Venture Debt

Our Head of Denmark is doing a series of articles for the Danish tech media @Bootstrapping, where he processes #TechLending. We publish the English versions in our LinkedIn channel. We pass the ball to Kim…

… My first article took an introductory approach to tech lending, fintech, and general business development. This second article deep dives into #VentureDebt.

Personally I have been working with venture debt loans in Denmark since the start of 2018. During the past 4 years, I have seen an enormous progress in the distribution and acquaintance with venture debt in Denmark, and also in Europe as a whole. If we leave the UK out, it is my observation that Denmark has come far in the perception and understanding of venture debt, when compared to the European neighbours.?

A Pitchbook analysis from Q1-2021 shows that the venture debt and tech lending activity has increased more than the venture capital activity over the past few years. That fact shows a whole lot. I have followed the progress with vast interest and curiosity. Besides having executed a number of venture debt deals through my prior work at V?kstfonden, I have worked alongside other venture debt lenders in syndicated deals.? Most venture debt lending is conducted by US- and UK-based firms.

What is venture debt?

Over the years I have come across many people intuitively thinking that venture debt has the same risk perception as venture capital. That is not completely correct. Seen through the eyes of a banker, venture debt surely is a high risk product. But a venture debt lender cannot absorb the same risk level as a venture capitalist. The upside is way lower on the venture debt facility, thus the risk level naturally also sits lower than when assessing an equity investment.

Venture debt is an excellent tool to supplement venture capital. And that is precisely the short definition; venture debt = “debt funding in continuation of venture capital”. The slightly more extended definition I would put as:

Debt funding with warrants, which is established in continuation of funding rounds with prominent venture capital investors.

Later in the article I will zoom in on structure and pricing in venture debt loans. Prior to this, I will do a brief historical perspective on the rise of venture debt, including a view on the venture debt market in the Nordics, Europe and the US. This is purely based on my own experiences, thus the observations will be set out from a Danish perspective.

The origin of venture debt

Venture debt as a term began forming in the 1970’s in the US. A number of young fast growing companies needed funding for their purchasing of computers, hardware and other assets. As they did not yet have positive cash flows due to growth investments, it was not possible to obtain bank loans. A small number of lenders began to specialise in “equipment financing”, which later became known as “venture leasing”. During the 90’s and through the expansion of the dotcom bubble, venture leasing took off. Many new incumbents arose. Risk appetite was significant, and the burst of the dotcom bubble resulted in great losses, which bankrupted many of the newcomers.?

In the years following dotcom, venture leasing came back, but now in a more sophisticated form. All assets were now included in the collateral, and generally the loan assessments were more extensive with a better understanding of the loan risk. The venture debt loan product as we know it today gained a foothold. US was the pioneering country, and several new venture debt funds were founded during the 00’s and 10’s.

Venture debt in Europe

It is my belief that the first venture debt funds on European ground saw the light of the day 8-10 years ago, and that it was not more than 5-6 years ago, until venture debt really began to take off in Europe. Silicon Valley Bank opened their office in London in 2012, and I will guesstimate that today there are more than 500 employees at the UK office covering Europe. In contrast to most venture debt providers, Silicon Valley Bank operates with a structure more like a bank, while the typical venture debt lender operates like a venture capital fund, where investors invest into a fund structure, from which the liquidity for the venture debt activity is collected. In regards to price and structure my observations are that there exist some nuances whether the venture debt loan is provided by a tech bank or a fund. Also whether it is paid out in the US or in Europe. I will get back to that later in the article.

When I began working with venture debt? back in 2018, there were a little less than two dozen venture debt providers in Europe. I would believe that number has doubled today. Before 2018 only a few venture debt transactions with Danish companies had been executed. During the past 5 years, 6 venture debt providers have had their eyes continuously focused on potential Danish targets. Common for all of them is that they have strong relations towards specific venture capital funds. One thing is that the venture debt lender has to withhold the strength and positiveness from the venture capitalist. Another thing is, that it is a condition for succés, that the venture debt lender is in terms of familiarity with the investors in the company she/he wants to establish a loan with. A good relation from a given case can make out a strong fundament for future collaborations in other cases. Thus it is common that strong relationships exist between certain venture capitalists and venture debt lenders. It is hardly surprising, and I do see it as beneficial also for the entrepreneur, that the different funders in the company have a good relation to set out from.

Pricing structures and levels

Fundamentally the pricing structure consists of 3 components; interest, fees and warrants. The warrants part of the pricing structure is, as mentioned earlier, a clear sign that it is venture debt. My experience is that, in general, the interest rates - unfortunately - are higher in Europe than in the US.?

Interest rates in Europe most often sit at around 9-11%. I have seen lower interest rates, and that would be when the company has significantly strong momentum with commercial traction consisting of a large recurring revenue base and in connection therewith, strong customer metrics. It could also be if the company has raised astronomical venture funding rounds.

Interest in the US would expectedly sit quite lower in general. I see three explanations to this. First of all, the venture market - both equity and debt - is way more mature than in Europe. I would assume the Americans to be more than a decade ahead. This means that the venture debt lenders have more data on hand to calculate the risk of the loan. Secondly, the competition is more intense. Obviously this correlates with the maturity of the market. Thirdly, and this is worth noticing, financial covenants are much more common in the US deals with the lower interest rates. The company gets more tied up, and insufficient execution on the presented plans potentially results in larger issues in the financial setup. Personally, if I were a CFO, I would be ready to pay higher interest rates in order to have more headroom in the financial setup.?

Warrants are often set at an amount of 8-12% of the loan quantum. In the diluted cap table it most often correlates to 0,5-1% ownership. Strike price is fixed to the latest actual funding round, which should have been executed within 6-12 months from the venture debt loan. Sometimes the strike price is older, and then it makes sense to see if the number of warrants should be set lower. There will always be negotiations, and especially the warrant part can be complex to get hold of as an entrepreneur. When the company continues to shine and raise new funding rounds, then the warrants will make up the largest part of the total cost of the loan.?

Fees typically consist of a closing/arrangement fee at around 0,5-1,5% together with a maturity fee of 0,5-1,0%. The maturity fee is a tail fee that is paid together with the last installment. There will also be different kinds of break fees, if the loan is repaid before maturity, as well as not insignificant handling fees, if the loan has to change structure after closing.

Loan quantum and structure

The venture debt loan comes on the back of a larger funding round with venture capital investors. In Europe, if we look back, it was common that venture debt became accessible post B-round and later. Just like the PE investors have moved downwards, and VC investors are investing earlier, the venture debt lenders are also moving down the market. Today I would say that the A-round is the golden milestone for opening up venture debt. I have seen one case, with venture debt coming in after a seed round. In my perspective that is unusual and an outlier. A company in seed level maturity level is - all things being equal - still searching for the optimal product-market-fit and its position in the market. They may still be somewhat experimenting with the value proposition and the price points, and the revenue base is still frail. For the same reasons, an entrepreneur should be careful in taking on too much debt. There is a risk that it will become a drag if the company needs to pivot to a smaller or larger extent.?

Loan quantums are most often set at levels of 25-33% of the latest real funding round, possibly larger in some cases. Different factors will increase the quantum, and others will decrease it. Actual cash position at the given time is also an important measure, especially if the latest funding round was executed way back. The lender would typically like to see a runway of at least 12 months before the loan or tranche is paid out.?

Maturity is typically in the range 36-48 months with the first 6-12 months being interest-only payments. Often the maturity and amortisation would be set for each tranche.???

Collateral

Floating charges covering all assets in relevant group entities is inevitable. Alongside that, share pledges could come up, but it is obvious that most VC’s cannot pledge their ownership. Owner loans must accept to sit junior to the venture debt loan, which also implies that real convertible notes with a contractual backstop can be included alongside equity, when the lender is doing the risk assessment. A venture debt lender will always, predominantly, make it a condition to be senior to other lenders.?

Concluding meta perspective

My observations are, that in general, nuances exist between the approach from tech banks on one side, and venture debt funds on the other. While loans from tech banks might have a better possibility of going lower on the interest rate, I have seen cases where the loan funds are more bullish on loan quantum. For an entrepreneur, it might seem tempting to draw down as much debt as any given lender would provide. The obvious pros are that it will extend the runway and increase valuation in future equity funding rounds, and thereby reduce dilution. Pitfalls are that potential future investors naturally will be looking at the amount of debt already in the company before they invest. Debt on the balance sheet would be fine in most cases, but (too) much debt might be a significant negative tricker in trying to onboard new investors. If the company ends up in a situation, where things do not turn out as presented in the budget scenarios, then it is obvious that more debt might result in heavier problems.??

There is a lot going on in fintech these years. This also shows in lending activities towards scaleups, where new intruders pop up. I have followed the tech lending market closely and with great curiosity the past 4 years. Sometimes I still get surprised, which delights me.

When I joined ArK in the beginning of 2022, I started to gain insights in the startup and funding ecosystem in Sweden. I have been surprised to see that within tech lending, there are significant market differences whether you turn your eyes to Sweden or to Denmark. It seems that venture debt is not as widespread in Sverige as it is in Denmark. On the other hand, it seems that revenue based financing has been more visible in Sweden, than what has been the case in Denmark. This is interesting. For years I have been surprised that revenue based financing has not been more available in Denmark. But that is not the case any more. During the past one and a half years, the Danish RBF parish pump has really started to move, with Danish RBF-companies being very visible. I will cover this in my next article, where I will turn my attention to revenue based financing and unfold what is up and down.

What we do at ArK

At ArK we are uniting the powers of tech and growth debt, and we have gathered a team of the brightest minds in the Nordics within each field. We fuse banking innovation and AI to analyze business health and craft custom loans.?

Through a range of API’s we connect companies’ raw business data systems to our #AIM platform. We crunch vast amounts of internal and external data. The ArK Intelligence Machine dynamically identifies and predicts granular business performance. We fund predictable parts of companies’ growth and spending and use scalable funding to match loans to customers’ data.

We return all the crunched data to the entrepreneurs in a smart and intuitive dashboard in order to let them see what we see. With the AIM dashboard, the entrepreneur can access real time data and analysis of the temperature of their business. We believe in transparency and openness with each entrepreneur.?

With the best from traditional banking, venture debt and revenue based financing, we are taking tech lending to the next level. We call this #PrecisionFinancing. With brand new tech, we support entrepreneurs with patient and non-dilutive long term debt funding that serve as a complement to venture capital.?

We are ready to grow together with strong entrepreneurs.?

Thanks for visiting. Comments and inputs are welcome.

/ Kim Lundberg, Head of Ark Kapital Denmark