Debt funding is an interesting option for start-ups in two scenarios: you can increase your funding base while times are good in order to maximize growth or you can use it stretch your runway when equity raises are tougher (or you don’t want to price your equity). But as the equity funding market is cooling down, we see the impact rippling over to the venture debt market as well. To understand this trend, we need to look at the two kinds of venture debt players in the start-up landscape today:

1. Specialized debt funds (e.g. Wellington, WTI, Vistara) that provide debt based on the start-up’s ability to pay back that debt through either cash flow or – if things don’t go that well – the liquidation value (e.g. assets)
   
2. A number of banks that are focused on start-ups (SVB, Comerica, etc.) that provide venture debt to a start-up often with the expectation that the start-up can pay back that debt with its next round of equity financing. These venture debt providers often consider the fundraising strength of the start-up, including the brand of the existing investors.

When the equity financing market was hot, the banks got much more aggressive in handing out venture debt: they wrote larger cheques, made their loans cheaper, got more creative in lending, and extended credit to companies in earlier stages. As funding rounds came together faster and faster, for larger and larger amounts, this second group of venture debt providers was more than happy to provide bigger debt amounts on top of the equity raises.

At the same time, many of the more traditional venture debt providers found themselves priced out of the market. It became increasingly risky to provide debt to companies that were growing quickly, but also had very high burn rates and sometimes unsustainably low gross margins. And, equity markets were providing cheap alternatives for raising capital.

Now that the equity funding party has stopped (or at least calmed down), the banks are starting to reverse course. They’re now asking start-ups to refinance their venture debt and/or they’re placing very restrictive terms on the debt. As a result, start-ups that have relied on venture debt might feel a bit of a squeeze over the next year or so.

Venture debt can be an important complement to a start-up’s financing strategy, especially after you have found product-market fit and you know how to scale sales & marketing. Before that, there are too many unknowns and debt can be dangerous, in particular when markets turn like they have in the past few months.

 

Thanks to Mark Macleod of SurePath Capital for reviewing an earlier draft of this post.