The Exciting Future of Alternative Financing in the UK
Written By: Rick Kirtland
In a fast-paced and ever-changing world where the entrepreneurial ecosystem is growing rapidly, traditional financing solutions have largely failed. As a result, alternative financing solutions such as venture capital have emerged as essential financial assets and catalysts for development in new high-growth early-stage start-ups who wish to propel economic expansion forwards and promote innovation.
However, despite venture capital’s well-established foothold in the US, its growing popularity in Europe and its more recent emergence in the UK, there’s a problem.
But the good news is it’s a problem with a solution, one which comes in the form of venture capital’s currently more low-key cousin: venture debt.
What is Venture Debt?
Many high-growth potential startups continue to face potential ruin as they are unable to raise the finance necessary to balance demand and supply. With an ever-widening disparity between what modern businesses need and what current financing instruments can manage, business owners are desperately searching for an answer to their problems. But they need look no further. The antidote to impending financial disaster can be found in venture debt – a relatively new addition the alternative financing sector, especially in the UK.
Venture debt – or venture lending – refers to a specific selection of alternative debt financing solutions, usually offered by technology banks or dedicated venture debt funds, which offer to fund working capital or expenses for early- and growth-stage startup companies that have already secured venture capital backing. When structured carefully, venture debt can be an extremely attractive and powerful financial ally.
By investing hundreds of millions of dollars, this little-known partner has worked hand in hand with influential venture capitalists to prop up and promote some of the biggest new start-ups of recent years.
From Venture Capital to Venture Debt: A Brief Background
The foundations of venture capital can be traced back to the late 1800s, although it only emerged as a financial industry after World War II. The ‘Father of Venture Capital’, George Doriot (a Harvard professor), was the first to invest considerable sums of money into commercial technologies. In 1947, he created the American Research and Development Corporation. Ten years later invested $70,000 in the Digital Equipment Corporation, which was valued eleven years later at $38 million – a return of over 500 times on the initial investment.
Venture debt followed shortly after and appeared initially as a completely collateral-driven enterprise; however, a decade later venture debt investors were offering 100% finance. Today, venture debt is highly adaptable and can be provided as both a financial investment and an investment of skills or technologies.
How Does Venture Debt Work?
Unlike more traditional types of debt financing, venture debt does not require large-scale investment of collateral; in fact, no collateral whatsoever is needed. Instead, due to the high-risk nature of the debt instruments, the lender is safeguarded by the start-up’s warrants on common equity. Venture debt is usually extended to companies which have already successfully completed several rounds of venture capital fundraising but do not yet have the necessary cash flow to enable them to fulfil their perceived potential in the market.
Debt terms are usually much shorter than more traditional lending mechanisms, with the average terms being short-to-medium, or roughly three to four years. Loan amounts are usually tied closely to the most recent sum acquired through equity financing, with the principal made available being, in most cases, approximately 30%.
Most venture debt instruments require interest repayments, which are based on either LIBOR or prime rate benchmarks, and due to the high-risk lenders receive warrants on the company’s overall equity. In general, warrant distribution represents up to 20% (usually 10–15%) of the principal value of the loan. Warrants can also be exchanged in future for common shares at a rate linked directly to the per-share price achieved at the most recent equity financing round; these warrants can often return the most considerable returns to borrowers.
In order to ensure repayment, many banks will include a number of covenants, whereas other lenders might be much more flexible and only include a small amount.
Uses of Venture Debt
It is important to differentiate between both venture capital and venture debt, as although they both support companies in their quest to establish themselves fully in their chosen market, they enter a company’s journey at different points.
In brief, venture debt supports companies who are already relatively mature, while venture capital instruments are usually used during the start-up phase when there is significantly more risk with immature companies that can project valuations in the millions.
Another difference is that venture debt is usually repaid in fixed term loans, whereas venture capital is oriented towards equity dilution (where capital is exchanged for a portion of the ownership of the company). As a result of this, investors might assume board seats, which means that the company founders lose an element of control.
So, what do investors look for?
As well as looking for superior and economical services and products that can supply a burgeoning demand, venture capitalists (VCs) for a competitive advantage in the target market as well as solid current and expected performance.
Read about more uses of venture debt here.
Startups & Fundraising
In terms of fundraising, there are a wide variety of options for startups. Some rely more on traditional methods, such as bank debt, working with investors, bootstrapping or grants, while others, like crowdfunding or securing venture capital, are more innovative.
Each has its own advantages and disadvantages. For example:
- Traditional bank loans are stable but usually require some kind of guarantee or security (which is not always possible for small-scale start-ups).
- Investors are sometimes easier to find or convince but might charge higher rates or be less sophisticated and/or experienced than necessary.
- Bootstrapping and grants allow the business owner to retain control but can stunt the growth of the business due to a lack of sufficient cash flow (when bootstrapping) or extended waiting times (when applying for grants).
- Crowdfunding can be a great marketing tool and a great, and fast, way to raise finance with minimal or no upfront fees. However, failed projects risk damaging the reputation of the company, as well as those who invested in them (and due to the nature of the crowdfunding itself, the damage done is made very public); owners might waste time constructing platforms which raise no finance whatsoever, and then there are the scammers. Many projects have a successful ‘raise’ but do not pull through on the execution of the project.
- Working with VCs usually means that you will gain advantages such as the ability to draw on their business expertise, resources, support and connections but must also acknowledge significant disadvantages such as larger investment sizes, fewer deals, a lack of control and minority ownership status.
All of this leaves business owners with one question: Is there a solution which has fewer disadvantages but a similar, if not even better, set of advantages? And the answer is, of course, yes: venture debt.
The Growth of Venture Debt in Europe & the UK
Venture debt as an alternative financial solution for startup companies has grown rapidly throughout in the US; however, it is still in its fledgling stages in the UK and in Europe. British Business Bank analysis of Preqin research shows that the UK currently (as of 2020) has 16 active venture debt fund managers compared to over 100 in the US. The good news is that although there has been little further analysis conducted on the venture debt industry in Europe and the UK, the number of UK venture debt funds is steadily on the rise.
Therefore, this is the perfect time for UK companies to get ahead of the curve, take advantage of this powerful – and above all profitable – new solution and reap all the benefits it has to offer.
As a myriad of industries worldwide strive to respond to the needs of a truly international and globalized world, there has been an ever-increasing demand for dynamic and innovate alternative financing solutions that can respond to the needs of these modern business owners and provide them with the working capital they need to continually consolidate and innovate, and by doing so drive the economy forwards.
Traditional modes of financing have struggled to satisfy entrepreneurs’ needs and so are finally giving way to a surge in alternative financing, of which venture capital and, more recently, venture debt are at the forefront.
Venture debt in the UK has a very bright future.
Will you be a part of it?