By Lyall Davenport, Principal, Claret Capital Partners
Following my previous piece on using venture debt , and my promise (to myself more than anyone else) to follow-up with monthly thought pieces, I have been working on a history of venture debt piece (watch this space). However, as I settle into my second coffee in an attempt to clear the inbox before a flight, I come across a Sifted Daily Newsletter from a few weeks ago and their lead piece on the Silence of the Rounds. Whilst I largely agree with the sentiment of the piece – VC’s have been quiet for the last 12 months, non-traditional sources of capital are filling equity rounds and quiet internal rounds are in vogue right now – there is one comment that sticks which I want to address…
“It could also mean that founders will look to cut costs rather than raise more money at a lower valuation […], it’s either that or look to venture debt – an expensive option given current business rates.”
Sifted Daily 21/2/2024
…the idea that venture debt is more expensive now (which in my view is only half true), and that this is driven by the current interest rates. So, to restore the honor of the poor-slighted venture debt provider (not all heroes wear capes), I will dive into this, and look at “true” venture debt versus other lenders and equity to understand the real cost of venture debt to a start-up in the down round economy.
Know-Your-Lender
For the purposes of this tome I will attempt to provide my brief definition of venture debt and a venture debt fund, versus other forms of lending. Whilst this is not exhaustive; I hope it will provide some light on the cost structure.
Venture debt traditionally provides secured term loans, with no – or low – covenants whilst charging an interest rate (typically low double digits) and warrant coverage, giving them the right to buy shares in the future at a defined price. In Europe today this market is served by a handful of funds (Claret Capital Partners being one of the leading independent managers in the space), and somewhat replicated by banks who dip their toe into the space.
There are also other debt providers that often get lumped within Venture Debt – these can be Revenue Based Lenders underwriting predictable revenue streams and charging a percentage of these streams, banks providing term loans but looking to drive other banking services through their platforms, or mid-market lenders that will charge similar interest rates but would introduce more restrictive covenants and typically wouldn’t have warrants as part of their deals.
With that preamble in place, the point is that a borrower should know their lenders’ sources of capital to understand the cost of capital for their debt. Funds (which make up most true European venture debt providers under the above definition), and those lenders that raised fixed, blind pools of capital from LPs typically have a fixed cost of capital (the hurdle rate). Therefore the assertion that central bank interest rates make the cost of venture debt more expensive misses the mark. The opposite is true of other sources of debt, (banks, mid-market, RBF lenders etc.) where they are investing capital provided by a bank or other institution, and are charging a premium over central bank rates for riskier investments, as their cost of capital has increased in line with the rate hikes over the last 24 months – going forward I will call these Alternative Lenders.
To put it simply, the return Alternative Lenders need to make to justify their access to capital has increased, and therefore so has the cost for the borrower. However, venture debt providers have maintained the same cost of capital throughout, despite the increase in interest rates.
So, the cost of venture debt hasn’t changed?
In absolute terms no. We have seen some increase in interest rates over the last 24 months – this is largely driven by the market and risk (as there is less equity in the market underwriting future equity rounds, and in many cases the repayment of loans has become riskier). It is also driven by Alternative Lenders having to come into the venture debt space to justify their cost of capital.
However, these increases have been minor compared to the central bank rates. Today the Bank of England central rate is 5.15% higher than it was in 2021, whilst the cost of venture debt has only increased from 1%-2% from the lowest interest rates at the peak of the free money era in 2020-2021.
What about warrants, I hear nay-sayers calling from the bleachers? Tune in next week as I explore warrant pricing in the current market.
I look forward to extending the conversation – please reach out to me directly if you have questions, comments, or corrections!