Investors point to the risks of subprime debt
Amid the economic downturn, many venture-backed companies are turning to lenders for capital, but some investors fear the risks of subprime debt are being overlooked.
This year, $26.5 billion has been invested in 2,419 venture debt deals in the United States, according to PitchBook data, with the second quarter of 2022 being the second quarter in terms of total debt value during the last decade.
Rising interest rates and market volatility made equity financing less available than in previous years. For startups looking to expand their leads without risking their valuations, venture debt seems like a natural fit, not least because it’s cheaper than equity.
But it’s not without risks for startups or their investors, which are heightened during economic downturns.
“A lot of people don’t recognize that the economics of being a venture capitalist is very different from being a venture capitalist,” said Nate Lentz, Philadelphia managing director at Osage Venture Partners. “For them to lend $2 million to a startup and lose it is a much bigger loss than for a venture capitalist. When things go wrong, the venture capitalist will very quickly go from your partner to wanting get his money back.”
More stringent clauses
Unlike equity, venture capital debt must be repaid. If a startup fails to meet repayment terms or covenants (loan terms that set minimum financial and performance requirements), the results can be disastrous.
In the event of default, the loan is due and payable immediately. And if the lender is unwilling to negotiate, interest rates may be increased or access to additional credit may be revoked. Although rare, lenders have the right to force a business to liquidate or sell in the event of default.
According to Lentz, the downturn has caused many subprime lenders to include more or stricter covenants. Achieving required growth rates or other performance-related metrics is more difficult given current market conditions, increasing default risk for businesses.
This is particularly concerning for companies that are going into debt to avoid a decline, said Jai Das, president and co-founder of Sapphire companies.
“What worries me is the scenario in which a company takes on risky debt in order to maintain an artificially high valuation,” he said. “If the business goes bad, it’s possible that the debt holders will own a lot of the business. On sale, the lenders get most of the value. I would generally dissuade my portfolio companies from incur venture capital debt.”
Impact on outputs
Debt is higher in the capital stack than equity, so when it comes to getting out, subprime lenders get their money back first. If a company takes on a lot of debt and the exit proceeds don’t cover everything, founders, employees and other investors can be left with nothing.
Too much debt can also impact a company’s exit prospects, Das said. A potential buyer might be reluctant to repay a loan or public investors might hesitate if a company has a high level of debt on its balance sheet in the event of an IPO. Das said he thinks companies need to think about the long-term consequences of risky debt rather than just focusing on the short-term benefits.
For some startups, raising venture capital debt is a way to hold them over until the next round. However, this can cause problems down the line when trying to raise, said Lainy Painter, a New York-based partner at Craft businesses.
“[VCs] prefer to invest in growth rather than paying down debt,” she said. “There is an assumption that the responsibility to repay venture capital debt rests with the next investors in a funding round. If a startup has a clear plan on how to pay off debt, that shouldn’t be a problem, but if it doesn’t, it might be harder to raise new money.”
A place for debt
For venture capitalists, the growth potential of a startup is always key when deciding to invest. If the capital raised is simply used to pay down existing debt rather than fund new initiatives or expansion, the benefit to the investor is limited, as their capital does not contribute to scaling the startup.
This is potentially a more important consideration now that venture capital deals are slowing. In the third quarter, the number of venture capital deals in the United States fell by almost 20% compared to the first quarter of the year, according to the PitchBook – NVCA Venture Monitor.
Although venture debt comes with risks, it still has a place in the startup community, Painter said.
“If a startup is cash flow positive or has collateral, it might consider going into debt,” she said. “It can be a great instrument to optimize the capital structure and reduce the cost of capital since debt is cheaper than equity. But if a company uses debt just to extend the track with no path to profitability, it creates Lots of problems. Debt needs to be repaid. If a startup uses debt to delay tough decisions, it’s a setup for disaster.
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