Venture debt: down rounds push start-ups to seek funds elsewhere  

In the US tech sector, venture funding for large start-ups has begun to seize up. VC firms have managed to raise plenty of funds but they are less willing to put them to use unless valuations come down to earth. Tech start-ups are notorious for burning through cash. The downturn in public markets has led to down rounds in private markets. Some companies have been forced to do it themselves. Grocery delivery company Instacart, which hopes to go public, is reported to have cut its own valuation from $39bn to $13bn in just over a year.

But start-ups who are unwilling to swallow lower valuations have another option: debt. Founders who hope the market downturn is temporary and believe demand for investment in large private tech companies will soon return can try to use debt as a means of extending their cash lifeline while keeping their valuation intact. Alongside specialists such as Hercules Capital, private equity giant Blackstone is expected to invest $2bn in start-up debt.

As well as avoiding a revaluation, debt has the advantage of not diluting the equity of existing investors. Data from PitchBook show that as of the third quarter of this year, debt transactions in the US have reached $22.8bn. This means the total is unlikely to beat the past three years, all of which hovered around $33bn, but will be above previous years recorded.

But the cost of taking on that debt is growing heavier. Like equity investors, credit investors want to see solid business plans and rising revenue before putting their money on the line. Any hint that this might be at risk means introducing different terms. That can include covenants that restrict start-ups from making acquisitions and undertaking other activity without the lender’s approval. Meanwhile, rising rates mean borrowing costs are increasing. PitchBook notes rates of up to 20 per cent.

The risk is that onerous debt repayments could hamper performance. Instead of loading up with debt, start-ups need a reality check.