Venture Debt: US vs Europe

For an entrepreneur, there are various ways to finance your startup. If you are just starting out, the first thing that usually comes to mind is putting in your own money and approaching friends or family members to help out. While the money raised this way is likely not going to be incredibly high, it should be enough to start your business. Once your startup has kicked off, you might run into a situation where you have to look for external financing to continue growing.

There are many different ways to raise money for your startup, such as through crowdfunding platforms (e.g. Kickstarter or Crowdcube), or approaching equity investors and raising funds from Venture Capital. Generally, the way Venture Capital works is very similar to how the popular TV show Dragon’s Den (or Shark Tank in the US) presents it — an entrepreneur goes into the “Den”/”Tank”, starts with a pitch in which he or she talks about the valuation, product, development of the company, financial results and future plans. After the pitch, the investors ask more specific questions in order to analyze the health of the company and whether it’s worth it to invest in the company. If everything goes according to plan, a deal is made and an investor comes on-board, providing both financing and their expertise.

For founders who want to raise funds, but don’t want to give away a large share of their business, there is a great solution — Venture Debt — a form of non-dilutive financing that a company can raise in addition to equity, both together or in-between equity rounds.

What is Venture Debt?

Simply put, Venture Debt is a term loan, which is generally repaid in 3 to 4 years, that companies can use to fuel growth by investing in marketing, equipment, hiring or even leveraged buyouts. The loan is used as a complement to equity, most often to extend the companies’ runway (time until it runs out of money), effectively postponing the next equity fundraising event.
Why postpone raising equity? Well, in each equity round the founders have to give away a share of their company, according to the valuation during the round, hence raising debt can help the company reach important value-creating milestones before the round!

Short History of Venture Debt

Venture Debt is nothing new — in fact, it has been around in the US since the 1970s! VD (or Venture Leasing) emerged together with the semiconductor industry: after Intel launched its first CPU in 1971, many more followed and the industry was developing quickly. Unfortunately, as microchips were just getting big, many companies struggled to afford the required equipment to produce computer hardware, so they were essentially forced to lease equipment from specialised equipment leasing firms. To combat this problem, Venture Debt was born, which allowed companies to finance the costs of equipment.

Later on, Equitec Financial Group, one of the first Venture Debt providers, developed a concept that has largely stuck to this day — an equity kicker (warrant). The warrant is essentially an option (but not an obligation) for the lender to buy into the equity side of the company during a liquidity event. The warrant coverage is relatively small — up to ~15% of the loan principal.

Why? Well, the warrant serves multiple purposes:
1) It is in the interest of warrant holders that the company grows into a successful business that potentially becomes public, meaning that Venture Debt funds, after issuing a loan, would be interested in maintaining a great connection with the company, as well as offering their help and expertise.
2) The warrant is only exercised during an exit event, and having it holds some value. Consequently, Venture Debt funds are able to provide loans at a smaller interest rate than they could without a warrant in order to reach the necessary returns.

Venture Debt — US vs Europe

Being around for 50 years, Venture Debt in the US is already a mature financial instrument. In fact, last year US Venture Capital backed companies attracted a total of $25billion in debt financing (as a comparison, the number was less than $5billion in 2010). Venture Capital investments are also at an all time high, and last year US companies received VC funding of $130billion in total. Based on these numbers, we come to a ratio for VC to VD investment of 5.2x in 2020, and the ratio was very much the same back in 2010.

So what’s the situation like in Europe?

Recently Europe celebrated its 25 years of Venture Capital, and Venture Debt has been around for even less than that — the first VD fund, European Venture Partners, launched only in 1998.

According to Pitchbook’s VC report, the total amount invested into European-based startups was €45.1billion in 2020 (And €47.1 billion in the first half of 2021!). What about Venture Debt investments? Data about the product is scarce, but, according to Dealroom, the overall amount of debt investments in 2020 was €6.9billion. That’s a ratio of 6.8x (4.9x in the first half of 2021!).

The data for the first half of 2021 are surprising — it is the first time that, when it comes to the ratio of VC / VD investment, Europe is ahead. Historically though, the US have always preferred debt financing more than Europe. A couple of reasons why it might be so:

1. The Venture Debt industry is undoubtedly more mature in the US, being in the market for more than twice as long. As a result, entrepreneurs already have an idea of what the Venture Debt product is, and hence feel safer about raising funds this way. Of course, there are also more Venture Debt providers, which compete with each other in who can provide a better deal for the startup.
2. In the US, people are not only more aware of Venture Debt, but taking on debt in general. People take student loans that could take decades to repay, as well as the younger generation is encouraged to start building credit history as quickly as possible, as having a good credit score is vital when, for example, buying a house or a car.
3. In Europe, especially Eastern Europe, historically people avoided taking loans like the plague.
   “Why do you want to take a loan? Do you want your house taken away if you can’t make the payments?”
   This is often what young adults hear when telling their parents that they plan to take a loan, especially in Post-Soviet countries. During Soviet times it was not even realistic to have any sort of credit for the majority of people (since, well, communism), let alone establishing a company.
   Nowadays though, especially in the first half of 2021, the mindset has changed towards being more open to debt. Additionally, interest rates are very low (thanks to COVID as well — low interest rates stimulate economic growth), which makes it even more attractive of an opportunity.

“So why Venture Debt? Surely a bank loan is cheaper, right?”

Well, consumer loans might be, but for businesses it varies widely depending on the stage of the company. Banks might offer a business / corporate credit card with a certain credit limit, but the amount is going to be way smaller compared to a loan, and hence mostly useful for covering small day-to-day expenses, instead of expanding the company and growing further. Additionally, it is quite difficult to get a bank loan for startups — banks prefer to give out financing that is safe and don’t like companies that burn cash, which is a typical side-effect when investing into growth. In addition, banks may impose financial covenants, i.e., make restrictions to what the money can be used for (such as only for office furniture, day-to-day expenses), whereas Venture Debt funds generally do not.

The future of Venture Debt

As the popularity of VD as a complement to equity investment increases, banks have started to notice and implement their own venture debt offerings, generally with a lower interest rate. Most popular of such banks are Silicon Valley Bank (it finances not exclusively Silicon Valley startups, but extends to Europe as well) and European Investment Bank. Such banks tend to offer a wide range of debt instruments, such as Venture Debt, growth loans, mezzanine loans, cashflow loans and so on, allowing the founders to choose what is the most suitable for the company. Nevertheless, banks are typically large institutions, hence having a loan approved can take way longer when compared to Venture Capital firms that also offer Venture Debt facilities.

Venture Debt investments are at an all-time high, reaching new highs each year, which will result in more Venture Debt funds. This means more competition, which results in lower interest rates on loans meaning cheaper financing, and ultimately results in more startups being able to grow quickly and effectively.

Based on most recent data, Europe has finally caught up to the United States when it comes to the ratio of VC / VD investment, and, while there is no basis to believe that Europe will begin to focus entirely on loans, it looks like the ratio will stabilize in the future.

Borrow responsively!