With Fed chairman Jerome Powell expected to announce another 75-basis-point (if not higher) interest rate hike tomorrow, the cost of borrowing is understandably front of mind for the economic world.
We’ve seen the number of mortgages decrease greatly in recent months in response to these increases (and inflation).
However, despite this more expensive debt landscape, there are certain areas of the business world that are actually borrowing more.
While it may seem counterintuitive, it is understandable when you look at the options at these companies’ disposal…
After experiencing a seemingly endless flow of capital throughout the past decade, the venture capital well has dried up quite a bit. However, that doesn’t change the events of the past few years.
Most notably, for startups that raised capital via venture capital or crowdfunding before 2022, they did so at a time when valuations were ballooning. This wild-west-like atmosphere pitted VCs against each other and rewarded startups for nothing more than lofty ideas.
So, when those same companies need capital, they’re faced with a choice: raise additional funds at a decreased valuation, or raise money through debt.
Increasingly, startups are opting against down rounds and favoring borrowing – despite sky-high interest rates.
In the first six months of 2022, venture debt was up 7.5% compared to the year prior. On the flipside, VC funding decreased 8% during that same timespan.
“When you have your plans set and you know you can reach them, and all you need is that little extra bit of cash, then venture debt for a founder, for a company, is cheaper,” Fractory Ltd. founder Martin Vares told Bloomberg. “You’re not giving away a part of your company.”
While the fact that a company’s cap table remains the same when taking on debt is relevant, the first portion of Vares’ quote is even more so.
When you have your plans set and you know you can reach them.
A large part of the VC frenzy from the past few years was directed toward buzzy tech startups proposing long-term, world-changing technologies.
Unfortunately, those same companies lacked tangible results and timelines.
These were inherently uncertain and speculative ventures. While valuations were propped up by the speculative upside, there was no downside to invest for angel investors and venture capitalists. It was a reasonably safe bet that the valuations would continue to climb.
With the economic landscape now growing more and more uncertain itself, that calculus has changed.
It’s always important to look at a startup from a 360-degree perspective when considering investment.
The reality is, with startups avoiding down rounds unless absolutely necessary, there are a growing number taking on debt. Evaluating startups with debt is a tricky proposition, and it’s important to be confident in a business’ ability to make routine payments without damaging its prospects for success.
In the best-case scenario, debt is a lifeline that builds a bridge toward a company’s final destination.
In the worst case, it is the dirt on top of the casket.
It’s paramount that a startup’s borrowing is with a specific plan in mind. It cannot just be a Band-Aid to buy additional runway and delay confronting underlying issues.
Which makes due diligence all the more important when considering an investment. There will be more and more crowdfunding startups in the coming years that raised capital via debt.
It will be up to you – the investor – to determine if it was prudent.