With the IPO market slowing in 2022 for technology companies, venture debt has become an attractive source of additional capital, and this trend has also opened up opportunities for asset-based lenders. Jennifer Post, managing partner at Thompson Coburn, discusses these trends and more in a Q&A with ABF Journal.

How has the IPO market fared in 2022 as a whole?

Jennifer Post: Coming out of 2021, it has certainly been a difficult year to get new issuances listed and out into the public markets. Part of that difficulty was driven by the fact that the SPAC market more or less collapsed during 2022. The SPAC market previously produced some deals that didn’t perform well post de-SPAC and that caused some investors to pull back. The SEC also proposed new regulations for SPAC issuances and, on top of that global financial pressures, caused a slowdown generally. Markets have a limit on up cycles, which is natural, as a way to select out of lesser deals. A lot of the good transactions that were waiting in the wings for de-SPAC opportunities were either taken up in the early half of 2022 or put on hold due to valuation and other market pressures. So, the SPAC market certainly felt a lot of headwinds in the second half of 2022, which led to a general fallout for other private company valuations, including technology companies that would have looked to exit through the capital markets in 2022 as a way to support higher valuations.

In the greater context, the IPO market simply is a subset of the capital markets, where companies are selling publicly to raise capital and create liquidity for their shareholders. Given the choppiness in the market this year generally, it was really difficult for companies and their investors to figure out how to price themselves and have successful exits with potential upside. So, overall, there was a pullback because of general market forces and valuation pressures, which caused the stock markets for tech companies in general to be very choppy in the second half of 2022.

Why has the technology IPO market, specifically, slowed down this year?

Post: The IPO market for tech companies slowed down in part because valuations across the board were really uncertain and mostly down in a lot of sectors. This created a mismatch of tech companies that had completed capital raises at very high valuations looking for exit opportunities in the context of uncertain valuation or clearly lower valuation. That reality, of course, was not acceptable to the founders, boards or investors who had invested under rising valuations and projections. So, declining valuations held back a lot of companies that might have raised additional pre-IPO capital and/or gone public.

The declining valuations came after a history through 2020 and 2021 of steadily climbing valuations and very active equity investments. A lot of unicorns or other highly valued companies developed and the private markets and valuations in tech were frothy, but 2022 pulled that down to earth a little bit, which was not necessarily a bad thing in the context of avoiding overheated values and creating losses in the public/post IPO market. The markets need to have adjustments. The rising valuations for pre-IPO tech companies couldn’t support the IPO push and would not result in the size of the exits or the scale of the exits that investors wanted to see in light of general market pressures – global uncertainty, energy prices, supply chain disruptions, rising interest rates and a growing risk of recession.

What are some other capital sources pre-IPO tech companies can seek out or utilize?

Post: That’s a tough question because there are only so many choices depending upon what stage of development a tech company is in as a pre-IPO company. One would think that if they’re truly pre-IPO, they’ve raised a significant amount of capital [and] have reasonable fundamentals in their business and a plan for continuing to scale and grow as a public company. This could mean there are multiple, although not unlimited, available capital choices.

If they truly have good fundamentals in the form of accounts receivable, they could seek bank financing in the form of accounts receivable financing. If they are a consumer-oriented brand or subscription based, they might be eligible for inventory financing, or they might be eligible for other types of repetitive revenue or revenue-based financing sources. Of course, banks have pretty stringent underwriting requirements and not all pre-IPO tech companies are really ripe for bank financing, but there are banks experienced in the tech markets that will loan to pre-IPO companies to sustain these companies through to a better market exit.

Of course, venture debt is an obvious choice for pre-IPO tech companies, and that’s an area I spend a lot of time in. That market has changed over the years and it’s growing substantially, especially as the equity markets remain quiet due to downward valuations. I think it’s a good place to go if you’re a company waiting for an exit in this market or simply looking for growth capital to support expansion, provided the company otherwise has the fundamentals in place.

If a company is not willing to raise traditional equity capital because the stakeholders are not happy with the valuations that are being put on the table, they must still have additional working capital to wait out the markets and continue to perform on their plans. And really, debt financing is probably a good choice. A company may get that debt from its existing investors in the form of convertible notes or other types of bridge financings to the IPO, but that can tend to be dilutive at a time when dilution is problematic for the stakeholders. If it is truly a late-stage company preparing for or waiting for that public exit, convertible equity because of the specter of dilution would not be as desirable as venture debt that would provide the runway without the dilution and necessity of a priced round prior to the IPO.

What are some sectors that are more attractive on the IPO market right now and why?

Post: The energy sector is still moving forward. And that’s quite broad and includes green energy and all types of technology related to electronic vehicles and charging capacity. There’s a huge movement for people to buy electric vehicles, and consumers are starting to demand more access and availability and inventory. In addition, especially coming out of the pandemic when people are back out buying and making significant buying decisions, there’s a lot of activity in the markets generally for green energy. I think that those items will keep moving forward as well as more traditional energy sources as the crisis in Ukraine and the disturbance in world oil markets continues.

What advice are you giving to venture debt funds and other capital providers in this environment?

Post: My practice involves a lot of representation of venture debt funds and those are funds that put working capital in the form of debt into a variety of emerging companies and/or further advanced companies, including some newly public companies. They play a unique role in providing a runway without dilution, often as a follow-on to equity events. In this market, because the valuations for equity investors are down, there’s a disconnect between what companies feel they’re worth on an equity valuation basis and what seed and other more advanced venture capital firms are willing to invest.

Those valuations are being dampened by multiple factors. One is a softening in the tech IPO market, creating less visibility around exits. Another is that venture funds are pulling back a little bit to evaluate their portfolios heading into 2023. If they haven’t made the investment by late 2022, it’s unlikely they’re going to continue to transact at the very end of the year. So, there’s just not a lot of capital flowing from the venture funds right now based on their portfolio evaluation and a choppy outlook for exits.

The gap there really has to be filled by debt providers. The venture debt community works side by side with the venture funds and other capital providers. This is not a conflict as much as a complement to bring in the venture debt at a time when the venture funds cannot or will not provide additional working capital to the startups based on disagreement around valuation or other metrics. The venture debt firms are knowledgeable with either specific domain expertise or with a venture ecosystem in general, so they’re good partners to have for companies that are either in transition or slightly held back by not having sufficient capital. So, they’re good business partners in that way as opposed to commercial banks, which tend to be more formulaic in creating and administering the loans. Venture debt lenders can be more flexible. They can provide differing terms. They can work with companies through difficult passages. Commercial banks are heavily regulated and just don’t have as much flexibility, especially when the credits become challenged.

Venture debt funds are able to step in and provide working capital, which is non-dilutive, so it doesn’t influence the valuation of the company. The venture lenders can provide that runway through to whatever’s next for the company, whether it be an exit, an additional priced round, or a significant acquisition or strategic opportunity. The venture debt funds really fill that gap, both at the early stages and at the later stages, especially when the equity markets are challenged.

From my perspective, the venture debt market has been healthy and will continue to be even more healthy going into 2023 in terms of dollar size of capital deployed overall and size of deals per investment and/or per loan. I think that will continue as the equity markets regain predictability and some of the global risks of recession are either realized or avoided.

The other issue influencing the venture debt market is higher interest rates related to the prime rate. Venture debt lenders tend to have higher rates given relatively higher risk and more relaxed covenant requirements. Traditionally, venture funds have to some degree competed with commercial banks that have a tech lending program. Those commercial banks six or eight months ago could make loans to tech companies at a pretty low interest rate because the prime rate was very low. So, tech companies that looked at a term sheet from a commercial bank vs. the term sheet from a venture fund would often choose based on face value. Now that the prime rate is so high and the cost at which the banks are deploying capital to tech companies is starting to even out in some degree, the choices that tech companies have between the commercial banks and the private venture funds are driven less by pricing. As mentioned, the funds tend to have more flexibility overall, but it really depends on the type of credit companies are looking for.

What is your outlook for the venture debt space in 2023?

Post: We’re seeing an influx and a growth in the number of venture debt funds that are doing lending in the technology space, and that includes private offices, high-net-worth individuals and limited partners who are in venture debt funds that want direct deal access or want to be brought into a syndicate outside of their fund relationships.

So, in addition to there being more opportunity in the market, there are actually more lenders coming into the space and therefore a lot more capital is coming into the space. It’s always about access to deal flow – who has the right relationships in the venture ecosystem, who can be a trusted partner, and who has domain expertise and a track record. Lenders entering the space are looking for those relationships. There’s more money looking to be involved in the venture debt space, and I think that will continue to increase the volume and potentially the scale of the venture debt transactions that will be done in 2023.

The majority of our readers are asset-based lenders. What do you think these trends mean (or could mean) for them?

Post: It largely depends on the size and scale of the business that they’re looking to lend to. There is definitely a very robust market for the ABL community with later stage tech companies that are waiting for their IPO opportunities or waiting for another sort of exit or milestone event. At a later stage, these tech companies should have healthy accounts receivable or inventory collateral, depending on their balance sheet. Again, depending upon the ABL’s focus, there may be a lot of opportunity in the market in less traditional commercial-grade credits. There may also be other revenue models that enable the ABL commitments to make sense, especially coupled with a subordinated working capital credit.

I think that if ABL lenders don’t currently have tech lending or a venture debt group in their organization or in their referral community, it would be something to put in place as a way to enter the venture debt space. I also think venture lenders would welcome flexible ABLs with deep domain expertise that can add dollars and value to tech companies that require additional financing outside of priced equity rounds. So, diversified financial platforms that have tech lending, venture and/or more traditional ABL structures, and that understand the venture debt space, would be well received and find a lot of opportunity in the pre-IPO market.