WASHINGTON: Persado Chief Executive Officer Alex Vratskides could raise venture funding. He’s just not sure he wants to.
His New York-based start-up doubled annual revenue this year and is on track to break even in 2017. Valued at about $200 million (Dh735 million) in April, the marketing automation company counts Bain Capital and Goldman Sachs among its backers-a source of validation in the eyes of many venture investors.
But Vratskides thinks there’s a better way to reach the finish line: take on debt. “Interest rates are low, and you avoid dilution. It’s a no-brainer,” says Vratskides, who is angling to secure a loan of $30 million or so in the second half of 2017. “It is potentially our first preference going forward.”
Last year venture capitalists ploughed a record $79 billion into start-ups at often unsustainable valuations. Enthusiasm waned in 2016, when fewer start-ups got funded, and those that did faced more scrutiny and tougher deal terms. While the market has recovered somewhat in the last few months, it’s down 10 per cent from its high mid last year, according to the Bloomberg US Start-ups Barometer, an index tracking funding and exits for private companies.
Venture deals in 2016-for all but the hottest start-ups, 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, US start-ups 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 start-ups surged 19 per cent 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 start-ups in 2016, double last year’s total. At Hercules Capital, annual volume is up and the average deal size increased 16 per cent year-over-year to $15.6 million. TriplePoint’s volume is up more than 25 per cent. Western Technology Investment CEO Maurice Werdegar called volume “robust” and described the lending environment as “hyper-competitive.”
Borrowing capital allows start-ups to postpone valuation negotiations that come with raising equity. Start-ups fear the prospect of selling shares at a lower price, known in the industry as a down around. “Folks don’t want to do down rounds or flat rounds,” says Haim Zaltzman, a partner at law firm Latham & Watkins, which has handled well over 100 such loan transactions so far this year. “Debt allows you to get around that.”
Zaltzman compares this year’s activity with the debt boom in 2008, when venture funding slowed to a trickle. Silicon Valley Bank, the granddaddy of tech lending, says loan volume and value could have gone even higher. “What constrained us was discipline,” says Marc Cadieux, the bank’s chief credit officer who has seen competitors offer start-ups double what his bank would do and at “materially cheaper” rates. “There are limits to what we’re willing to do.”
Taking on debt can be risky. Unlike venture investors who typically bet one investment will hit big and compensate for duds, lenders get no upside if a start-up succeeds. They require timely payments from all their companies, with interest that’s designed to provide the lender with a more predictable and less risky source of revenue than venture investing. When start-ups miss payments, as GigaOm and Ouya can attest and gaming company Mind Candy is finding out, lenders can be unforgiving.
“When things go bad, they go very bad, but there’s usually little information about the wind down,” says Mike Driscoll, founder and CEO of Metamarkets, an advertising technology start-up founded in 2010 that has raised around $40 million. “Silicon Valley buries its dead very quietly.”
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 per cent to 15 per cent over two to five years, and the terms protecting the lenders varied. Financial covenants, especially ones permitting the lender to take control of the start-up, were sometimes stringent.
One lender had a clause that would force Metamarkets to pay off the debt early if it failed to hit 80 per cent of its revenue projection. Driscoll passed on that, opting instead for cleaner terms for a $14.25 million loan in October at around an 11 per cent rate from Wellington Financial and City National Bank. He’ll use the cash to invest in Metamarkets’ cloud infrastructure, which should ultimately lower operating costs.
Although debt activity is up this year, the practice is hardly a new phenomenon. VCs have long arranged lines of credit for start-ups-which they can draw from, or not-at the time they invest to help them meet operating costs and ensure they don’t run out of cash between rounds.
Western Technology Investment names several hundred start-ups on its site as current debtors, including insurance start-ups Collective Health and Oscar Health, Jet.com, which was acquired by Wal-Mart Stores for $3.3 billion in August, and data mining giant Palantir Technologies. Another customer is car-buying site Beepi, which shut down its business outside California, cut 180 jobs and merged with another start-up this month.
Matt Murphy, a partner at Menlo Ventures, says most companies he works with have some amount of debt. So long as the terms are structured properly, it can be a good way to minimise dilution and build to the next funding round, he says.
Latham Watkins’ Zaltzman expects the brisk pace to continue through next year as more mature companies seek options other than venture investment or going public.
“You don’t have to grow 20 per cent or 30 per cent every year to be a good candidate for debt credit,” he says, adding that some start-ups valued at north of $1 billion will fall into that category. “Some of these unicorns are limping, but they haven’t gone completely bust yet.”
