The tide has turned for growth-hungry early-stage businesses looking to raise finance. The previously plentiful supplies of equity funding are becoming less abundant – venture capital (VC) investment in UK businesses fell by almost a quarter in 2022, according to analysis from KPMG, as caution mounted in the face of economic volatility. But with valuations under pressure from the sell-offs on listed markets, now may not be the time for founders to be thinking of selling equity.

And, of course, in the wake of Silicon Valley Bank, Signature Bank and Credit Suisse, banks are going through some form of ‘correction’ as the economy gets used to rising interest rates, changing valuations of assets and altered investment strategies.

Against this backdrop, the stage is set for rapid growth in the burgeoning venture debt market, believes Fenton Burgin, Deloitte M&A debt and capital advisory partner covering the US-Europe deal corridor, and member of the Corporate Finance Faculty board. “Venture debt is still less well-known in Europe than in the US, where it’s a very well-developed concept,” he says. “But with VC equity becoming a scarcer commodity, venture debt is gaining ground fast as a means of VC-backed companies extending their cash runway to a further equity raise, IPO, or a sale.”

Jack Bates, associate director at venture debt provider Shawbrook Bank, agrees. “There is still something of a knowledge gap in Europe, but the pipeline has become stronger over the past year or two,” he says. “Founders, management teams and boards are quite sensibly thinking carefully about whether now is the right time to take on any kind of debt, but venture debt is increasingly part of the mix when they do consider their funding options.”

In November 2022, Hambro Perks launched its inaugural £100m closed ended venture debt fund. At the time of the launch, managing director David Hayers told Preqin that it would be lending between £1.5m and £10m to UK and European companies, adding: “We focus on software, primarily business-to-business (B2B) software as a service (SaaS), and patented hardware and advanced manufacturing.”

The venture debt team Hayers has put together is the same one he headed up at Virgin Money, which has been lending to those sectors for almost a decade.

The next stage

Venture debt is most commonly aimed at businesses that have raised at least one round of VC equity and need additional funding to ensure they have sufficient runway to make it to their next raise, says Luis Navarro Motilva, a corporate finance manager at Deloitte. “The lender is banking on the business growing quickly and securing a route to sustainability and profitability,” he explains. “But it is also thinking about the credentials of the VC backer and the potential success of the next raise, which will enable refinancing if cash flow alone doesn’t prove sufficient.”

For the business – and its backer – securing venture debt provides capital without any need for equity dilution. The funding can then be deployed to accelerate the business’s path to profitability. Cash raised is typically used for strategic purposes – expansion, recruitment or even M&A – with the aim of driving a higher valuation once it is time to raise further equity.

There are other advantages to this arrangement. Venture debt rarely requires the business owner to put up personal guarantees, or to comply with covenants. “We do keep a close eye on the cash runway of the business,” explains Bates, “but the traditional covenants on business loans aren’t appropriate for what are often still loss-making businesses.”

The funding can also be quicker to arrange because lenders don’t normally seek external due diligence; instead, they depend on the due diligence conducted by the VC investor when it backed the company.

Set against these advantages, the downside is the relatively high cost of venture debt – compared with equity, clearly, but also to other types of loan. And venture debt is not completely unsecured; the business will be required to put up collateral, typically in the form of a debenture against its assets.

In practice, venture debt usually incorporates three elements. There will be a headline interest rate: 9-12% is pretty typical in the current market, with most rates floating and pegged to a reference point such as Euribor. In addition, there will be fees to pay – possibly totalling as much as 2.5% of the loan approved and often split between upfront transaction charges and end-of-loan fees. Finally, lenders look for an equity kicker, often worth 10-20% of the loan. This is usually structured as a warrant, giving the lender the right to buy a small slice of equity – 1-3% is a common arrangement – at a fixed price during the term of the loan.

Over a term of, say, five years, the loan repayments will include both interest and capital, scheduled so the debt is completely repaid by the end of the term. This means businesses must be confident they will generate sufficient cash to service both a demanding coupon and repayments of principal, though there is typically the option to start with a period of interest-only payments – this might be for six to 12 months, or even a little longer. Loan sizes can vary significantly. Most commonly, venture debt providers offer between £2m and £10m of debt, but some arrangements are significantly larger.

Experience counts

Shane Barry-Lyons, an investor at Atempo Growth, one of the most prolific venture debt providers of the past year, says there is significant appetite among his peers to lend more. “We’re effectively underwriting the loan on the business’s ability to raise another round before the debt has to be amortised in full or the business’s ability to get to profitability and amortise the loan through operational cash flows,” he explains. “Set against these advantages, the downside is the relatively high cash interest cost of venture debt – compared with equity clearly, and other types of loan. The quid pro quo is that venture debt seeks only 1-3% equity ownership, whereas comparably sized equity rounds seek more than 10%.”

Nevertheless, lenders tend to be relatively cautious; while venture debt providers will rank as the senior debtors, they’re also conscious that they’re offering finance to early-stage businesses still striving for sustainability. Atempo, Barry-Lyons explains, wouldn’t typically expect to lend more than 10-15% of the enterprise value of the business, or more than 40% of the value of the previous equity raise.

Moreover, while lenders have a safety net, in that they expect to be repaid from the next raise, they are still demanding about borrowers’ growth prospects, warns Greg Forde, a Deloitte director specialising in venture debt. “They will be assessing a number of the metrics that VCs focus on.”

Indeed, many lenders have an informal target in mind – the ‘rule of 40’. They look for projected growth in enterprise value and EBITDA over the term of the loan to add up to a percentage of more than 40.

As a result, businesses in certain sectors of the economy have tended to find it easier to secure venture debt. Fast-growing digital and technology businesses are an obvious target for lenders – particularly in the SaaS market, where recurring revenues from subscriptions provide the lender with additional comfort even if they’re not yet sufficient to provide profitability. Business services, healthcare and pharmaceuticals are also hot sectors.

It’s also the case that businesses lacking the right VC support may struggle to secure finance. “Venture debt providers are quite often looking to work across the portfolio of the VC, so if you don’t have a well-known and trusted backer it may be harder to secure funding,” adds Navarro Motilva.

Innovation ongoing

The venture debt market continues to change with the times, particularly as new players also evolve. Variations on the theme include asset-backed lending arrangements and hybrid venture debt structures in which lenders are more demanding in terms of covenants. Private equity-backed companies are also beginning to explore venture debt, although lenders are cautious given the potential for conflicting interests in the event that a business backed by a single PE house runs into trouble.

In addition, the advent of aggregators, such as the Amazon business acquirer Thrasio, has seen venture debt providers increasingly investing in roll-up strategies. Thrasio itself has raised hundreds of millions of dollars of debt alongside equity in order to pursue an aggressive strategy of acquiring ‘fulfilled by Amazon’ businesses. Venture debt providers have subsequently supported similar strategies in markets ranging from dentistry to social media influencers. They provide a debt facility that can be drawn against as the borrower identifies each new target.

Atempo’s Barry-Lyons expects to see further evolution of the model, as well as increased take-up of conventional venture debt. “As we move into a period of reduced equity availability, these capital-efficient structures are going to become more and more important,” he says. “Not so long ago, equity was ubiquitous – that’s no longer the case.”