriters” — relying upon decades of trusted personal relationships and on-the-ground knowledge to ensure that VCs would stand behind their portfolio companies and mitigate early-stage business credit risk.
Increasingly, venture lending will resemble other forms of credit underwriting, focusing mainly on hard business fundamentals versus softer relationship banking.
In light of new market conditions, are there certain genres of startups that are no longer a fit for venture debt?
It remains an open question whether the average Series A-stage technology and life sciences companies will have access to attractive venture debt options in the coming years. The venture lending industry has produced relatively low loss ratios because it had patient bankers who were fully immersed in the ecosystem, playing the long game.
How do you ensure startups feel confident about venture debt? How much education do present-day founders need regarding venture debt to make an intelligent choice for their startup? Is that more or less than in recent years?
Board members should ensure founders are making informed decisions about whether venture debt is appropriate for their company, appreciating the benefits as well as the potential downsides and risks.
The current regional banking crisis compounds the difficulty of making that decision. A founder must ask not just whether the product itself is appropriate, but whether the lender will remain solvent.
In a more conservative equity investing market, will tighter lending standards and more expensive debt be enough to limit startup dependence on loaned capital?
Startups have never depended on venture debt. It has been a useful product to (theoretically) help extend cash runways, but equity capital is the true lifeblood for startups.
Over the past 18 months, we have seen a significant contraction in both the equity and credit markets, which makes capital much more expensive for those fortunate to have access in the first place.
What should companies look for when evaluating the terms and costs associated with a potential venture debt deal? What should they avoid?
Interest rate and deal structure are the most obvious places founders look first when evaluating potential venture debt options. But in my view, that misses the point.
It’s not the what, but the why. What is the lender’s reputation, what are their incentives and motivations to be in this business, and what is the evidence of their past behavior in times of crisis? That is what any sophisticated management team should be evaluating before even negotiating business terms.
Finally, has the cost of capital in venture debt reached its peak or should founders expect this form of capital to continue to rise in price?
Interest rates have likely peaked, but I would guess it’s not the cost but availability of venture debt that founders and venture investors will be bemoaning in the coming years.
Melody Koh, partner, NextView
How have lending standards changed for startups looking to raise venture debt? (ARR growth, minimum cash balances, etc.)
Venture debt lenders will increasingly focus on a mix of the following:
- Recurring nature of the revenue/revenue quality.
- Health of unit economics/margin profile.
- Equity cushion (how deep-pocketed existing equity investors are and the likelihood of the next round of equity financing).
These were always part of the consideration set, but in this new environment where only the highest-quality companies are raising follow-on rounds, venture debt providers will further scrutinize the above.
How much education do present-day founders need regarding venture debt to make an intelligent choice for their startup? Is that more or less than in recent years?
Regardless of market conditions, it’s critical for founders to understand the fundamentals of how venture debt works. Although venture debt can provide valuable financing, it’s crucial for startups to understand the associated risk and carefully review the covenants and ensure they can satisfy the lender’s requirements.
For example, if the debt provider is a bank, the covenants usually involve a clause that the company keeps all its cash deposits with that particular bank so that it can serve as the collateral against the drawn credit line.
This is a perfectly reasonable requirement from the lender’s point of view, but it might not be the best treasury/cash management strategy for the company. This needs to be taken into account as the “cost” of utilizing such a source of capital.
What should companies look for when evaluating the terms and costs associated with a potential venture debt deal? What should they avoid?
One of the intangibles has always been about the lender’s past behavior through market cycles. This is where SVB used to shine, as it had a reputation of “working with you through tough times” with a level of flexibility beyond the written covenants.
Now that some of these more “cycle-tested” lenders are no longer around, it’d be interesting to observe the new set of behaviors from venture debt providers still active in the market.
Finally, has the cost of capital in venture debt reached its peak or should founders expect this form of capital to continue to rise in price?
The cost of capital (across all capital types, debt or equity) will likely continue to go up if the Fed is not done raising rates.