U.S. Startups Increasingly Tapping Debt Markets As VCs Pull Back From Egregious Valuations

After investing nearly $80 billion into startups in 2015, Venture Capitalists, growing slightly weary of the $1 billion valuations being handed out like candy to every 22 year old with an app that can replace your face with that of panda, have pulled back a bit in 2016 resulting in a 10% reduction in equity capital for America's graduating snowflakes.  But as Bloomberg points out, that's not a problem as many of Silicon Valley's revenue-free startups see debt capital as a better alternative anyway...sure, what could go wrong?

Venture deals in 2016—for all but the hottest startups, anyway—required founders to give up more equity in exchange for less money than they did last year. So, despite cautionary tales from tech blog GigaOm and game console maker Ouya, which both flamed out after failing to pay back lenders, U.S. startups have loaded up on debt, enabling them to borrow money without ceding a potentially lucrative stake.

No one publishes national data on venture debt, but a half dozen lenders provided numbers showing activity spiked in 2016. Silicon Valley Bank's loan volume to venture-backed startups surged 19 percent during the past year to $1.1 billion for the quarter ending Sept 30. Wellington Financial made more than 10 new loans to venture-backed startups in 2016, double last year's total. At Hercules Capital, annual volume is up and the average deal size increased 16 percent year-over-year to $15.6 million. TriplePoint's volume is up more than 25 percent. Western Technology Investment CEO Maurice Werdegar called volume "robust" and described the lending environment as "hyper-competitive."

Borrowing capital allows startups to postpone valuation negotiations that come with raising equity. Startups fear the prospect of selling shares at a lower price, known in the industry as a down round. "Folks don't want to do down rounds or flat rounds," says Haim Zaltzman, a partner at law firm Latham & Watkins LLP, which has handled well over 100 such loan transactions so far this year. "Debt allows you to get around that."

Yes, no one like the "down rounds or flat rounds" which presumably come because companies aren't performing well against their business plans.  But, according to Latham & Watkins, that underperformance makes them great candidates for the debt markets.

Of course, debt markets were increasingly tapped in late 2015 and early 2016 just as VC firms started to pull back.

Bloomberg Startups

As startups like GigaOmOuya and Mind Candy have found out, debt lenders are slightly less accommodating when hockey stick business plans don't work out.  While debt can certainly help avoid the dilution of those "down rounds," debt lenders don't get to participate in the upside so they tend to be a little more practical in structuring deals.  In fact, as Bloomberg points out, one lender wanted to accelerate the debt "Metamarkets" if it missed it's revenue projections by just 20%...outrageous

Despite the risk, Driscoll decided to take a loan this year. He says he didn't consider tapping VCs again because another round would have diluted his shares too much. Driscoll says he ran a formal process, getting term sheets from five lenders along with lots of advice from Khosla Ventures and his other investors. The offers had interest rates ranging from 9 percent to 15 percent over two to five years, and the terms protecting the lenders varied. Financial covenants, especially ones permitting the lender to take control of the startup, were sometimes stringent.

One lender had a clause that would force Metamarkets to pay off the debt early if it failed to hit 80 percent of its revenue projection. Driscoll passed on that, opting instead for cleaner terms for a $14.25 million loan in October at an average rate of around 11 percent from Wellington Financial and City National Bank.

But we're happy that Metamarkets was able to raise their $14.25mm covenant-light loan at 11% with no cash flow...we vaguely recall something bad happening with loans like that back in the olden days around 2008...but it was probably nothing.

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Nick De Peyster, CFA 8 years ago Contributor's comment

What could possibly go wrong? Are there publicly traded companies involved in this trend?

Nick de Peyster

http://undervaluedstocks.info/

Nick De Peyster, CFA 8 years ago Contributor's comment

What could possibly go wrong? Are there publicly traded companies involved in this trend?

Nick de Peyster

http://undervaluedstocks.info/

Nick De Peyster, CFA 8 years ago Contributor's comment

What could possibly go wrong? Are there publicly traded companies involved in this trend?

Nick de Peyster

http://undervaluedstocks.info/

Nick De Peyster, CFA 8 years ago Contributor's comment

What could possibly go wrong? Are there publicly traded companies involved in this trend?

Nick de Peyster

http://undervaluedstocks.info/