How venture debt can bridge the funding gap in today’s uncertain market

Espresso Capital venture debt for startups

Although VC activity remained strong in the UK during the first quarter of 2022, the same cannot be said everywhere else. Recent data from Pitchbook and the National Venture Capital Association shows that the total value of equity deals in the US in the first quarter of 2022 was lower than in any quarter in 2021.

At the same time, inflation, rising interest rates, and political instability are conspiring to undermine confidence and usher in yet another period of macroeconomic uncertainty around the world. 

Valuations are down dramatically, too. The BVP Cloud Index, a popular benchmark for public SaaS companies, has declined more than 40% since November 2021. Weakness in public technology share prices has begun to impact earlier stage private market valuations and the terms upon which deals are getting done, as the entire sector adjusts to the new valuation environment.  

With greater uncertainty, management teams and boards are developing more conservative growth scenarios to help preserve cash. At the same time, many companies are also reconsidering their capital-raising strategies in the face of a cooling fundraising environment where flat or even down rounds are likely.

Fundamentally, they have to decide between waiting things out in the hope of being able to raise equity at a higher valuation in the future (and potentially foregoing near-term opportunities) and exploring alternative sources of capital to help fuel their continued growth, including venture debt. 

Longer funding cycles, deals that favour investors 

While the full impact of the current economic uncertainty has yet to be seen, a slowdown in VC activity here in the UK is very possible. If that happens, investors will likely seek to mitigate their risk by demanding additional protective provisions.

Although best-in-class tech companies will continue to secure investment on attractive terms, for many, the process of raising equity could very well become more challenging in several ways (as is already the case in the US): 

  • Term sheets could be issued much more selectively
  • Negotiations and diligence could take longer, exposing companies to more execution risk
  • Valuations could remain under enormous pressure as investors seek to insulate returns 
  • Investors may require more aggressive protection provisions

Faced with the prospect of longer processes, uncertain valuations, and less favourable investment terms, many companies may opt to put their plans to raise equity capital on hold.

If you’re the CEO or a board member of a tech company, you’ll be left with a choice: either reduce your need for capital or look for alternative sources of funding.  

Cash is king yet again  

With so much capital flowing into the sector over the past decade, many companies took the opportunity to invest heavily in growth as they sought to acquire customers and scale their business. Yet faced with market uncertainty and the prospect of a more challenging fundraising environment, many will need to reassess their growth strategies and put renewed focus on their cost structures.

That means eliminating or reducing expenditures where possible and prioritising investment toward activities that help drive new, or preserve existing, revenue. 

While cost reductions almost invariably come at the expense of growth, companies that have reached critical scale or have highly flexible operating models and can run their business without burning cash will be able to postpone new funding and wait out the storm.  

Of course, achieving positive cash flow may not be a possible, or even a desirable strategy for everyone. Some will simply not have reached the scale necessary to operate at break-even. And for those companies that are still growing, albeit at a slower rate than before, there’s a strong argument for continuing to make investments to support customer acquisition and retention.

Regardless of a company’s particular situation, having additional cash on the balance sheet during times of uncertainty can also serve to increase strategic flexibility (for example, to make opportunistic acquisitions) helping the company to not only survive but also thrive.

Indeed, indications are that boards are increasingly encouraging their companies to take steps to increase their target runway from 12 to 18 months to 24 months.  

Using debt funding to bridge the gap 

In light of the current environment, many companies and their investors will be re-evaluating their funding strategies. That includes using venture debt, a form of debt structured specifically for growth-stage technology companies, to extend their runway from anywhere from nine to 18 months and defer raising equity until market conditions normalise. For technology companies that need capital and are able to support debt, venture debt offers a number of attractive features for the current environment including:  

  •  Faster access to capital. Venture debt deals can close in as little as four weeks, and can often be completed without in-person meetings. 
  • Avoiding a potential flat — or even down — round. Venture debt can help companies avoid dilutive financing and defer raising equity until economic conditions — and valuations — have stabilised.
  • Avoiding suboptimal deal terms. These might include veto rights and unfavourable liquidation preferences. Debt financings don’t include such terms and, in contrast to equity, can be refinanced or renegotiated if necessary. 

Given the challenges of raising capital at favourable valuations in the current environment, many companies are turning to existing shareholders for funding. While existing investors may be willing to continue to support the business, they may not be able to meet the company’s capital requirements in full. In situations like these, venture debt can also be used to complement insiders’ investment to help the company secure the full amount of capital it needs and provide insiders confidence that the company has a fully-funded plan.

When considering venture debt, it is important to understand how the solutions different providers offer can differ in terms of debt availability (i.e. leverage) and deal terms such as covenants, amortisation, and overall pricing.

Generally, traditional banks’ solutions will be the least expensive but offer less leverage availability and have more structural elements. They also often have to be paired with a concurrent equity round.

In contrast, the venture debt solutions that non-bank providers such as specialized technology credit funds offer, can offer materially more leverage availability and structural flexibility. 

It’s not over yet 

There’s no playbook for managing through periods of massive uncertainty like the one CEOs and boards of directors find themselves in today. The macroeconomic landscape has had a material impact on virtually every aspect of running a high-growth technology business, including fundraising. 

While only time will tell what the long-term impact on venture funding will be, what’s certain is that companies will continue to face challenges that they can and can’t foresee.

Now more than ever, they should examine all sources of capital and ensure they are sufficiently funded to emerge from this period stronger than they entered it. 

Shane Jayaprakash is a director at Espresso Capital, a leading provider of innovative venture debt and growth financing solutions with offices in London, San Francisco, Los Angeles, Chicago, and Toronto.

Since 2009, Espresso has helped more than 300 technology companies and their investors accelerate growth, extend runway, and increase strategic flexibility with non-dilutive capital. Learn more at espressocapital.com.

This article is part of a paid partnership with Espresso Capital.