Venture debt: start-up borrowing fails pandemic test

Venture capital investment updates

Venture debt is the financing method of the future. It looks set to remain so. Lenders are cutting prices and loosening terms in an effort to hold their own as money floods into Silicon Valley equity. They were supposed to have a great year in 2020, amid collective belt tightening by equity investors. It never happened. The pandemic boosted tech stocks instead.

Total outstanding venture debt reached $28.2bn in 2019 — up fivefold from 2010, according to Pitchbook data. But 2020 did not top that figure. The number of early-stage debt financings in the US fell compared to the previous year. The sums involved are still dwarfed by equity deals. The median venture loan last year was $2.9m. The median late-stage VC deal was $10m.

Start-ups most commonly sell venture debt after Stage C funding rounds. Most is short term, senior in rank and may bear equity warrants allowing investors to buy shares later. Silver Lake and Sixth Street Partners made a near 100 per cent return lending to Airbnb last year before the home rental company went public.

Low interest rates in the US, where the 10-year Treasury yield is 1.43 per cent, have increased demand for high-yield debt. But venture lender Applied Real Intelligence estimates that three quarters of the market is still controlled by just 10 commercial banks and lenders, including Silicon Valley Bank.

Control means terms that benefit lenders. Losses have been low — at 0.5 per cent annually over the past 15 years. For lenders, annual returns are between 15 and 25 per cent, ARI says.

Existing equity investors like debt funding because it dilutes their ownership less. That explains why they often help start-ups secure loans. Companies without a strong record of cash flows risk default and even collapse.

Large private companies are borrowing more than they did a decade ago. But venture debt is set to remain a minority pursuit. The fortunes of most tech start-ups are too unpredictable for borrowing to seriously challenge equity as a significant form of capital.

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