There are many questions about the implications of the collapse of Silicon Valley Bank (SVB) that will go unanswered for a long time. But there’s one question that many startups and investors hope will be answered sooner rather than later: What’s happening with venture capital?
SVB was one of the larger, if not the largest, providers of venture capital to US-based startups. And now that First Republic Bank has also gone under, that question has spiraled and become increasingly complex.
Many startups rely on venture capital: it’s both a cheaper alternative to raising equity and can serve as a capital vehicle that allows companies to build in ways that equity capital can’t. For some companies in capital intensive areas such as climate, fintech and defense, access to debt is often the only path to growth or scale.
Fortunately, venture capitalists aren’t overly concerned about the impact of the SVB’s collapse on venture capital as a whole.
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MinRegion+ surveyed five investors, all in different fund sizes, stages and focus areas, to get the inside-line on the state of venture capital debt. And they all feel that even amidst the turmoil, venture capital will still find its way to the companies that are looking for it – it may be a little harder for some to get.
“With the fall of industry stalwarts such as SVB and FRB, we suspect that access to venture capital is harder to come by and more expensive, as partners traditionally seen as ‘marginal’ are not as flexible around factors such as scale or impose stricter covenants. We will see how Stifel, HSBC and JPMorgan (with FRB) and First Citizens behave in the marketplace,” said Simon Wu, partner at Cathay Innovation.
Sophie Bakalar, a partner at Collab Fund, said that while the process and planning required to raise venture capital will change, it is still a fantastic resource for growing companies.
“Venture debt has its benefits, more than ever before,” said Bakalar. “It encourages founders to build rather than grow, which is a good thing when we think about the innovation that can take decades.”
But the process and underlying business fundamentals required to get venture capital are likely to change, several investors think.
“Our prediction is that venture capitalists will begin to rely less on what a company’s ‘loan to value’ is and instead focus on capital efficiency, ability to become profitable, etc.,” said Ali Hamed, general partner at Crossbeam.
Read on to learn how rising costs of capital affect venture capital, what investors are doing to educate their startups about taking on debt, and what types of startups are best suited for this form of funding.
We spoke with:
- Sophie Bakalar, partner, Collab Fund
- Ali Hamed, Managing Partner, Crossbeam
- Simon Wu, Partner, Cathay Innovation
- Peter Herbert, co-founder and managing partner, Lux Capital
- Melody Koh, partner, Nextview
Sophie Bakalar, partner, Collab Fund
How have lending standards changed for startups looking to raise venture capital? (ARR growth, minimum cash balances, etc.)
The immediate answer is that our continued economic uncertainty has dramatically changed the current credit market, particularly for early stage startups looking to venture into venture capital, in terms of credit standards and the cost of debt.
In terms of lending standards, there has been a focus on revenue growth and profitability. Lenders are looking for startups with a track record of consistent revenue growth and a clear path to profitability. For unprofitable companies, this also means taking a critical look at the unit economy, as lenders want to make sure the capital is used for value-adding investments.
This means that startups with strong annual recurring revenue (ARR) growth rates and high gross margins are more likely to be approved for venture capital, regardless of market conditions. We have a saying that good startups will always get funded, so there is always an exception to this rule.
Second, we see lenders putting more emphasis on minimum cash balances. Startups are expected to have a certain amount of cash on hand, usually enough to cover several months of operating expenses, to demonstrate their ability to weather any financial storms.
Today, this emphasis on several months is more like a year plus. In addition, in the former “at risk” market, lenders were more likely to adopt “covenant light” structures; in the current environment, we expect and have seen lenders demand stricter covenants.
Finally, we see lenders taking extreme caution when assessing venture capital startups based on the strength of their leadership team. Startups with experienced, proven management teams are considered less risky than startups with less experienced leadership, especially in a market where there is so much uncertainty. A strong leadership team can reduce enormously [the impact of] a crisis if and when it arises.
In light of new market conditions, are there certain genres of startups that are no longer suitable for venture capital?
Venture debt has its benefits – now more than ever before. It encourages founders to build rather than grow, which is a good thing when we think about the innovation that can take decades.
As far as startup market conditions and genres go, no one should be immune to it. Everyone should think carefully about how this financing model will help their business run. The first piece of information that a bank and/or regulator typically looks at is whether or not the company is generating revenue and has low compliance risk. Fintechs probably have a tougher challenge here.
We are still actively investing in climate tech startups focused on execution and problem solving. A few of these are startups that have implemented a venture-debt model.
In the current environment, the cost of debt has risen significantly with the rise in interest rates. That’s an important factor for money-burning startups when they think about monthly interest payments and amortization of their debt over time relative to their income and other expenses.
How do you ensure that startups have confidence in venture capital? How Much Education Do Current Founders Need Regarding Venture Capital To Make An Intelligent Choice For Their Startup? Is that more or less than in recent years?
For most startups, education and resources around this type of debt financing is always valuable, especially in today’s market. Founders whose funding plan includes venture capital should start modeling scenarios that assume they lose access to this debt. Even if that risk seems small, it’s always good to be prepared.
In addition, we try to help founders sensitize and soundly audit their forecasts in light of the covenants and downside protections requested by lenders. For example, if sales aren’t growing as fast or margins are lower, we want founders to understand the potential downside scenarios and make sure they have an adequate buffer.
Venture debt can be a great addition to a growing near-profit startup, but it can be a drag for startups burning a lot of money, especially if they’re underperforming.
In a more conservative equity investment market, will tighter credit conditions and more expensive debt be enough to limit the reliance of first-time buyers on borrowed capital?
In addition to stricter credit standards, in this environment it is more likely that lenders will take more time to make decisions and evaluate startups. As lenders lean into the void in the market left by the SVB, less capital is likely to be available and therefore lenders will find it easier to pick and choose in a slower, more conscious way than in 2020 and 2021.