What’s driving the current decline of venture debt?
The slump in lending was mostly brought on by rising interest rates and risk aversion.8 Still, with both venture capital and venture debt funding shrinking and strategic investors becoming more risk-averse, it’s becoming increasingly difficult for unprofitable companies to raise funds; we predict this trend will continue until well into 2024.
In the short term, venture debt deals could become smaller, rates higher, and generally harder to obtain. Similar things are happening in VC: Fewer deals, smaller deals, lower valuations (“down rounds,” or deals done at valuations lower than previous rounds), and more restrictive terms.9 Companies that might have preferred to borrow might need to raise capital and dilute their equity, divest less profitable business segments, or be acquired by competitive buyers during a vulnerable time. We expect to see strategic VC deals (either equity stakes or outright purchases) rise in 2024, as cash-rich, mega-cap tech companies with high valuations invest or buy out smaller companies that can’t raise capital or debt at acceptable prices.
With technology venture funding more difficult to secure, we may also see strategic buyers seize the opportunity to acquire or obtain stakes in early-stage companies that are dependent on more competitive venture funding. While VC funds run by large corporations (venture arms) might have preferred to purchase percentages of early-stage tech companies, we may begin to see them make moves to acquire them outright to gain a competitive edge.10 We may also see lenders begin to ask for more warrants in their deals, allowing them to buy stock at a predetermined, lower strike price.
Venture debt market prediction for early-stage tech companies
In the wake of these developments, early-stage tech and telecom companies should weigh carefully how to proceed. With venture debt more difficult to obtain, early-stage tech organizations should prepare to show robust revenue and strong margins to be competitive in securing difficult-to-obtain funding. Where the focus was solely on revenue growth and market share in 2021, companies may want to reduce costs and show a faster path to profitability. Venture debt will likely become expensive, so even companies that are able to secure funding should still plan for steeper costs.
Less venture money and high venture debt cost are also likely to affect the innovation ecosystem. Given that options to buy and acquire may be fewer (because promising startup ventures with positive cashflows could be fewer), tech companies can focus within their own enterprises on talent strategy to improve their rates of innovation in cost-effective ways. Those efforts might include offering specialty training programs for highly valued employees and considering relationships for research and development within the tech ecosystem to help ensure they don’t lose their competitive edge.
Financial institutions should seize the opportunity to gain a competitive edge
Financial institutions should consider the considerable gap in the venture debt market, which means there is a significant opportunity for other venture debt lenders to fill the market demand. With banks behaving in ways that are more risk-averse, we’re already beginning to see large private equity firms and alternative non-bank lenders start to fill the venture debt space.11 We anticipate that these lenders will drive the recovery of the technology venture debt market.
Bottom line
During this rebound phase, early-stage start-ups should plan to keep more cash on hand to weather economic uncertainty if funding becomes more difficult to obtain down the road. They should also plan for the risk that debt may be challenging or impossible to obtain, and they may need to raise further equity rounds at lower prices. These developments in the market are likely to encourage early-stage tech companies to build more stable growth over time.
Regulators had seen early signs that SVB was in trouble as early as 2021, however, bank managers failed to address the problems.12 In the wake of the bank failure, questions have been raised about the role of regulatory bodies in preventing bank failures. In 2018, regulations in the Dodd-Frank Act which went into effect during the 2008 recession were amended to exempt banks with assets between US$100–250 billion from keeping sufficient liquid cash for thirty days of withdrawals on hand at all times.13 Some have argued that this change, combined with SVB management's failure to address concerns, appears to be a significant contributor to the bank’s failure.14 As a result, many observers anticipate more regulation,15 which could contribute to the cooling of venture debt markets in the short term.
For financial institutions, the collapse and rebound of the venture debt market presents a compelling opportunity to gain market share. Institutions moving into the venture lending space should proceed cautiously to manage heightened risk. For example, lenders may need to ask for more warrants, in order to buy stock at a predetermined price, possibly at lower strike prices, in order to help reduce their risk factors.
Nonetheless, one possibility that venture debt could unlock for the tech startup ecosystem is serving as an additional pathway to raise funding. And it could work well both for the lender (less risky) and the borrower (access to funds of smaller ticket size). Beyond traditional VCs, venture debt could serve as an alternate asset class for tech startups to keep the innovation engine on. For instance, venture debt lenders can help startups by offering lighter funding in the range of US$5–8 million to support pilots and prototypes (for example, generative AI solutions) via strategic joint ventures, academic collaborations, joining hands with adjacent tech players as part of an industry consortia, or participating in ideation labs and other accelerator programs.
Moreover, startups are sprouting in new areas such as sustainable tech (for example, ESG software and analytics, AgTech) and generative AI and private large language models. These new areas are expected to require a continuous flow of funds to help those startups launch innovative solutions to help generate value for their customers. Venture debt can serve as another plausible alternative investment avenue for the hundreds of new/emerging startups, beyond the established investment avenues such as VCs and PEs.
All said, tech start-ups may still have to think carefully about their funding strategies in the coming year as venture debt funding recovers. Still, as the market recovers, tech start-ups will likely be well-positioned to build toward sustainable growth in the future.
