Venture debt: the market outlook in Europe

Venture debt, or growth lending as it is also known, has become a catch-all term to describe a type of debt financing product available to early and growth-stage companies that are fast scaling but generally pre-profit. As venture debt facilities are designed specifically for pre-profit businesses, they require lenders to look at both credit analysis and legal documentation from a different perspective than they would a traditional profit-generative business or one with high-value tangible assets.

The European venture debt market has grown substantially over the last two decades, but some founders and investors are not familiar with what is out there in terms of debt financing for pre-profit businesses.

European venture debt

In the US, venture debt has long been a popular source of financing for early-stage companies as a tool to supplement and complement venture capital investment. In the last 20 years, the product has travelled across the pond to the UK and more recently wider into Europe. There is now an established and thriving venture debt market in the UK, and there are rapidly growing markets in Germany, the Netherlands, the Nordic region and certain central European countries. This geographic expansion has been primarily driven by existing market participants following the growth of the technology and innovation eco-systems in these countries.

Continental Europe and UK-based tech companies raised over €30bn from venture debt in 2022, which is, according to Bloomberg, almost double the amount raised in 2021. This uptick has come off the back of equity markets being less buoyant as well as founders and existing investors looking to improve the liquidity "runway" with less dilution to their equity holdings.

When is venture debt suitable?

Venture debt products are most appropriate for companies that are pre-profit (whether early-stage companies or more mature companies that are actively choosing to focus on high growth over profit). Typically, they have completed at least one or two decent-sized equity funding rounds with reputable institutional investors (venture debt providers will take comfort in this and will, to an extent, piggy-back on the diligence conducted by those investors), have a clear plan to raise further equity in the near future and have a cash runway that will see them through to the next inflexion point (increased revenues/next equity raise etc.). The main targets for venture debt tend to be tech companies with proprietary intellectual property (IP) or companies with recurring "sticky" revenues, like software-as-a-service (SaaS) providers.

For earlier stage companies, venture debt extends cash runway to enable the company to grow and hopefully achieve a higher valuation at their next funding round; for more mature companies, it is expansion capital and best employed for specific purposes such as breaking into new markets, meeting customer acquisition costs, internationalising or fulfilling a "buy and build" strategy.

Venture debt's key features

Today, there are a lot of options available in terms of venture debt products, in part due to there being more competition in the market in the form of both credit fund and bank lenders. European venture debt products commonly offer the following features:

• Types of loan. Venture debt is provided via term loans (often provided in tranches linked to the achievement of certain revenue, performance or fundraising milestones), convertible notes and, for more proven business models, revolving credit lines linked to recurring revenue or accounts receivable-based formulas.

• Less dilution. Unlike venture capital, venture debt is a less dilutive fundraising option. Lenders will often take an equity kicker (known as a warrant) which may be a right to subscribe for a stake in the company at an agreed strike price (normally a modest percentage of the loan commitment and in the class of share held by the institutional investors). The lifespan of a warrant is normally 10 years and will contain protections to ensure the warrant holder (lender) is treated commensurate to shareholders. It is often common to also see a right to invest in the next equity round (again usually a modest amount).

• Pricing. Like all loan arrangements, the overall cost of a venture loan is a made up of a combination of several elements. In addition to interest (which will be a percentage comprised of a coupon plus base rate) there will be a mix and match of upfront arrangement fees, exit fees and the warrant entitlement to spread the cost of the loan. There may also be non-utilisation fees (for a revolving line) and prepayment fees (also known as non-call or "make-whole" fees for a term loan).

• Financial and non-financial covenants. Traditionally, financial covenants were not seen alongside pure term debt (they are more common alongside revolving credit lines); however, they do occasionally feature depending on the credit and overall package offered by the lender. Where financial covenants are part of the agreed terms, they will generally focus on revenue (or recurring revenue), liquidity and sometimes cash burn rate. And, not unlike venture capital, venture debt providers will restrict things that could distract from the business plan, soak up cash, devalue the business or allow incurrence of further indebtedness. But they will always provide sufficient flexibility to allow the business to operate and grow as planned. Lenders will also be very focused on not only the continued support of the core institutional investors but also key people; they will want to mitigate any risk of losing a key person, usually a founder. Early communication between the borrower and lender on any out of ordinary scope items is the best way to proceed and lenders are normally responsive and supportive.

• Board oversight. Some lenders may require an observer seat on the board. All lenders will require sight of annual accounts, regular financial information and performance to KPIs (key performance indicators). There will normally be a monthly compliance certificate to confirm adherence to key measures. Venture lenders do not expect to as involved in day-to-day decision making as equity investors may expect to be through their investor board seats but want to be close to the business and have access to the same information as the institutional investors (confidential and legally privileged information aside).

• Security. Generally, venture debt will be offered on a secured basis and, in jurisdictions where it is possible, an "all assets" security agreement will be taken. The focus of the security will typically be on any cash, material IP, stock or inventory and any accounts receivable of the business. When lending against recurring revenue or customer receivables, the security may involve blocked collections accounts for the company's cash and accounts receivable. Most lenders will take a practical approach to balancing the cost/benefit of taking security across a geographically widespread group. Where group entities are not generating material revenue or are cost/development centres lenders often exclude them from the security net in return for covenants limiting the amount of cash held by and financial assistance provided to such entities.

Osborne Clarke comment

Venture debt as a fundraising tool has risen in popularity in the last few years, partly because of the downward pressure on equity valuations and partly because attitudes towards it have evolved in a positive way.

Looking to raise debt at an early stage in the lifecycle or pre-profit is now a sign of financial prudence. Founders and investors regard it as a helpful, non-dilutive supplement to equity in fuelling growth and there is an increasingly symbiotic relationship between founders, investors and debt providers.

As valuations continue to come under pressure, it is crucial that companies do not become stagnant; cash runway is as critical now as it has ever been. That's why many companies, including many of our clients, have been increasingly looking to venture debt products to extend their cash runway, shore up their balance sheet and avoid an equity "down round".

A key area of growth in the venture debt market is around the market participants – there is a lot of competition out there at the moment from banks and credit funds with new players entering the market regularly.

Venture debt is an attractive asset in terms of return on investment and risk and, venture debt poses an opportunity to deploy capital in a competitive lending environment and as a means of gaining access to attractive tech and life science credits earlier in their life cycle.

This has created healthy competition and innovation in new products, but more choices can be daunting for founders so there is a role for venture capitalists and their legal advisers in guiding founders through the options available to them and ensuring the company partners with the right lender and secures competitive terms.

Many of the loans we advise on in the space currently are based on a multiple of recurring revenue, catering to businesses adopting a subscription model (notably SaaS) – and we have seen a recent uptick in recurring revenue financing in the European market.

The Osborne Clarke venture and growth debt finance team has been advising on venture debt products since 2000. We advise on the full spectrum of venture debt products and act for both lenders and borrowers.

We have been advising more early-stage and growth companies on debt financing options as investors and CFOs become more familiar with the debt-financing options available to early stage, pre-profit companies and how they can complement an equity fundraising plan.