Are they the new venture round?

In the first seven months of the year, venture capital (VC)-backed businesses in the U.S. raised nearly $15.9 billion in debt through 321 deals, according to Crunchbase data. Startups disclosed over $13.3 billion in debt in 320 acquisitions by the same time in 2021.

Debt experts claim that the growth is definitely real

While it is critical to note that these numbers are not all-inclusive and that some entrepreneurs in industries such as fintech often take out loans for working capital, the increase in debt coincides with many venture capital firms cutting back on funding.

The following are some of the most highly advertised debt financings of the year:

• Connecticut-based financial services company Freepoint Commodities disclosed a $2.6 billion debt financing.

• EdgeConneX, a Virginia-based provider of edge infrastructure, completed a $1.7 billion loan transaction.

• Liquidity Capital, a newcomer to alternative financing in New York, announced a loan application of 725 million dollars.

Why is debt financing gaining momentum?

Venture debt financing offers a business a loan that can be used for specific goals; such as capital expenditure, liquidity for the next equity round, or acquisitions, as opposed to traditional equity investments, which dilute existing owners. Lenders assess the loan’s risk profile based on upcoming equity rounds and the company’s capacity to raise additional capital based on its strong performance and growing momentum, so it does not completely replace equity investments.

Since the debt is not guaranteed by ongoing, positive cash flow or the company’s assets, which can be taken care of by regular loans or bank lines of credit, the financing model is ideal for growing businesses. To make it easy for companies to manage their capital structure, interest is paid over the first months of the loan, and the loan terms change according to the company’s maturity profile.

Imagine considering debt and credit facilities as more attractive options for startups looking for capital, especially during a downturn like the one we’re currently experiencing. If so, you will see that the number of businesses raising loan capital appears to be increasing. There can be a number of reasons for this. While some founders may find it challenging to seek venture capital, others may not because they would rather avoid diluting their ownership.

Clara, an expense management startup in Mexico City, said on August 8 this year that Goldman Sachs had authorized it for funding worth up to $150 million. According to the statement, the facility will enable Clara to expand its corporate card, accounts payable and short-term financing products for companies in LATAM. The business claims it currently works with over 5,000 businesses in Mexico, Brazil and Colombia, and it hopes to double that number by the end of the year. Notably, at the time of a $30 million funding in May 2021, Clara’s estimated valuation was $130 million. Eight months later, it had received a $70 million Series B led by Coatue and became a unicorn.

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

This is a brief reminder that debt financing differs from warehouse facilities because debt lends money for operating purposes. A line of credit is essentially what warehouse facilities are.

What you should keep in mind before choosing debt financing

For venture debt, you need to make advance plans to be implemented shortly after an equity raise. Everyone at the table – founders, venture capitalists and lenders – is happy, and there is no adverse choice for the lenders. You won’t be able to get debt if you try to start something with less than six months of cash. It can be scaled back far into the future if implemented after equity financing; this is known as a forward commitment/drawdown, and gives the start-up a large degree of flexibility.

It is crucial to understand each and every term. The existence of things like funding MACs, or investor break clauses, are often unknown to entrepreneurs. The lender can use these clauses to prevent the startup from receiving funds or cause default once funds are received. In both cases, the business is at risk and cannot rely on the funding. So you should be aware of your lender, get your venture capitalists to be aware of your lender, and pay close attention to your terms.

Do not take out personal loans. Lenders often include a number of conditions in a deal’s structure, such as minimum capital requirements. For example, if you continuously keep $2 million in the bank, they will lend you $4 million. In that case, the actual amount of new capital you receive is only $2 million. In addition, the potential for investor desertion or MAC clause may prevent you from actually using the funds.

Lenders are becoming increasingly cautious even though start-up interest in venture debt is on the rise. Startups are contacting venture funding more often than ever before. Lenders are also reducing the dollar amounts for new commitments, shortening grace periods, asking for more warrants and becoming much more selective about which firms they choose to finance.

Conclusion

Although debt financing appears to be making more headlines, it is too early to declare the end of venture capital raisings as the industry appears to be adjusting.

Ramp, a business card and expense management startup, reported raising $750 million to $8.1 billion, $550 million of which was debt financing backed by Citi and Goldman Sachs. Following other fintech peers such as Brex into lending, banking services provider Mercury has announced it will launch its own venture debt offering. Mercury hopes to lend over $200 million this year and about $1 billion over the next two years.

There is one more thing that should be kept under consideration.

Most business owners would only use debt financing if price was the only factor, avoiding dilution of ownership. Because of the first rule of risky debt, this strategy is ineffective for high-growth companies. You can start your business by forgoing venture financing, but venture debt is probably out of the question for your business. More conventional debt may be an option, but they require positive cash flow, such as term loans based on cash flow or asset-based lines of credit.

Since risk financing is intended for businesses that put growth ahead of profitability, the venture lender will instead follow in the footsteps of reputable investors rather than take a chance on a loan to an unsupported business.

Venture debt is usually not available to seed-stage companies. Regardless of their natural entry point, most VCs (unlike most angel investors) often invest in many equity rounds and hold cash reserves for this purpose. Taking on a significant amount of debt at the start-up stage is definitely not ideal if additional equity is needed to finance the company, even if you can find a loan with an angel-backed profile. Typically, institutional VC investors don’t want to see a significant amount of their new equity pay off previous debt.

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