The Evolution of Venture Debt

For over a decade, low interest rates provided early-stage tech companies with access to cheap capital. Companies intensely sought debt to help fuel the top-line growth investors wanted, and to pad their balance sheets to improve overall valuation and show investors they had ample liquidity.

It also helped business improve the timing of their equity raises to maximize valuations. Through the pandemic, as valuations soared, and software businesses were rewarded for growth above all else, higher debt loads became more common with some companies even looking to the private debt markets to maximize leverage.

With interest rates now higher, the use of debt is a more calculated exercise. Where debt was previously used to pad valuation and balance sheets because it was simply cheap, what is now a “good” use of debt is a much more pertinent question than ever before.

Consider higher interest costs can make it more challenging to hold debt on the balance sheet. Also, high debt loads can make a business less attractive to potential buyers or investors. That’s why in this volatile interest rate environment, companies need to assess whether their use of debt will be a net positive or negative for their long-term prospects.

Many early-stage tech companies use debt financing to extend their start-up runway as they cut costs to achieve positive cash flow. In the days of low interest rates, the idea was to delay raising equity and create a six-month runway extension through a debt facility instead. They would use that time to grow the business and, if they could time the equity markets perfectly, attract a higher valuation in a few months.

But things have changed. Now, higher interest costs could negatively impact their ability to reach breakeven cash flow. In this context, determining how to put debt to the best use means you’ll need to be more diligent about demonstrating a return on investment.

In the current environment, tech companies can explore three potential uses for debt facilities that deliver tangible return on investment.

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  Geographical expansion. Access to new markets can provide opportunities for your business to scale; create a “first-mover” advantage in markets with no or minimal competition; and acquire new customers who can provide additional insights and feedback to further improve your product offerings.

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  Product expansion. You can create new cross-sell and upsell opportunities, which can drive the top-line and bolster growth. The greater variety in your offerings also delivers the potential to improve customer retention and feedback, as well as potentially attracting new customers.

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  Mergers and acquisitions. There are plenty of opportunities to acquire company assets at attractive valuations. That includes businesses complimentary to your product offerings and customer base, or competitors to help bolster your market position, enter new markets, or acquire technology capabilities that would otherwise be out of reach. Ideally, such a deal would improve your balance sheet and liquidity position, which can bolster valuation and provides confidence to investors and stakeholders.

Tech start-ups are under pressure from their boards to reduce burn and deliver strong ROI. If you’re using debt instruments as an insurance policy against a tighter capital environment, it may be harder to demonstrate your return on investment, which could put more pressure on the company without any potential upside.

But even in a high interest rate environment, debt financing can be a valuable tool. The key is determining what constitutes better uses of debt for your company.

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