The tenuous state of Silicon Valley Bank will change the accessibility of venture debt. The implications on startups, investors, and the private markets will be profound.
In Silicon Valley Bank‘s (SVB) Q1’23 mid-quarter update issued last week, the following commentary sticks out:
“Clients continue to opt for debt over raising equity at pressured valuations.”
This was a telling statement.
And its impacts will be significant, including:
- Lower tech valuations
- Higher startup mortality
- Intensifying layoffs
We will detail each of these implications below.
But first, let’s go back to SVB’s comment.
Debt was being used to avoid pressured valuations.
This provides some clarity on a perplexing question: Why have private market valuations still held up despite the sharp declines in public market valuations for tech companies?
This sentence from the SVB presentation helps explain what was going on.
It also sheds light on what is about to happen in the private markets, given there will be less venture debt to go around.
To start, it’s worth understanding venture debt. If you’re already familiar, skip this part and jump to the implications here.
First, what is venture debt?
SVB describes venture debt on its website very well, so we’ll use its description:
- Venture debt is a loan that enables fast-growing and investor-backed startups to access capital with less dilution, typically soon after an equity round. It is used to extend the runway until the next fundraising round.
- Venture debt is typically set at 20-35% of the latest equity round, though other factors like company growth rates, investors, industry, and customer base may also be taken into account.
- Venture debt-to-valuation, a common metric for evaluating debt worthiness, is usually around 6-8% of the company’s latest post-money valuation.
SVB also provides this illustration of venture debt vs. equity to highlight why debt is less dilutive than equity — and hence attractive to founders and teams.
Source: Silicon Valley Bank
Unlike traditional business loans, which might be backed by cash flows or assets, venture debt lenders underwrite deals to fledgling (and often money-losing) companies using 3 criteria:
- The quality of the VC investors doing the deal. To inform this, SVB built an extensive network of top-tier VCs. You can see its technology investment syndicate here and its healthcare investment syndicate here.
- Future financings. This is the likelihood that the company will raise another round down the line.
- The ability to take warrants in the company to minimize overall losses. Warrants for small equity stakes serve as a sort of “schmuck insurance” for any bad deals, as the bits of equity in the winners more than makes up for the losers.
Now, let’s get back to how startups have leaned on debt to avoid pressured valuations — and the implications of this on financing and valuations moving forward.
Implication 1: Valuations have much further to fall and down rounds will become more common
First, let’s cover what has been going on in private and public market valuations.
By Q4’22, private tech valuations across most stages had fallen modestly from 2021’s heights, but were still up compared to 2020, per CB Insights’ valuation data.
While there was a bit more deal structure in later-stage financings (as we note here on page 3), valuations were still elevated and had more room to fall given how dramatically the situation on the ground had changed.
In fact, as highlighted below, tech valuations in Q4’22 for Series C deals were actually up 20% over full-year 2020 levels. Valuations for Series D+ deals were up 30% vs. 2020.
Source: CB Insights’ Tech Valuations 2022 Report
It’s feasible that companies with momentum and metrics were the ones raising in the more challenging climate of the past year, and so they might still have been able to command premium valuations.
But companies that didn’t have the metrics were availing themselves of debt to avoid “pressured valuations,” as SVB noted.
Debt helped companies delay taking the medicine of a lower valuation, dilution, and tough conversations with the team. In some cases, it also helped companies avoid (or perhaps delay) layoffs or even failure because of an inability to raise equity capital.
To put the valuations in the private markets in perspective, let’s look at how tech IPOs since 2020 have fared.
As of this week, the combined market cap of the 50 largest tech IPOs since 2020 is down 59% vs. the day they IPO’d. Compare that to the private markets in Q4’22, when Series C and Series D valuations were up 20% and 30%, respectively, vs. 2020.
That doesn’t make much sense.
Perhaps the public valuation drop was driven by a few large IPOs that cratered, meaning it wasn’t a broad phenomenon?
Of the top 20 tech IPOs since 2020, 90% (18 of 20) currently trade lower than their IPO valuation — often by a significant margin, as shown below.
So, implication 1 — of the reduced availability of venture debt post-SVB — is that propped-up valuations will be “pressured” and start falling faster, as they have in the public markets. This will mean more down rounds.
Implication 2: Startup mortality will increase
When there’s cheap and plentiful debt that can be used to extend runway and avoid compressed valuations, it makes sense to take advantage of that.
But even with venture debt available, dealmaking has been slowing down and is currently trending even lower through mid-March 2023.
Investors are becoming increasingly discerning, evidenced by the longer time period between rounds. All this while startups need more access to equity funding, now that debt is less of an option.
So we have a slower financing market, more discerning investors who need to support the existing winners in their portfolios, and less debt available.
Expect harder decisions to be made by VC investors about which companies to back and which ones to set adrift.
Implication 3: Layoffs at startups will intensify
If you are a startup and have yet to recognize the importance of unit economics, profitability, EBITDA, cash flow positivity, or other similar metrics, this is your warning.
- There are fewer venture deals and dollars being doled out.
- VCs are taking longer to place bets, and so time between rounds is going up.
- Debt — which you might have used to extend runway and avoid valuation reality — won’t be as available moving forward.
You may be thinking that startups had already taken steps to anticipate this point in time and ensure they weren’t wasting resources.
However, SVB’s comments in its Q4’22 financial highlights presentation from January 2023 clearly show this is not the case:
“Client cash burn remains ~2x higher than pre-2021 levels.”
Still “2x higher.” After all this time?
To test this, we analyzed employee headcount data for US-based unicorns. (Note: Headcount data is launching on CB Insights very soon. Get notified when it’s live here.)
We found that 86% of unicorns (459 out of a sample of 531) have actually increased headcount since Q1’22. In fact, 37% (198/531) of unicorns have grown headcount by more than 50% vs. this time last year, as the graph below illustrates.
Companies, investors, and boards of directors that have not taken the time to seriously consider their expenses are about to do so. This means startup layoffs will intensify in the near term.
SVB was a critical member of the venture ecosystem. As access to non-dilutive capital for startups diminishes, the effect on startups and investors will be considerable.
The data suggests it will get more volatile and choppy out there. Buckle up.If you aren’t already a client, sign up for a free trial to learn more about our platform.