With the collapse of Silicon Valley Bank (SVB) and the slowdown in venture capital funding, some early-stage companies and startups in the United States are more cash-strapped than usual.
Those circumstances have sparked the idea that venture debt will be the financing vehicle to rescue some privately held businesses. Provided bank and nonbank lenders see the opportunity, firms will use venture debt to fund working capital, add resources to research and development, and bridge to better terms for equity raises.
The truth is much more complex and sobering if you’re the CFO of one of those cash-hungry, early-stage businesses. Here are five facts about venture debt and SVB’s role in the venture economy.
While SVB had $6.7 billion in outstanding venture loans when it failed (according to Pitchbook-NCVA Venture Monitor), venture lending wasn’t the most valuable thing it did for customers and wasn’t what drove profits.
“[Silicon Valley Bank] was not looking to make money off the loans,” said Zack Ellison, a former credit trader and founder of Applied Real Intelligence (A.R.I.), a venture debt investment manager. “They made money off all the other [less risky] products.” It provided all the other banking services to startups and their venture capitalists, which was the core of SVB’s business.
“It was a VC-centric model,” said David Spreng founder and CEO of Runway Growth Capital, which provides “growth debt.” SVB could grant a subscription line of credit to a VC’s fund, offer mortgages to the VCs and portfolio company executives, provide asset management services to the VCs, and sell cash management services, credit cards, and all the accounts that a newly minted company needs to get its finance department up and running.
VC-funded companies largely rely on equity as the primary funding source in the early stages. But once a company starts to generate revenue, founders become interested in holding onto their existing stakes and not bringing more equity holders into the funding stack.
Maybe 20 or 25 years ago, corporate finance experts would have said, ‘Hey, you shouldn’t use debt on a pre-profit company.’ — David Spreng, Runway Growth Capital
“Founders started to realize, ‘Initially I have to use equity because I don’t have the cash flow,” Ellison said. Once companies start to grow and get past their Series B or Series C venture-funded rounds, they have real revenue. “And revenue means I can pay interest, which means I can borrow money,” said Ellison.
Debt, of course, is also cheaper than equity. “Maybe 20 or 25 years ago, corporate finance experts would have said, ‘Hey, you shouldn’t use debt on a pre-profit company,” said Spreng. “And now conventional wisdom has come to believe that it’s appropriate. It’s prudent. It’s wise, and it’s certainly OK to use it on pre-profit companies.”
In addition, it’s faster to raise debt. “You can get a loan in four to six weeks, whereas to raise a round of equity capital” can take many months, said Ellison.
Crunchbase data shows that venture and growth investors put $76 billion into early-stage companies globally in the first quarter of 2023, a 53% decline from a year earlier. Only 18 unicorns (privately held startups valued at more than $1 billion) were minted in the first quarter, the lowest quarterly new unicorn count since 2017, according to Pitchbook data.
But for many companies, venture debt will not be a “bridge” they can use to their next funding round.
I think we would all like to see JPMorgan Chase or one of these banks sort of step in and provide the service [startups need], but we’ve seen no indications that’s gonna happen. — Ben T. Smith IV, Kearney
Runway Growth Capital’s average customer has raised $100 million or more in VC equity and has $50 million in revenue. The most important thing in Runway Growth’s underwriting is that the borrower has a predictable path to profitability, which is uncommon.
“If you’re making a loan to a company in Series A, they probably don’t have any revenues,” said Spreng. “Their path to profitability is unclear and dependent on future equity rounds to get there.” Runway Capital’s loans are often “the last money in,” Spreng noted.
In addition, venture debt is not cheap. At this point, a venture lender could borrow floating-rate capital at the Secured Overnight Financing Rate (SOFR) plus 300 or 400 basis points, for example, so it may be charging borrowers SOFR plus 800 or 900 basis points. On April 6, 90-day SOFR was 4.5%.
“[SVB’s] biggest value was that they were easy to deal with,” said Ben T. Smith IV, a senior partner at Kearney and a Silicon Valley executive for 30 years.
“I think we would all like to see JPMorgan Chase or one of these banks sort of step in and provide the service [startups need], but we’ve seen no indications that’s gonna happen,” Smith IV said.
First Citizens Bank, which purchased $72 billion of SVB’s existing loans and assumed $56 billion of deposits, is a North Carolina-chartered commercial bank that does not have deep relationships in Silicon Valley. “The history of East Coast banks serving West Coast innovation has been problematic,” said Smith IV.
“I think that the business of making $5 million loans to startups based on the relationship with the VC may just go away,” Spreng added. “I don’t see anyone else being able to replicate [SVB’s] footprint.”
Indeed, the loans SVB was making were not venture debt; they were “sponsor-dependent” loans, meaning that the underwriting relied on the VC backing the startup to step in if the borrower ran into cash flow problems.
That kind of loan book would not be attractive to most commercial banks. Venture loans have very low loss rates historically, much lower than traditional small business loans, said Ellison. But the reason that a lot of banks don’t do this [kind of lending] is [the borrowers] are almost always pre-profit,” said Ellison. “They have top-line revenue, but they’re burning a lot of cash to grow and still losing money.”
“Silicon Valley Bank held a very special and unique position in that they were afforded a lot of regulatory freedom,” said Spreng.
As the FDIC and the Federal Reserve investigate the SVB failure, they may think they need to institute rules to increase the capital held for such loans, for example, or otherwise make venture lending more difficult for banks. (Even though it was not SVB’s loan book that brought it down.)
However, plenty of nonbank lenders are willing to lend to venture-stage companies, like ARI and Runway Growth. Other providers include Trinity Capital and Hercules Capital.
These lenders are usually industry-specialized but can underwrite loans faster, customize terms, and write big checks.