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Venture debt — Now is the time

This week, the AFR’s Chanticleer wrote about the potential for an acute refocus in the Australian equity VC landscape, citing the sharp decline in investor sentiment in Silicon Valley.

It highlights some of the key reasons that venture debt piqued my interest when I joined OneVentures in Jan 2022 — and why now is the perfect time for both founders and equity investors to consider venture debt.

Despite sliding public market valuations and heightened uncertainty, companies with strong fundamentals should not be restricted in raising capital, and venture debt could be the best path forward for three reasons:

1. Limiting cash burn creates opportunity cost

“With this in mind, local VCs are telling start-ups who thought they could raise capital in the next 12 to 18 months they probably need to make the money last for as much as two years.”¹
Chanticleer, attribute to local VCs

Why do companies need to eke out their funds? Because VCs don’t want to incur paper losses as a result of down rounds?

The problem is, with this approach to the downturn, companies will incur opportunity costs from:

  • Forfeited or slowed growth due to hamstrung expenditure, reduced or rationalised sales & marketing teams;
  • Lost commercial opportunities; and
  • Lost competitive ground due to lack of investment in engineering, product & marketing.

We need to balance risk management with opportunity cost.

Venture debt can unlock funding for companies that need to increase their burn to grow, or to pursue time-sensitive growth opportunities available to them. Venture debt providers can work with equity VCs and founders to provide interim funding — a bridge between rounds that allows companies to pursue growth (sales & marketing teams, new market entry, NPD), at pace.

2. Avoid setting a valuation now

If shareholders can avoid setting a valuation in this environment, they can escape excessive dilution that can materially impact the control structure of the business, and significantly increase the cost of capital to both existing investors and founders.

There are also indirect consequences in an unfavorable valuation environment. Paper valuations are often deemed markers of objective success in the startup & VC community. See publicity around Australia’s recent unicorns such as Canva, Airwallex, Judo Bank, Go1, Culture Amp, Safety Culture & Rokt. They bolster investor sentiment and can generate interest from peers, potential customers and of course, new VCs.

Down rounds and write downs on the other hand, can cast doubt on future exit pricing or further deteriorations in value.

Companies with good fundamentals can push through a trough in the market and avoid the need to ‘set’ a valuation, deferring until:

1. The market sentiment has improved, and; 2. The business itself has achieved greater scale.

Venture debt allows companies to raise capital without setting a valuation until markets have improved, and additional growth milestones have been achieved.

3. Pre-IPO investors will be under pressure — and options are available

“The IPO window has effectively closed.”²
Aussie start-up investors hold firm against valuation jitters, Yolanda Redrup and Jessica Sier, May 2022

As compared to typical VCs with an investment horizon of c.10 years, the issue of softening markets is acute for pre-IPO investors given the public market response is swift.

Typically, pre-IPO investors establish binding deadlines towards a public market exit (IPO). These deadlines are usually 12–24 months.³ Compare this to a typical economic growth cycle: the OECD estimates cycles last an average of ~5 years, with economic downturns in Australia typically lasting c.1.5 years.⁴ Pre-IPO investors have a nearer term investment horizon and the particular challenge of timing their terms against public market cycles.

The issue can exasperate founders who may need to double down on the potential discount offered in a typical pre-IPO convertible note (at the expense of their own dilution), should the exercise deadline extend as a result of poor equity market performance. These terms are pretty common, and in several recently publicized Australian start ups.⁵

Exit deadlines keep companies focused on the “end goal” — but can be tough in a deteriorating valuation environment.

Other options include raising new notes, or other forms of capital.

In this context, venture debt can offer a non-dilutive solution that gives founders, convertible note holders and other investors additional flexibility to plan for their IPO, particularly the opportunity to be intentional with their IPO timing.

In summary

The impact on private companies in Australia will be more nuanced than a broad decline in valuations.

The established mid-market may be divided between those able to pass on the impacts of inflation, and ability for private equity firms to leverage buyouts affordably given forecast rate increases.⁶

On the other hand, the Australian start up scene is about to receive an unprecedented injection of capital, with Blackbird’s ~$1bn across several new funds, Square Peg’s $US550m across two new funds, and AirTree’s $700m across three new funds.

This surge in capital supply will likely have a supportive impact on private valuations in the face of global tech re-ratings and reduced inflow from US or Asia-based VC firms. Indeed, our own Michelle Deaker believes this influx of new capital into the Australian VC market will “…shield Australian startups from a severe re-rating…but only for the next 12 to 18 months”.²

For high quality companies seeking to extend runway, avoid setting a premature valuation or increase flexibility ahead of an IPO, now is the time to consider venture debt. It’s non-dilutive, can be completed quickly and can be structured flexibly so that founders can use the cash as they see fit.

If you’re interested in exploring or better understanding venture debt please reach out to the OneVentures credit team.

Justine is an Investment Director at OneVentures. OneVentures is one of Australia’s leading venture capital firms, with over $500m in funds under management and two active venture credit funds, including the 1V Venture Credit Fund IV and 1V Venture Growth Credit Fund.

1V Venture Credit Fund IV was launched in June 2020 and has $80m in Funds under Management and 16 investee companies. The fund was formed in collaboration with Viola Credit of Israel, The Fund is focused on rapidly growing companies that are differentiated through technological innovation, with strong revenue growth.

1V Venture Growth Fund (VGF) was launched in November 2021 with $30m in committed capital including $15m from Invest Victoria. The fund’s objective is to support ongoing innovation, new industries and development of technology within Victoria. Operating alongside the first 1V Venture Credit Fund, the VGF is expected to invest in high-growth Victorian technology companies.

https://one-ventures.com.au/

We are currently uncovering current attitudes and understanding of Venture Debt in partnership with the Tech Council of Australia, we’d love your participation in this survey: https://www.research.net/r/VYPG3QK

Sources:

1. VCs about to learn a hard investment lesson, Chanticleer, published May 9, 2022
https://www.afr.com/chanticleer/vcs-about-to-learn-a-hard-investment-lesson-20220508-p5aji6

2. Aussie start-up investors hold firm against valuation jitters, Yolanda Redrup and Jessica Sier, published May 3, 2022 https://www.afr.com/technology/aussie-start-up-investors-hold-firm-against-valuation-jitters-20220426-p5aga4

3. “…Generally, the maturity date of the notes will be within 12 to 24 months of their issue…” Australian IPO Review 2021: Pre-IPO Capital Raises, Herbert Smith Freehills Legal Briefings — Alexander Mackinnon — published 28 February 2022
https://www.herbertsmithfreehills.com/latest-thinking/australian-ipo-review-2021-pre%E2%80%93ipo-capital-raises#:~:text=Pre%E2%80%93IPO%20convertible%20notes%20form,events%2C%20most%20importantly%20the%20IPO.

4. The changing nature of the business cycle. Reserve Bank of Australia Economic Conference. Sydney, Australia July 11–12, 2005. “Business Cycle Dynamics in OECD Countries: Evidence, Causes and Policy Implications” by Jean-Phillipe Cotis and Jonathan Coppel OECD, Economics Department. Note: Australian economic downturns refer to periods where the growth rate is below the “long-term trend rate of growth.” https://www.oecd.org/economy/growth/35125435.pdf

5. “The convertible note will convert at a 20 per cent discount to IPO price, if the business lists within 2022. If the listing slips into 2023, it will convert at a 25 per cent discount.” Men’s health player Mosh joins pre-IPO raisers, Anthony Macdonald, Yolanda Redrup and Kanika Sood, published Dec 6, 2021
https://www.afr.com/street-talk/men-s-health-player-mosh-joins-pre-ipo-raisers-20211206-p59f2p

“The conversion at IPO would take place at a 20 per cent discount to the listing price, the term sheet said, or a 30 per cent discount if it takes more than 12 months. Converted shares would be subject to a 90-day escrow on listing.” Beforepay back with another pre-IPO raising, Sarah Thompson, Anthony Macdonald and Tim Boyd, published Mar 25, 2021
https://www.afr.com/street-talk/beforepay-back-with-another-pre-ipo-raising-20210325-p57e2a#:~:text=The%20convertible%20notes%20would%20pay,takes%20more%20than%2012%20months.

6. https://www.rba.gov.au/media-releases/2022/mr-22-12.html

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