Venture debt in the spotlight amid tech downturn, falling valuations

venture

When investor exuberance in tech stocks faded as COVID-19 spending habits petered out and recession predictions grew, the head of the Silicon Valley Bank’s Canadian arm knew what would keep startups going: venture debt.

The loans obtained by early-stage companies from banks and other lenders complement equity investments, but were often overshadowed when valuations surged during the health crisis.

However, venture debt is handy for extending a company’s runway, making it popular as businesses navigate a downturn that has triggered mass layoffs, spending cuts and falling valuations across the sector.

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“Throughout the pandemic, there was a lot less scrutiny. People were raising millions of dollars on not a lot of revenue. I was seeing Series A raises of $50 million, which is kind of unheard of,” said Paul Parisi, who leads the U.S. bank catering to technology companies and venture capitalists. (Data company Briefed.in says the average Series A funding a Canadian company receives is about $16 million.)

“But now without that, we have to sustain their ability to stay in business until the valuations come back a little bit, and it makes sense for both the founder and the venture capital firms to invest in each other.”

Parisi has seen data suggesting valuations for small businesses are down 27 per cent and 70 per cent for larger companies.

Swedish “buy now, pay later” darling Klarna, for example, raised US$800 million in August at a valuation of US$6.7 billion, an 85 per cent decrease from its US$46 billion valuation last year.

Toronto-based Wealthsimple reached a $5 billion valuation last year, when it raised $750 million from stars including rapper Drake and actors Ryan Reynolds and Michael J. Fox.

However, the investing company controlled by Power Corp. of Canada has since seen the holding company drop its valuation of its 24 per cent stake in Wealthsimple to $492 million, down almost 50 per cent from $925 million in March.

With drops like that, Parisi said, “Nobody really wants to raise money.”

But for many its unavoidable. Some need to drum up cash to survive the current market and others are keen to have money on hand because industry heavyweights like Y Combinator, a U.S. startup accelerator that championed Airbnb and Dropbox, recommend companies strive for “default alive” status, when revenues will cover expenses before cash runs out.

Venture debt winds up being attractive because it delivers capital and helps companies save face.

“You don’t want to have your company worth $100 million and raise money against that $100 million valuation and then three months later or six months later, raise for half that amount,” Parisi said.

“But you still need money to run your business … and there’s not a lot of places to turn right now … so a lot of people are turning to venture debt.”

PitchBook, a Seattle data company, found U.S. venture debt deals, which have exceeded US$30 billion annually in the past few years, notched more than 1,900 deals totaling US$22.4 billion by the end of September.

The Canadian Venture Capital and Private Equity Association (CVCA) found venture debt given to Canadian companies made up $317 million across 62 deals in the first half of 2022 alone, putting the country on track to break its previous record.

“We’re almost at 90 per cent of what was deployed last year and I don’t think it’s surprising at all,” said Kim Furlong, CVCA’s chief executive.

“When the value of your company is not as high as it was last year and you’re looking for financing, it may make more sense for an entrepreneur to look at debt versus looking at equity because your investor has a better deal.”

Before the downturn, the Silicon Valley Bank would offer venture debt to companies on top of their raise. Their venture debt was typically between 30 and 50 per cent of the amount raised, said Parisi.

However, when valuations were soaring beyond a startup’s desired raise during the health crisis, few needed to rely on that cash.

“So a lot of people were sitting on the sidelines,” said Parisi.

“Now, people have figured out or unfortunately are realizing that ‘I’m probably going to have to use my debt to extend my run, so I don’t have to raise again when the value of my company is low.'”

Chris Albinson, chief executive at Waterloo, Ont. innovation hub Communitech, has noticed this logic playing out among companies that didn’t have much of a runway headed into the year or raise money ahead of the downturn.

Mezzanine debt, favoured by larger firms because it allows lenders to convert debt to equity in the event of a default and often after venture capitalists and senior lenders are paid, is also being considered more, he said.

But he reminds founders that debt isn’t a good option for every startup.

“If your fundamentals aren’t strong, debt can be a super dangerous way to finance a business,” he said.

“It’s kind of like taking out a mortgage on your house and if you miss the mortgage payments for whatever reason, the bank can own your house, so debt can be tricky and has other elements to it that you need to be thoughtful about.”

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