Why it matters:
- Venture capital funding in the U.S. dropped to $238 billion last year from $345 billion in 2021, Pitchbook and the National Association of Venture Capital reports.
- As venture capitalists tighten their purse strings, startups are tapping venture debt — a loan or line of credit, usually with rights to buy company warrants (the right to stock options) that is often backed by a startup’s assets — for expansion capital in this uncertain economic environment.
- Companies that have robust revenue growth and are backed by venture capital investors are strong candidates for this form of funding.
In October, when James Budge, Chief Financial Officer of Automation Anywhere, needed expansion capital for his private company, he didn’t turn to his long list of prestigious venture capital investors that include SoftBank and New Enterprise Associates. Instead, he opted for venture debt, a form of alternative finance to shore up its cash coffers.
That may seem surprising considering the company – which automates business functions with its robotic process automation (RPA) software — is a darling on Wall Street. It’s already raised $1 billion in equity capital as it readies itself to go public this year.
But like many startup executives trying to grow their private companies amid a looming recession, venture capital isn’t as attractive a financing option as it has been over the last three years. VCs have tightened their purse strings and they are now demanding more equity from the ventures they invest in due to the economic downturn and stock market volatility.
The trend is reflected in the latest quarterly report from Pitchbook and the National Venture Capital Association, which showed a sharp decline in the amount of VC funding last year. According to the report, $238 billion in venture capital was invested in 15,852 deals, versus $345 billion in 18,521 deals in 2021.
“It’s a sign of the times,” said Budge, considering the go-go days of raising venture capital are over. Venture capitalists have become more selective on the kinds of deals they will fund, and deal-making has slowed. As a result, entrepreneurs are turning to alternate forms of financing including venture debt for capital to grow their businesses.
Looking beyond VCs: Startups with healthy revenue growth draw venture debt financing
Venture debt isn’t anything new. It’s been around for decades. It’s a loan or line of credit, usually with warrants — options that give the holder the right to buy a company’s stock sometime in the future — that are often backed by a startup’s assets. It is typically offered by specialized banks or lenders to help fast-growing, VC-backed companies get bridge financing until they are ready to raise another round of venture capital — or go public.
Venture loans are most often structured as three- to four-year term loans with an interest-only period of six months to two years, and then amortize over the remainder of the term.
Last year, lenders anted up $29.3 billion in venture debt through November 30 to companies of all sizes, according to Pitchbook.
Startups that have healthy revenue growth and are backed by venture capital investors are top candidates for this form of funding.
For example, Automation Anywhere generated revenue growth of 50% in 2022 and attracted over 15 potential venture debt lenders when it shopped around for financing last fall.
In the end, the company chose $200 million in venture debt financing arranged by Silicon Valley Bank and Hercules Capital. It is composed of a $125 million five-year debt loan and a $75 million line of credit. Warrants are also part of the deal.
The financing will fund product development and acquisitions in the months ahead as Automation Anywhere grows its business and works to becoming profitable, Budge said.
The company has been on a growth trajectory since its inception in 2003 when it was an early entrant into the $2.9 billion RPA software market. Since then, it’s evolved into a 2,000-employee company that serves over 5,000 customers worldwide including Dell, Humana, KeyBank, and Stanley Black & Decker.
As Budge explains, the company’s technology combines artificial intelligence, machine learning and robotic process automation to automate mundane repetitive tasks – such as HR onboarding, claims and data processing, and medical charting — through bots so workers can be redeployed in other areas of a company, boosting productivity. It’s helped companies like Stanley Black & Decker automate its data processing operations and save millions of dollars, he said.
As venture capitalists tighten their purse strings, startups are tapping venture debt — a loan or line of credit, usually with rights to buy company warrants (the right to stock options) that is often backed by a startup’s assets — for expansion capital in this uncertain economic environment.
Know the caveats of venture debt financing — from high interest rates to equity expectations
It’s not surprising that venture debt financing is now in vogue for companies of all sizes. “Demand has grown since the second quarter of 2022,” Marc Cadieux, Chief Credit Officer for Silicon Valley Bank, the largest venture debt lender in the U.S., told CO—, “along with a drop in VC investment.”
But to qualify for this form of alternative financing, companies must have good fundamentals. They must be scaling their business and growing revenues. And they must have VC investors they can tap if they need more venture capital in the future, Cadieux explained.
There are also caveats to be aware of with this form of finance. Interest rates on these loans can be high. “They are typically based on the prime rate [the interest rates banks charge for loans], plus a 6% to 10% [interest rate] spread,” said Zack Ellison, Managing General Partner of Applied Real Intelligence (A.R.I.), a Los Angeles-based venture debt provider.
Another key consideration is that these deals come with warrants that typically range from 0.5% to 1% of the equity in the company, he noted. (“However, while the total cost of venture debt may seem expensive, it is typically only 25% to 50% of the cost of equity,” Ellison added.)
What’s more, “Keep in mind there is a blanket lien on all company assets, sometimes even the intellectual property of a company,” said Diane Earle, Chief Credit Officer at Horizon Technology Finance, a business development company focused on venture debt lending. That means if the borrower defaults on the loan, the lender can seize all business assets as collateral.
You need to be cautious with this form of financing, according to Gary Mittman, founder and CEO of Kerv Interactive, a startup that has developed a digital video shopping platform that is now being used by ad agencies such as Publicis and Omnicom. “It could kill you if you cannot afford to carry the debt,” he points out.
He learned this firsthand when he raised $4.5 million in venture debt from Trinity Capital in April. He found out there are contingency variables in deals he had to be aware of. In some cases, you must maintain a certain level of revenues or pay a penalty. Warrants are generally exercised when a company raises its next funding round or has an acquisition or IPO, he said.
An attractive financing alternative: ‘A cash cushion we can use to expand into new markets’
Despite the potential downsides, many entrepreneurs think venture debt is an attractive funding option to use so they can hit their strategic business goals.
Kin Insurance, a six-year-old Chicago startup, can attest to that. The company that provides homeowners insurance direct to consumers through its licensed online network raised $145 million in venture debt in October thanks to the fact that revenues grew 120% last year and are expected to grow by 60% in 2023. The financing was led by Runway Growth Capital LLC and Avenue Venture Debt Fund.
The money will be used as a capital base to meet financial regulatory requirements in the states it operates in. “It’s also a cash cushion we can use as we expand into new markets next year,” says Sean Harper, CEO and Co-founder of Kin Insurance, who notes the startup has raised $240 million in venture capital since its launch. Notable investors include Nigel Morris, the Co-founder of Capital One Financial Services, which backed Credit Karma and Commerce Ventures.
Kin has disrupted the insurance market in the U.S. by aiming to make it easier and more affordable to buy homeowners insurance online. Since it cuts out an agent or middleman, Kin’s product saves individuals an average of $600 per year, Harper said. A customer just goes to the website, enters their address, customizes the type of coverage and deductible they want, and pays for a policy through their mortgage escrow or directly to Kin.
The company’s proprietary data analysis software tool taps into such data sources as property records, permit data, and aerial imagery to get a nuanced understanding of the physical properties of homes and how they’ll be affected by extreme weather conditions. This provides an understanding of the physical properties of homes and how they will be impacted by extreme weather and other risks so policies can be customized to suit customer needs.
Kin currently has 105,000 policyholders in Florida, Louisiana, and California, garnering $230 million in gross premium income. Plans are to enter new markets in Alabama, Michigan, Mississippi, South Carolina, and Texas next year.
For those entrepreneurs thinking of raising venture debt, Kerv International’s Mittman offers this advice: “This is a great alternative if your company has strong revenues and is on the path to profitability but be sure to assess the pros – and the cons,” he said.
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Published January 18, 2023