Are they the new round of adventure?

In the first seven months of the year, venture capital (VC)-backed companies in the United States raised nearly $15.9 billion in debt through 321 deals, according to data from Crunchbase. Startups disclosed more than $13.3 billion in debt across 320 acquisitions at the same time in 2021.

Debt experts say the growth is real

While it’s crucial to note that these numbers aren’t exhaustive, and some entrepreneurs in industries like fintech frequently raise loans for working capital, the rise in debt coincides with many venture capitalists which cut their funding.

Here are some of the most announced debt financings this year:

  • Connecticut-based financial services firm Freepoint Commodities disclosed $2.6 billion in debt financing.
  • EdgeConneX, a Virginia-based leading infrastructure provider, closed a $1.7 billion loan transaction.
  • Liquidity Capital, a newcomer to alternative financing in New York, announced a fundraising of 725 million dollars.

Why is debt financing gaining momentum?

Subprime debt financing offers a business a loan that can be used for specific purposes; such as capital expenditures, liquidity for the next funding round, or acquisitions, as opposed to traditional equity investing, which dilutes existing owners. Lenders assess the loan’s risk profile based on upcoming funding rounds and the company’s ability to raise additional capital based on its strong performance and growing momentum, so it does not replace the equity investment entirely.

Since the debt is not secured by positive ongoing cash flow or corporate assets, which can be supported by regular loans or bank lines of credit, the financing model is ideal for growing businesses. In order to simplify the management of the companies’ capital structure, interest is paid on the first months of the loan and the terms of the loan are modified according to the maturity profile of the company.

Suppose you consider debt and credit facilities as more attractive alternatives for startups seeking capital, especially during a recession like the one we are currently experiencing. In this case, you will see that the number of companies obtaining loan capital seems to increase. There can be various causes for this. While some founders may find it difficult to seek venture capital, others may not want to as they prefer to avoid diluting ownership.

Clara, a Mexico-based expense management startup, said on Aug. 8 this year that Goldman Sachs had authorized it to fund up to $150 million. According to the release, the facility would allow Clara to expand its corporate card, accounts payable and short-term financing products for LATAM businesses. The company says it currently works with more than 5,000 companies in Mexico, Brazil and Colombia, and hopes to double that number by the end of the year. Notably, during a $30 million financing in May 2021, Clara’s estimated valuation was $130 million. Eight months later, he received a $70 million Series B led by Coatue and became a unicorn.

In August 2022, Yieldstreet disclosed that it had acquired a $400 million warehouse from Monroe Capital LLC in the United States. According to a representative of upstart alternative investment firm, Yieldstreet, this funding is the highest of its kind to date. Since its launch in 2015, the firm claims to have attracted over 400,000 clients and received over $3 billion in funding for various investment products. This is not typical corporate debt; it uses a warehousing facility, which means it’s intended to expand the pool of investments available to Yieldstreet’s platform users rather than paying for operations or general expenses.

This is a brief reminder that debt financings differ from warehouses because debt lends money for operating purposes. A line of credit is essentially what warehousing facilities are.

What to keep in mind before opting for debt financing

For risky debt, you need to make plans in advance to implement soon after a fundraiser. Everyone around the table – founders, venture capitalists and lenders – is happy and there is no adverse selection for lenders. You won’t be able to incur debt if you try to start something with less than six months of cash. It can be pulled far into the future if implemented after equity financing; it’s called a term commitment/levy, and gives the startup a lot of flexibility.

It is crucial to understand each term. The existence of things like MAC funding or investor drop-out clauses is often unknown to entrepreneurs. The lender can use these clauses to prevent the startup from receiving funds or causing a default once the funds are received. In both cases, the company is in danger and cannot rely on financing. So you need to know your lender, make sure your venture capitalists know your lender, and pay close attention to your terms.

Do not take out personal loans. Lenders frequently include numerous covenants in the structure of a transaction, such as minimum capital requirements. For example, if you continually keep $2 million in the bank, they will lend you $4 million. In this case, the actual amount of new capital you receive is only $2 million. Additionally, the potential for investor desertion or MAC clause may prevent you from actually using the funds.

Lenders are becoming increasingly cautious even as startup interest in venture debt is on the rise. Startups are reaching out for venture capital funding more frequently than ever. Lenders are also reducing dollar amounts for new commitments, shortening interest-only periods, asking for more terms, and becoming much more selective about which businesses they choose to finance.

Conclusion

Although debt financing seems to be increasingly in the headlines, it is too soon to declare an end to venture capital raises, as the industry appears to be undergoing an adjustment.

Ramp, a startup specializing in business cards and expense management, announced a fundraising round of $750 million to $8.1 billion, including $550 million in debt financing backed by Citi and Goldman Sachs. Following other fintech peers like Brex into the lending offering space, banking provider Mercury has announced it will launch its own venture debt offering. Mercury hopes to lend more than $200 million this year and about $1 billion over the next two years.

There is yet another thing that should be kept in mind.

Most business owners would only use debt financing if price was the only factor, thus avoiding ownership dilution. Due to the first rule of risky debt, this strategy is ineffective for high growth companies. You can start your business without venture capital funding, but venture capital debt is probably out of the question for your business. More conventional debt may be an option, but these require positive cash flows, such as cash flow-based term loans or asset-based lines of credit.

Since venture finance is for businesses that put growth before profitability, the venture lender would rather follow in the footsteps of reputable investors than take a chance on an unbacked business loan.

Venture capital debt is generally not available to early-stage companies. Regardless of their natural entry point, most venture capitalists (unlike most angel investors) often invest in many rounds and keep reserves of money for this purpose. Taking on significant seed-stage debt is certainly not ideal if additional equity is needed to fund the business, although you can find a loan with an angel investor-backed profile. Typically, institutional venture capitalists don’t want to see a significant portion of their new equity paying off previous debt.

Also remember the major debt rule. You have to pay it off at some point, either in full or through debt consolidation, and you can’t predict in advance how inconvenient that day will be.

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