What impact might Silicon Valley Bank's collapse have on the Irish venture debt market?
The collapse of Silicon Valley Bank (SVB) has brought the rapidly growing venture debt market in Ireland into sharp focus.
Against the backdrop of SVB’s downfall, founders, CEOs and CFOs of Irish growth businesses are now grappling with deteriorating funding conditions that are likely to impact short term growth, and will certainly give pause for thought as to whether venture debt continues to be a viable alternative to equity capital.
First Citizens’ impeding take-over of SVB’s loan book and HSBC’s acquisition of Silicon Valley Bank UK, will have gone some way to calm immediate liquidity concerns for start-ups and growth businesses in Ireland. Nevertheless, founders, CEOs and CFOs will likely have to re-evaluate their funding structures while the venture debt market navigates the current market correction. The market turmoil also presents opportunities for non-bank lenders to increase market share in the Irish venture debt space.
The venture debt market in Ireland
Notwithstanding current economic headwinds, the appetite for venture capital among young Irish companies is unlikely to diminish given the size of the domestic technology and healthcare sectors. The Irish venture capital market increased steadily in 2022, primarily driven by several deals with funding values of more than EUR10 million.
However, increasing costs of funds will be a significant factor for businesses determining whether venture debt continues to be an attractive proposition in the immediate term. If the cost of venture debt increases further as Central Banks wrestle to tame inflation and tackle turbulence in the global banking system, businesses may need to closely consider whether debt or equity capital is more favourable. The valuation of each individual company is likely the key factor for companies determining their capital structure given the dilutive effect of equity capital.
Benefits of venture debt
Given venture debt is specifically geared towards growth businesses, loans are invariably interest only, covenant lite and structured with warrants to balance the risk/return for both the company and the lender. As a result, businesses incurring venture debt are actively encouraged to grow (particularly given the potential equity upside for lenders availing of warrants) in a manner not seen in traditional senior debt deals.
As venture debt is usually borrowed shortly after an equity raise, it will continue to be appealing to many growing companies in Ireland as it limits additional equity dilution and provides further runway while a business continues to be cash-flow negative.
In addition, venture debt increases liquidity thereby maintaining momentum in a company’s growth trajectory. It also allows more time for growth before the next valuation milestone and acts as a mitigant against any delays in implementing the company’s business plan. Moreover, venture debt enables founders/management to maintain more control over their business (rather than ceding equity share), which should increase flexibility on an exit.
Risks of venture debt
There are undoubtedly risks associated with venture debt that Irish businesses should consider, particularly in light of changing market conditions following SVB’s collapse. Venture debt is generally more expensive than traditional sources of debt, given the higher risk profile of early-stage companies which are likely to be ‘burning’ cash.
The heightened risks associated with venture lending in the current economic climate mean that lenders are increasing likely to require warrants (perhaps at lower strike rates and for a greater slice of equity).
Businesses also need to be mindful of how amortisation might hinder growth. Although non-bank lenders may seek to fill the gap where more risk averse banks are unwilling to lend, pricing is unlikely to fall in the near term, which means businesses need to balance the cost of capital against the need to protect against dilution.
Potential impact of SVB’s collapse on the Irish market
As a prominent funder of growing Irish businesses since 2012, SVB has a significant footprint across the Irish venture debt market. While SVB UK will likely continue to consider lending opportunities in the Irish market following HSBC’s acquisition, there will undoubtedly be a period of stabilisation while HSBC assesses SVB UK’s existing liabilities and it is uncertain what SVB UK’s risk appetite will be for new deals. As such, we expect the following for the period ahead:
- Increased competition: a clear gap has developed in the market, which should present opportunities for non-bank lenders (particularly those with greater risk appetite, innovative products, an ability to execute quickly and an established international offering) given funding requirements of many young Irish businesses.
- Debt vs equity conundrum: changes in market terms and economic headwinds will cause Irish borrowers to more carefully examine their capital structure. Lenders will also be continually re-assessing their risk profile (particularly when it comes to start-ups) as the market fluctuates. However, as valuations continue to drop, some venture capitalists will likely continue to carefully consider new investments, which should present opportunities for lenders with greater risk appetite to enter the Irish market. The funding dynamics may also mean that we start to see more new/innovative products locally, such as revenue based financings.
- Lender friendly market terms: as valuations have fallen and some equity investors have pulled back from certain sectors, terms have changed in favour of lenders, with increased rates, shortened drawdown periods and warrants being increasingly common. This trend is likely to continue as existing market participants cease new lending / exit the market and new participants enter.
Conclusion and outlook
While the Irish economy is predicted to grow this year, the uncertain global economic outlook along with rising interest rates and inflation will likely maintain pressure on equity valuations of growth companies. Venture debt financing will likely therefore continue to be an important factor in the capital structure of growth companies in Ireland, albeit pricing will greatly impact its attractiveness as compared to equity capital.
When developing an overall capital-raising strategy, Irish companies should therefore carefully consider their options to incorporate the ideal mix of debt and equity. Finding the correct balance results in a capital structure that optimises the cost of capital while providing founders with flexibility and control, all of which are becoming increasingly important in the current economic climate. Of course the ideal mix of debt/equity depends on the specific business, but the significant number of domestic and international venture lenders and venture capital funds operating in Ireland provides companies with invaluable options on the journey to achieving the optimal mix of capital.
As a global law firm, DLA Piper in Ireland is well positioned to provide insight, advice and guidance on a cross-jurisdictional basis on capital structures and venture debt facilities for growth companies and lenders alike.
If you are a startup, founder, incubator, accelerator, venture capitalist and/or other stakeholder in an Irish growth business, then our Irish Startup Pack (which seeks to provide assistance and support to early stage startups and high growth enterprises by providing forms of the key legal documents needed to establish their business in Ireland) will also certainly be of interest.