- As VC funding declines and equity becomes more expensive, venture debt volume is on pace for a record year led by large, late-stage debt deals.
- Venture debt can be a useful tool for cash-burning companies. The median non-bank venture debt facility has the potential to increase runway by up to a year.
- Companies should carefully consider factors like growth rate, revenue model, burn rate and IP strength to help determine the optimal amount of leverage; too much can hamstring a business.
Over the past two years, VC investment in the US has decreased 47% – nearly 60% if AI is excluded. At the same time, the cost of equity has increased, with the median late-stage tech valuation down 40% since 2021. This puts many founders in quite the predicament: to raise capital, they’ll have to face higher dilution rates — or at the very least, tougher terms.
Founders of cash-burning companies that rely on ongoing access to capital (debt and equity) to finance operations are increasingly realizing the importance of less dilutive capital in their capital stack, chiefly venture debt.
This is evidenced by the upward trajectory of venture debt over the past decade. Since 2014, the total volume of US venture debt deals has grown by 17% annually.1
2024: A record-breaking year for venture debt
As the chart below shows, US venture debt deal volume dipped in 2022 and 2023 after peaking in 2021, mirroring the trend in VC funding. This year is set to break records thanks, at least in part, to larger deal sizes and a growing number of lenders targeting innovative startups. Excluding CoreWeave’s $7.5B debt raise in May (which is closer to an infrastructure deal than venture debt), 2024 annualized venture debt run rates remain largely in line with the five-year moving average.
Meanwhile, the average deal size continues to tick upward, with the YTD 2024 total (excluding the CoreWeave deal) at $46M, up 125% from $20.4M in 2020. This spike in deal size shows that large, later-stage companies are increasingly raising venture debt to access additional capital.
It’s important to consider the limitations of data on venture debt. Due to the private nature of many venture debt transactions, industry-wide investment amounts are likely understated.
Debt-to-capital ratios for tech startups
Among public tech companies, debt levels have fluctuated over time. In the wake of post-pandemic stimulus and the “cheap money” era, public tech companies increased their use of debt. Debt-to-capital ratios rose to their highest levels in 2022. Starting in March 2022, however, the Fed and other central banks began to hike rates, and debt levels decreased in tandem.
Private tech companies are generally less sensitive to changes in interest rates since the cost of equity is so high that even a 3% change in interest rates likely won’t meaningfully change the cost of debt relative to equity. That said, as debt for a VC-backed companies grows, so does the cost of servicing debt. Debt service includes interest expense, other loan fees and the principal. At low levels of debt service, founders can avoid dilution while using a modest percentage of burn to pay for the interest expense. This is especially the case with venture debt provided by non-bank lenders that tends to have less (sometimes zero) amortization, leading to low levels of debt service as the principal does not need to be repaid quickly.
At these low levels of debt service, companies and founders potentially get the most value from debt if the business is still burning cash and other liquidity resources are tight.
Read next: SVB’s innovation economy outlook, the 2024 State of the Markets Report
Fueling growth with venture debt
The data underscores the strategic role of venture debt in the capital stacks of large, later-stage companies as a substitute for additional equity financing, often at a significantly lower cost.
For cashflow negative companies, venture debt can significantly extend runway at a fraction of the cost of equity, preserving shareholder value and enabling the company to achieve key milestones. This can lead to greater enterprise value creation, less dilution and ultimately better outcomes for management, employees and investors.
Source: PitchBook Data, Inc.
For high-growth, capital efficient companies, longer runway can increase a founder’s ownership without resorting to dilutive equity financing.
To demonstrate, imagine that a company raises $100M on $500M post-money. In this case, 20% of the company is acquired. Let’s say the company ends up needing $50M to reach its next milestone, at which point it will benefit from a key valuation inflection point. To bridge the $50M intermediate gap, the company can either: 1) raise $50M on terms consistent with the original round, resulting in an additional 10% dilution, or 2) draw on a debt facility with less than half a percent of dilution in the form of warrants.
Read next: The benefits of venture debt
How to size your debt facility
Given the advantages of venture debt in minimizing costs and dilution, it might seem logical that debt be the primary source of capital for high growth, later-stage startups. Yet, most capital should (and does) come from equity financing – with debt serving as a complementary tool.
Determining the optimal debt-to-equity ratio is a challenge every founder faces, and a decision we believe is more art than science. Still, there are certain metrics we consistently evaluate when sizing a debt facility for our clients:
1. Debt to company size
A company’s size is measured by annual recurring revenue (ARR) or gross profit. Companies that have consistent recurring sales are best benchmarked to ARR or other revenue metrics. On the other hand, a deep tech company is often best benchmarked to a measure of profitability such as gross profit given the product costs are far higher compared to software and revenue streams are often less predictable.
An acceptable amount of leverage is around 0.5x to 1x debt to ARR. While many lenders may exceed this amount, we advise against it as it could be detrimental to a company’s ability to raise capital in the future.
2. Debt to equity
This measures how much debt the company is taking on relative to the size of the last equity round (or sometimes total equity raised) and/or total equity raised to-date. It is often favored by bank lenders and measures debt’s share of the capital stack.
We generally aim for a debt-to-equity ratio of 10-20%. That said, for many capital-efficient companies, the ratio might be as high as 100%, or even irrelevant as a benchmark.
3. Debt to valuation
This metric, also known as loan-to-value or LTV, shows the loan as a percentage of the company’s valuation. It is more commonly used by non-bank lenders.
The benchmark for debt-to-valuation ratio has been volatile due to recent market fluctuations. Ideally, the debt shouldn't exceed 25% of the total valuation, and likely lower for companies with a potential valuation overhang.
Read next: How do lenders think about loan types?
Determining the right amount of leverage
Recently, given more competition in debt markets (from bank and non-bank lenders) and near-record dry powder among debt funds, lenders have begun offering ever larger commitments to companies. While these large quantums can be attractive to founders and investors, not to mention appropriate in some cases, it is important to avoid becoming over-leveraged. Taking on too much debt can hamstring a venture-backed company by limiting future fundraising, diluting shareholder value and potentially forcing a premature sale.
When determining optimal leverage, founders should keep these principles in mind:
Growth rate. High growth companies can take on more debt than those growing at a lower level, as they will more easily and quickly scale into the larger facility size as their valuation increases. Still, if top line performance doesn’t meet expectations, the business can become over-leveraged compared to its size.
Revenue model. Companies with recurring sales, such as those with Software-as-as service (SaaS) or Hardware-as-a-service (HaaS) models, are often able to take on more debt as their revenue streams are more predictable than those operating with a one-time sales model. They also typically have the opportunity (generally) to generate higher cashflows over time.
Defensibility of IP. Companies that have more defensible intellectual property (IP) can generally take on more debt as they are insulated from a potential race to the bottom in terms of pricing when other companies compete, which can crush margins. Margin compression can lead to a scenario where the business is over leveraged.
Burn rates and runway. Companies with high burn rates or low runway can quickly become over leveraged and do not have enough time to grow into key business milestones. If companies have high burn that is not mitigated by high efficiency (offsetting growth), equity should typically be the core funding mechanism.
Use case. Debt should be used to drive underlying growth in the business. If the company is drawing on the debt facility and is using the capital for non-value creating activities, the company can become over-leveraged.
Read next: What’s the right amount of venture debt?
Avoiding pitfalls
Thus, companies should be mindful about how much debt they need and should use. A trusted lending partner with a good reputation is important both in helping to determine optimal debt sizes and in following through on their commitments to the company. For instance, some lenders offer too-large debt facilities to entice borrowers. Making matters worse, many fail to follow-through on these commitments. Some use the material adverse change (MAC) clause to back out of their lending commitment if they feel something has materially changed in the business. Others may offer uncommitted accordion facilities, which require the borrower to request drawdowns from the facility they already have in place and permit the lender to not honor the request if they don’t like the performance or do not have the actual lending capacity.
Read next: The “Four Cs” of choosing a venture debt lender
Every company’s capital needs are unique. As the number of venture debt providers grows, we expect debt volumes to continue to rise, with debt playing an increasingly important role in the financing strategies of top venture-backed companies.
Our Strategic Capital team, with a combined 90 years’ experience in lending to innovative companies, partners with later-stage startups day in and day out to determine the role debt should play in helping them reaching their next milestones. Since its inception in 2011, the team has committed $4.5B to 420+ deals across technology, life science and healthcare. Our flexible financing solutions including larger venture debt, mezzanine, private company convertible notes, cater to the diverse needs of growth stage companies.
As a lender who’s ‘seen it all’ throughout market fluctuations, we know there is one constant: debt will continue to be a valuable tool in a VC-backed company’s capital stack.
