Minh Le was busy.
As Market Manager for Silicon Valley Bank’s Washington and Western Canada region, he helps entrepreneurs access various lines of credit. And last year, when venture capitalists slowed their spending in response to the cold economy, he had a rush of new clients.
“We’re seeing as much speed as you’ve seen in the last decade,” he told me.
With traditional venture capital getting more and more difficult to raise, many startup advisors are asking founders to seek alternative financing tools such as project debt or revolver loans as a way to secure cash and avoid equity buyouts.
Speaking at a Perkins Coie event in Seattle in October, Bonfire Ventures principal Tyler Churchill said his firm is advising nearly all of its portfolio companies to consider what a project debt facility would look like.
Advisers to startups point to multiple benefits of debt: extending runways for cash without dilution, maintaining ownership control, and avoiding potential volatility, when companies accumulate cash at a lower valuation than in previous rounds.
But debt comes with its own set of caveats: increased financial scrutiny, strict barriers to growth and spending, and principal repayment obligations.
However, Zachary Hoeney, a commercial banker at JPMorgan who focuses on technology companies, said many startups didn’t even consider debt when stock markets were hot a year ago.
The second quarter of last year was the second-largest quarter in terms of total project debt over the past decade, according to PitchBook data. By the end of the year, the value of debt deals for tech surpassed 2021 figures with more than $29 billion raised across 2,188 deals, according to PitchBook’s Venture-Monitor report.
CEO Melissa Widener said Lighter Capital, a Seattle lender that provides revenue-based debt instruments to early-stage startups, doubled the size of its book in 2022, marking its best year in history. She noted that Lighter is funding more companies that have been on the traditional venture capital path and don’t want to risk a high or low.
The increase in venture debt comes as venture capital markets calm. Venture-backed companies raised a total of $209 billion last year, down 36% from a year earlier, according to a financing analysis by Ernst & Young.
PitchBook analysts predict that the upward trend will continue in 2023. Equity markets will remain rough, they wrote, leading many startups to “consider venture debt as a way to supplement their need for equity financing.”
SVB’s Lu said underperforming general technology stocks could also be a factor in why interest in debt is renewed.
Many startups raised their latest stock round at a time when revenue multiples were high, relative to the market, inflating their valuations. In the current bear market, startups are likely to be valued at the same or lower prices, which leads to the possibility of a flat or downward round.
Startups are often advised to avoid these scenarios because they could mean more dilution for founders and their employees, Lu said. He added that it also requires their financial backers to have to reduce the value of the company in their portfolio, and to report this to their limited partners.
In down markets, it may be “helpful” for startups to accumulate enough debt to continue operating their businesses, avoiding a possible downturn, Lu said.
“Growth-stage tours are special,” he added. “It’s really hard to get them now. And so debt-seeking tends to be a good alternative.”
A number of Seattle startups have taken on some form of debt in 2022, including: Convoy ($100M), Coding Dojo ($10M), and Icertis ($150M).
JT Garwood, founder and CEO of medical supplies marketplace Bttn, said his company is receiving a revolving credit facility from Silicon Valley Bank. He said that the debt instrument helps cover inventory expenses, and the company’s accounts receivable are used as collateral.
“We needed to make sure we weren’t using venture money – which is normally used to grow businesses – to buy inventory,” he said. Bttn secured $20 million from equity investors Tiger Global and others in June.
Garwood said that taking on debt has prompted Bttn to be more financially stringent. Since the lender requires quarterly audits, the startup needs to know when its customers will pay for their purchases. In some ways, he said, this has changed the company’s payment and sales flow.
“It’s not a downside,” he said of the added financial barriers. “But it does force you to invest in resources capable of providing that level of monthly quarterly reporting.”
Another potential drawback to the debt, said Hoeney, is the legal covenants attached to bank loans. These could include annual growth requirements, a burn cap, or a minimum cash balance, he said.
These circumstances can also force a change in the way founders think, forcing them to take a more conservative approach to growing their business.
Debt instruments are usually only available to companies that have raised equity financing in the past and have some measure of success, Huene said, making it difficult for new or less established startups to access this type of financing.
In 2022, more than 40% of all outstanding debt in venture-backed companies went to growth-stage startups, according to PitchBook.
Venture debt deals are often around 20 to 30% of the amount a startup has raised in its most recent round. It’s like a kind of insurance, Huene said, providing a rainy-day fund in case it becomes difficult or impossible to collect money elsewhere.
“It’s very difficult for a bank to come up with any kind of project debt facility if you have less than four months of runway,” Huene said, adding that the legal process for closing terms could take months.
Project debt lenders make money by charging interest, origination fees, or prepayment penalties. They often have a higher interest rate than a conventional loan, and come with shorter repayment terms (12 to 24 months).