Key Takeaways
- Beyond helping accelerate rapid growth, debt financing can also be beneficial in bridging a gap between larger equity financing events.
- Venture debt is free of covenants, eliminating risks of unwelcome surprises later on.
- Reduction of equity dilution is another key attraction, enabling founders to retain more equity for themselves and/or to incentivise key employees.
Growing numbers of startups across Europe are overcoming their misconceptions and turning to venture debt as part of their financing needs.
Venture debt has been widely used for decades by fast-growing start-ups in the United States as a means of turbo-boosting funding rounds or giving themselves an additional cash cushion against any bumps lurking down the road.
But in the UK and Europe its usage has been much less common. Some founders fear onerous restrictions from debt covenants or just that the costs of this type of debt financing are too high.
The reality is very different, however. Firstly, venture debt is free of covenants, eliminating risks of unwelcome surprises later on.
Secondly, interest costs may be lower than many anticipate. Compared to the potentially much greater long-term costs of dilution from an equity raising, it is easy to see why many fast-growing innovative companies are turning to venture debt as part of their funding requirements.
So what exactly is venture debt? Venture debt encompasses a wide range of loans tailored to startup companies that have already raised equity from venture capital firms or other similar investors. Unlike conventional loans that focus on metrics such as historical cash flow, venture debt homes in on companies' ability to raise additional capital to fund future growth and to repay any outstanding loans.
Wide-ranging advantages
The benefits to companies can be wide-ranging:
- Gain increased financial flexibility for unforeseen events
- Lengthen the time between capital raising events
- Lower the average cost of capital
Some companies also turn to venture debt to guard against potentially challenging capital market conditions. GoCardless, a fintech offering solutions to simplify direct debit payments, took on venture debt early on in the COVID-19 pandemic, giving it a longer cash runway and greater flexibility over the timing of its next equity raising.
"When COVID and lockdown hit in March 2020, we wanted to ensure we had funding available to both pursue our long-term growth strategy and protect our revenue in the short term, given the likely impacts of the pandemic," explains Catherine Birkett, Chief Financial Officer at GoCardless.
"Using venture debt with SVB enabled us to have access to the capital we needed without diluting shareholders."
"It was not an ideal time to raise equity, so using venture debt with SVB enabled us to have access to the capital we needed without diluting shareholders. As a consequence, we had the freedom to continue to grow and invest in the business throughout the year, ending 2020 with a successful Series F fundraise," she continues.
Stay in the driving seat
For car-rental service Drover, acquired by the online used-car retailer Cazoo, the main appeal of venture debt was to give it more flexibility over the timing of future fundraisings.
"Venture debt has proven a pragmatic and time efficient way of financing growth and extending runway in between our Series A and B," says Drover CEO and founder Felix Leuschner. "While it's a financing form that comes with lots of T&Cs, we have experienced the reporting and corporate governance implications to be very manageable and believe venture debt was the right instrument for us at that point in time."
Boost growth
Debt finance can also be used to accelerate growth. Indeed, here at SVB, we are seeing more and more European companies using venture debt as growth capital, enabling them to:
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Launch more products
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Expand into new geographies
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Invest more in R&D or sales and marketing
This can mean that when the next capital raising comes round, they are raising money at a higher valuation.
A case in point is TrustPilot, the popular online consumer reviews website founded in Denmark in 2007. Today, the company numbers more than 700 employees and registers almost seven billion impressions a month on its Trustbox widgets.
"Debt financing can operate as a helpful non-dilutive supplement to equity in fueling growth."
Peter Holten Mühlmann, the company's co-founder & CEO, is a strong supporter of venture debt, having used such funding from SVB to invest in the company's product offering.
"Debt financing can operate as a helpful non-dilutive supplement to equity in fueling growth," he says. "Beyond helping us accelerate our rapid growth, debt financing can also be beneficial in bridging a gap between larger equity financing events."
Minimise equity dilution
Reduction of equity dilution is another key attraction, enabling founders to retain more equity for themselves and/or to incentivise key employees. This was a key attraction for Signal AI, a media monitoring company which uses artificial intelligence to help companies track critical information in real time. The company has twice used venture debt as a means of minimising equity dilution, including securing a £6 million debt facility from SVB in 2020.
"Debt is a non-dilutive and efficient way to fund the business outside or alongside equity," says David Benigson, the company's founder and CEO. "As our business continues to scale and grow, using non-dilutive channels of funding is highly attractive."
Having started life with three people in a garage in 2013, Signal AI now counts more than 150 employees across offices in New York, London and Hong Kong with numerous Global Fortune 1,000 businesses as its customers.
In addition to interest costs, venture debt typically comes with an arrangement fee (usually up to 1%) and sometimes also a back-end maturity fee (again usually up to 1%) as well as a warrant giving the lender the right to purchase shares at an agreed price.
Take a simple example of a company valued at $100 million looking to raise $10 million in equity, a move which would require the founder to give up 10% of the business. By opting instead to take a portion as venture debt — say $3 million which might typically come with a 0.5% warrant – the founder would instead be getting $10 million of capital whilst giving away just 7.5% of the business. It is easy to see how, when following this approach over several capital rounds, equity dilution can be significantly reduced.
Stay in control
Clearly the obvious drawback of debt over equity is that debt does need to be repaid. However, plenty of flexibility can be built into venture debt agreements such as capital repayment holidays or tranches, whereby additional debt facilities are only made available as key milestones are met. To support our lending clients during the pandemic, SVB introduced a debt deferral scheme to all borrowers giving them a break from capital repayments for six months.
There are other welcome advantages of venture debt, too. Some venture debt lenders may insist on taking a board observer seat or having voting rights. But, at SVB we don't, thereby distractions for business owners are minimised.
"The best of both worlds - venture capital to fuel growth, and venture debt to enable us to continuously invest..."
We readily admit that venture debt will not suit every situation. But if you're a founder and you are looking to extend your cash runway and you are constantly getting people showing you equity tickets, we would just say stop and consider debt as it is less dilutive.
Ken MacAskill, CFO at Snyk, a cybersecurity company that develops security analysis tools to identify vulnerabilities in open-source solutions, agrees, insisting that venture debt is a "cost-effective component of our capital structure."
"Venture debt can be a very flexible, non-dilutive way to extend your cash runway and time between equity rounds, which is particularly valuable in periods of high growth, to allow you to maximise your valuation between rounds," he says.
Find the right financial partner
Whatever the debt solution, however, it is important to seek out the right financial partner. With over 40 years' experience in lending to startups, a period encompassing a dot-com boom and bust, a global financial crisis and now a worldwide pandemic, SVB believes we have the patience and experience to be a truly supportive partner.
For Valentina Milanova, CEO and Founder of Daye, which is pioneering the development of cramp-reducing tampons, the right partner is crucial.
"Through venture debt with SVB, Daye got to enjoy the best of both worlds – venture capital to fuel growth, and venture debt to enable us to continuously invest in R&D projects that will pay off in the long term. We wouldn't have been able to deliver on our promise for genuine product differentiation if we didn't have venture debt at our disposal," she says.
Raising your first or subsequent rounds of fundraising can be a major challenge. Take the time to consider which fits your financing needs best. If you've already raised equity from venture capital firms or other similar investors, consider venture debt. It might just be what you need.
Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup's early life. And, for the latest trends in the innovation economy, check out our State of the Markets report.