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King Street: Venture Debt Offers a Way Around Slowing Valuations

Start-ups want to avoid “down rounds.” Credit manager King Street says debt — or growth lending — is one answer.

For venture-backed companies looking to raise more capital, now may be the wrong time — and it’s not because fewer venture firms are looking to invest.  

Chatter about a slowdown in venture fundraises has proliferated in allocator conversations and on social media, but TechCrunch recently chalked that up to just talk, at least for now.  

“I don’t think it’s as much of an issue around fundraising,” said Ed Testerman, partner at credit firm King Street. “More of it is driven by valuations that are going to have to reset for these later-stage businesses. You don’t want to have to go to market and raise a down round.” 

According to Pitchbook data, early-stage venture valuations in 2021 had increased 5.5 percent since 2010, while late-stage valuations had increased 3.7 times during the same time frame. Thanks to 2021’s high valuations, it would be difficult for companies to raise another “up round” — that is, a round of capital that values the company higher than the previous fundraise.     

In 2021, venture equity investing increased twofold, hitting $330 billion invested, compared with $167 billion in 2020, according to statistics cited in a new King Street white paper. Venture debt, meanwhile, declined to nine percent of capital raised by companies, compared with a high of 22 percent in 2019. The venture debt market is worth about $30 billion. 

Traditional venture debt investments are made up of senior secured term loans combined with equity warrants or success fees. As such, in addition to the return of capital and interest, investors either receive the right to buy shares at a certain price (via equity warrants) or a small portion of equity ownership of the portfolio company, which can only become valuable when the company is sold.   

As Institutional Investor previously reported, Silicon Valley Bank is a major player — it owns about 60 percent of the market. Publicly traded business development companies and upstarts like Applied Real Intelligence and Mercury Capital, meanwhile, are vying for the remaining share of the market.   

According to Testerman, King Street is targeting loans that are larger than what these financiers typically provide. Since it launched the strategy in late 2019, King Street has deployed about $1.5 billion through its opportunistic strategies. The firm sits at the later-stage end of the market, providing capital to growth companies that need one-to-three-year bridge financing, which it provides via a variety of vehicles, including term loans, unsecured mezzanine bonds, hybrid capital, M&A lines, and others.    

And Testerman expects that to grow. Although fundraising hasn’t slowed down, deal flow has. “If you look at general VC deal flow in the first quarter, there was less capital deployed than [there] was over the last quarter or two,” Testerman said. “You’re seeing a shift in dealmaking from late to earlier stages. You’re seeing a move to earlier-stage deals.”     

But the dearth of deals — Testerman said his team has seen 50 come through the door in the past quarter — doesn’t mean that these investments are without risk.  

Venture debt providers, or growth lenders, as Testerman calls King Street, are betting on companies that are not yet profitable and thus don’t have cash flows. This is unlike other pockets of the credit market, where loans are made against revenues, cash flows, or real assets.  

While some growth companies do have real collateral, others don’t. “There's a higher risk that these companies won’t become cash-flow generative to ultimately repay your loan from cash flow generated by the company itself,” Testerman said.  

But there’s a way around that. Even if they haven’t started pulling in cash flows, these venture-backed companies can always go back to market, raise more equity, and repay their loans. Perhaps there’s a market for more venture capital deployment after all.  

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