Venture debt is a valuable tool for treasurers to consider as part of their financial planning and is becoming an increasingly popular alternative for those looking to extend their runway, lower their cost of capital and maintain growth momentum. At a high level (although this is not a hard and fast rule), businesses that might suit the instrument are revenue generating, can demonstrate sustained growth in those revenues, and have a clear product market fit.
These companies should have good business models with nice margins and pricing power, and can also ideally present decent levels of forecastability in their P&L. The majority – but not all – of these companies are venture capital or equity backed.
There are multiple use cases in which venture debt can suit the situation of a business. For example, to support organic growth, i.e. funding the organic burn of a business so that it grows its revenues as quickly as possible and therefore scales the enterprise valuation of the company, or to fund M&A, where the leading tech players in a market look to consolidate others and finance the acquisition of such targets without raising equity.
One of the key advantages of venture debt is its ability to diversify a company’s funding sources. By incorporating venture debt alongside equity financing, treasurers can reduce reliance on a single source of capital, mitigating potential risks and enhancing financial stability.
In addition, it offers the opportunity to access capital at a lower cost compared with equity financing. This can be particularly advantageous for companies looking to optimise their cost of capital and minimise dilution for existing shareholders. By leveraging venture debt, treasurers can strike a balance between funding needs and preserving equity value.
Ultimately, venture debt provides access to financing that is used to get a business from one value point in its journey to the next, with less dilution along the way than if it used equity. These companies can then either raise an equity round 12 to 24 months later at a much higher valuation (i.e. saving lots of dilution for the shareholders than if they had used equity instead of the debt), or they may be bridged all the way to profitability, or even to an exit, thus avoiding raising more expensive capital at all.
Alongside lower dilution and a lower cost of capital from day one, it therefore also helps treasurers to optimise the timing of future capital raises, allowing the early shareholders to retain control and governance of the business. Shrinking businesses, with weak or falling margins are typically unsuitable. Very high burn, inefficient businesses are not ideal candidates – and even less so should they appear to be structurally loss making.
It’s worth noting that any substitution (in place of equity) should only be executed in successful, growing companies that could raise equity, but choose not to (rather than those who cannot raise venture capital, and instead are seeking debt as a last resort).
By incorporating venture debt into their financing programme, treasurers can unlock new growth opportunities and optimise capital structure, while retaining control for their shareholders.
Antony Baker is a principal at Claret Capital Partners
This article was taken from Issue 4, 2024 of The Treasurer magazine. For more great insights, members can log in to view the full issue.
