The ascent of Venture Debt (and why it matters)

29th October 2020  

by Gaia Giorgio Fedi

Venture Debt, or Venture lending, has experienced a tremendous growth in recent years. This alternative financing option for startups and scaleups, which does not substitute equity-based forms of financing but integrates them, offers many advantages, both for founders and investors, and has growingly gained in popularity.

According to Pitchbook, venture lending accounts from10 to 15 percent of the total VC capital invested. Although it still remains an underutilised option compared to VC, last year was an exceptional period for Venture lending, which exploded to $26,2 billion, and the positive trend should have continued in 2020. Especially under the particular circumstances created by the pandemic, when startups started turning loan-based forms of financing to solve their liquidity issues.

This success finds an explanation in the special characteristics of Venture Debt. From the founder's point of view, it has the advantage of bringing a smaller dilution effect. While in equity round the financing subjects subscribe new shares of the company, reducing the stakes of the existing shareholders, to an extent which is proportional to the dimension of the round, this does not happen with Venture lending. Yes, sometimes the lenders take warrants, giving them the option to subscribe a certain amount of new equity at the time of the exit, but even in this case the dilution effect is very limited. It also avoids a loss of control: lenders do not ask for board seats. And compared to conventional bank loans, Venture lending is more flexible, available in larger amounts, and it requires less covenants. And Venture Debt providers, unlike banks, act like real partners, supporting the company in many ways.

Furthermore, in times of crisis, or for companies facing a difficult phase in their life cycle, Venture lending also avoids down rounds: a company asking for an emergency equity round may indeed face a heavy drop in valuations, because the offer of financing may be reduced in difficult times or because the company has not yet succeeded in producing positive cash flows, or because the conditions of its sector are challenging. In this case, Venture Debt can serve as a cushion to extend the cash runway, to achieve better results, to make it through difficult times and then obtain an equity round at better valuations. Loan providers are inclined to support negative-cash-flow companies, as long as their perspectives are positive: Venture Debt, like Venture Capital, is a bet on future growth.

Another reason behind the recent success of Venture lending is that it focuses heavily on two sectors, technology and life sciences, which have been outperforming the general market during the pandemic.

Venture Debt has been around for around half a century. It started in the '70s, as equipment financing, when a growing number of early stage companies needed computers, hardware and other assets to expand their businesses but did not fulfill the conditions normally required to access traditional bank loans. On the supply side, many players – mainly banks – started offering forms of equipment financing, known as Venture leasing, to companies which were already backed by equity investors who would guarantee the business continuity in financing future rounds. The lenders also used to structure deals taking into account what the company had already secured in equity rounds, meaning that Venture Debt has always been a financing option integrating, and not substituting Venture Capital.

Then Venture leasing started growing heavily in the '90s, with tech companies reaching higher valuations, and a growing number of specialised lenders entered the market, providing debt financing to startups which wanted to integrate the equity funding avoiding an excessive dilution. In the following years, the early forms of leasing turned into more structured enterprise value loans (that secured all of the company's assets, not just its equipment), turning into proper Venture Debt.  

Today Venture Debt can assume various forms, such as term loans, revenue-based financing, equipment financing, convertible notes. This market has been growing rapidly in recent times but in Europe it's still relatively small compared to the U.S. market. In Italy it is also very small, but as the development of this market traditionally tracks Venture Capital's progresses, the introduction of recent measures to enhance the innovation ecosystem might also boost Venture Debt. Especially because, in a low rates/low yields worlds, asset management players are increasingly betting on illiquid investments to find alternative sources for their clients' returns, putting up vehicles and funds (Alternative PIRs, ELTIFs, AIFs) investing also on Venture Debt.