February 21, 2024

there are many Questions surrounding the impact of the Silicon Valley Bank (SVB) collapse have remained unanswered for a long time. But there’s one question many startups and investors want answered sooner: What happens to venture debt?

SVB is one of the largest (if not the largest) providers of venture debt to U.S. startups. Now that the First Republic Bank is also down, the problem is getting more complicated.

Many startups rely on venture debt: both as a cheaper alternative to raising equity and as a capital vehicle that helps companies build in ways that equity isn’t suitable for. For some companies in capital-intensive sectors such as climate, fintech and defense, access to debt is often the only way to grow or scale.

Thankfully, venture capitalists aren’t too concerned about the overall impact of SVB’s collapse on venture debt.

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TechCrunch+ surveyed five active investors across fund sizes, stages, and areas of focus to get an inside look at the state of venture debt. All of them agree that even in the turmoil, risky debt will still go to companies that are looking for it — it just might be a little harder for some to get it.

“With industry stalwarts such as SVB and FRB down, we suspect it will be harder and more expensive to acquire venture debt, as partners historically viewed as “fringe” are less flexible on factors such as size, or impose stricter rules. We will see how Stifel, HSBC, JPMorgan (and FRB) and First Citizens will act in the market,” said Simon Wu, partner at Cathay Innovation.

Sophie Bakalar, a partner at Collab Fund, said that while the process and planning required to raise venture debt will change, it remains an excellent resource for growth companies.

“Venture debt has its advantages, more than ever,” Bakalar said. “It encourages founders to build rather than grow, which is a good thing when we think about innovations that can last for decades.”

But some investors believe the process and underlying business fundamentals needed to secure venture debt could change.

“Our prediction is that venture creditors will start to rely less on corporate ‘loan-to-value ratios’ and start focusing instead on capital efficiency, profitability, etc.,” said managing director Ali Hamed. Partner at Crossbeam.

Read on to learn how the rising cost of capital is affecting venture debt, what investors are doing to educate their startups on how to raise debt, and which types of startups are best suited for this form of financing.

We interviewed:

Sophie Bakalar, Partner, Collaborative Fund

How have lending standards changed for startups looking to raise venture debt? (ARR growth, minimum cash balance, etc.)

The immediate answer is that our ongoing economic uncertainty has revolutionized today’s lending market in terms of lending standards and the cost of debt, especially for early-stage startups looking to raise venture debt.

In terms of lending standards, there has been a focus on revenue growth and profitability. Lenders are looking for startups with a track record of consistent revenue growth and a clear path to profitability. For unprofitable companies, this also means a scrutiny of unit economics, as lenders want to ensure capital is invested in value-added investments.

This means that startups with strong annual recurring revenue (ARR) growth rates and high gross margins are more likely to be approved for venture debt, regardless of market conditions. We have a saying in the VC world that good startups will always get funded, so there are always exceptions to this rule.

Second, we’re seeing lenders put more emphasis on minimum cash balances. Startups are expected to have a certain amount of cash on hand, usually enough to cover operating expenses for a few months, to demonstrate their ability to weather any financial storms that may arise.

Today, the focus of these months is more like more than a year. Additionally, in previous “risk on” markets, lenders were more likely to approve “covenant light” structures; in today’s environment, we expect and see lenders demanding tighter covenants.

Finally, we’re seeing lenders take great care in evaluating startup venture debt against the strength of the leadership team. Startups with experienced, proven management teams are considered less risky than those led by less experienced leaders, especially in uncertain markets. A strong leadership team can greatly reduce a crisis when it arises.

Are there certain types of startups that are no longer suitable for venture debt given the new market conditions?

Venture debt has its advantages — now more than ever. It encourages founders to build rather than grow, which is a good thing when we consider innovations that can last for decades.

When it comes to market conditions and types of startups, no one is immune. Everyone should carefully consider how this funding model will help their company perform. The first piece of information that banks and/or regulators typically look at is whether the company is generating revenue and represents a low compliance risk. Fintech companies may face tougher challenges in this regard.

We are still actively investing in climate tech startups focused on execution and problem solving. Some of these include startups that have already implemented venture-debt models.

In today’s environment, the cost of debt increases significantly as interest rates rise. This is an important factor for cash-burning startups to consider when considering monthly interest payments and the amortization of debt over time relative to revenue and other expenses.

How do you ensure startups are confident in their venture debt? How much education do today’s founders need on venture debt to make informed choices for their startups? Is it more or less than in recent years?

Education and resources around this type of debt financing will always be valuable for most startups, especially in today’s market. Founders whose funding plans include venture debt should start modeling scenarios that assume they don’t have access to that debt. Even if this risk seems small, it’s always good to be prepared.

Additionally, we try to help founders increase the sensitivity and robustness of their forecasts based on the covenants and downside protection required by lenders. For example, if revenue growth isn’t fast or margins are low, we want founders to understand the potential headwinds and make sure they have an adequate cushion.

Venture debt can be a good extension for growing, near-profitable startups, but it can be a drag on startups with high burn rates, especially if they perform below plan.

In a more conservative equity investment market, are tighter lending standards and more expensive debt enough to limit startups’ reliance on loan capital?

In addition to stricter lending criteria, lenders are more likely to spend more time making decisions and evaluating startups in this environment. While lenders are leaning into the gap in the market left by SVB, there may be less funding available, so lenders will be able to pick and choose more easily, in a slower and more deliberate manner than in 2020 and 2021.