as venture capital rebounds, what’s going on with venture debt?

The American venture capital landscape has demonstrated a remarkable recovery following the initial uncertainty of the COVID-19 pandemic. There were initial concerns that startups would encounter difficulties securing funding for several quarters, potentially resulting in workforce reductions, a slowdown in recruitment, and budgetary constraints.

However, as the pandemic expedited the transition of many businesses to online platforms, a number of startups experienced greater popularity than anticipated. These favorable conditions enabled the venture capital sector to regain momentum significantly, contributing to an exceptionally strong third quarter for venture capital activity within the United States.

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As previously covered by The Exchange last week, “The total amount of funding secured by U.S.-based startups in Q3 2020 reached $36.5 billion, as reported by CBInsights, and $37.8 billion according to PitchBook. CBInsights identifies this figure as a high point over the past seven quarters, representing a 22% increase compared to Q3 2019 and a 30% increase from Q2 2020.”

This observation naturally leads to the question: What is the current status of venture debt amidst these developments?

Venture debt encompasses various types of financing offered to startups, regardless of whether they have previously obtained equity-based funding, such as venture capital. One common form is provided by institutions like Silicon Valley Bank, which may extend credit to rapidly growing startups with established investors, equivalent to a portion of their most recent funding round, enabling them to access additional capital without significantly increasing equity dilution.

Alternative forms of venture debt, like revenue-based financing, involve sharing a percentage of the startup’s revenue streams to repay the borrowed funds. Furthermore, there are other, less conventional sources of this type of capital.

I have been following this area with interest for several quarters. Therefore, when survey data regarding the venture debt market from Runway Growth Capital became available, I began compiling my observations into a comprehensive analysis.

Venture debt continues to play a role in the current market; however, while venture capital is achieving record levels, recent data from PitchBook suggests that its less-publicized counterpart is unlikely to replicate the performance of the preceding years. Let’s delve into the details.

Venture debt in 2020

Runway Growth, a significant participant in the venture debt market, reported $41.5 million in funded loans during the third quarter of 2020, as disclosed to TechCrunch. This figure is provided for your information. A recent survey conducted by the company, encompassing 493 entrepreneurs with venture capital backing and 50 investors from the venture capital and lending sectors, revealed that 60% of founders believe venture debt has become more advantageous for founders. This might lead one to anticipate an overall increase in the utilization of venture debt.

That was my initial interpretation, at least.

The same survey also presented two related pieces of data that illustrate the role of venture debt in the current market: 86% of providers indicated that venture debt is crucial for companies to extend their financial runway and achieve key objectives, while slightly more than 25% of founders shared this view. Regardless of which perspective is accurate, venture debt has experienced substantial growth in recent years.

According to data from PitchBook, here are the updated venture debt statistics for the United States up to 2019:

• 2013: 1,610 transactions totaling $8 billion.
• 2014: 1,986 transactions totaling $11.6 billion.
• 2015: 2,513 transactions totaling $17 billion.
• 2016: 2,346 transactions totaling $14.8 billion.
• 2017: 2,512 transactions totaling $13.9 billion.
• 2018: 2,673 transactions totaling $24.3 billion.
• 2019: 3,031 transactions totaling $27.2 billion.

A period of rapid growth occurred through 2015, followed by some moderate decreases, and then a significant increase in both 2018 and 2019. The data from those last two years contributed to the increased discussion surrounding venture debt leading into 2020. In fact, The Exchange covered this topic on several occasions based on that observed trend.

What has transpired in 2020 to date? PitchBook data received yesterday, covering the period up to October 20th, 2020, indicates that the U.S. has recorded a total of $18.6 billion in venture debt activity across 2,237 funding rounds. Is this total lower than anticipated? We also observed this result.

So what?

The Exchange sent a series of questions to Runway Growth, Element Finance, and Lighter Capital – all firms specializing in venture debt – in an effort to understand the current state of the debt market. Prior to the release of data from PitchBook, David Spreng, CEO of Runway Growth, conveyed to TechCrunch his belief that “we are likely to achieve another record year for venture debt.”

Spreng attributed this to robust interest from SaaS companies, as well as those in the healthcare and life sciences sectors. He explained that “following a temporary slowdown in March and April, the venture debt market swiftly returned to conditions seen before COVID-19, which continue to be advantageous for borrowers, offering low interest rates and appealing terms.”

John Gallagher of Element Finance shared with TechCrunch that many companies within their target size range utilized PPP funding and reduced their spending to extend their financial runway. As these PPP funds are depleted, Gallagher noted they are observing a significant number of companies seeking venture debt financing.

Government stimulus programs may have temporarily reduced the need for venture debt by providing an alternative funding source. This does not suggest venture debt is any less desirable, but rather that the unique circumstances of 2020 have influenced the overall figures for this type of capital, differing from what might be expected in a typical economic environment.

Gallagher further stated that startups not significantly impacted by the pandemic are “probably experiencing slower growth and are inclined to postpone an equity raise until more favorable market conditions arise.” This observation aligns with the implications of the survey, as viewed from the perspective of venture debt providers.

Melissa Widner, CEO of Lighter Capital, similarly highlighted the impact of PPP, stating in an email that “demand for venture debt decreased in late spring/early summer as companies applied for PPP loans.” However, she added that “in August, Lighter Capital saw demand for our revenue-based financing product return to pre-COVID levels.”

It is reasonable to consider whether the initial pause mentioned by Runway Capital and the reduced demand due to PPP funding were too substantial for the venture debt market to fully compensate for in the third and fourth quarters, resulting in a recovery that still falls short of previous peaks. In this context, the 2020 data should not be interpreted as a negative indicator for the long-term potential of venture debt.

There are indications of improvement, however. Comparing PitchBook venture debt data from the period up to April 21, 2020, with more recent data from October 20, 2020, reveals the following:

• Venture debt deals and total funding amounts, averaged per day through April 21, 2020: 6.7 deals, approximately $90 million.
• Venture debt deals and total funding amounts, averaged per day through October 22, 2020: 7.6 deals, approximately $63 million.

Analyzing these two data points, we observe a general increase in the pace of deals throughout the year, although the average deal size has decreased. The relative importance of deal volume versus total funding amount is left for individual assessment.

The survey data indicating that founders perceive venture debt as increasingly favorable has contributed to a rise in the number of deals over time. However, the specific conditions of 2020 have skewed the overall numbers. It remains to be seen what developments 2021 will bring.