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Venture debt in Switzerland: Unlocking growth potential for start-ups

By: Semir Ben Ammar on Feb 26, 2024 5:44:01 PM

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Key takeaways

  • Venture debt is a powerful instrument to extend cash runway with minimal to no equity dilution.

  • While venture debt is in its early stages in Switzerland in comparison to the U.S., the present funding landscape is poised to expedite its expansion as founders explore alternative funding sources, including venture debt.

  • Start-ups being at the brink of (or already having reached) profitability might want to consider venture debt as a viable add-on solution to their existing funding but need to understand the pros and cons.

Introduction

In the dynamic but currently challenging landscape of start-up financing, entrepreneurs often seek diverse avenues to fuel their growth trajectory. Amidst the familiar territory of equity financing through venture capital, a lesser known, yet compelling option exists: venture debt financing.

In this post, we'll explore the intricacies of venture debt, its benefits, the status of venture debt in the Swiss market, and how this type of financing offers start-ups an additional opportunity to optimise their capital structure and accelerate growth.

What is venture debt?

Venture debt provides start-ups with the opportunity to borrow capital from specialised lenders, such as venture debt funds and to some extent banks. Unlike traditional loans, venture debt is tailored to meet the specific needs of high-growth start-ups, offering flexible terms, lower equity dilution, and complementary funding to equity rounds.

Despite the word “capital”, we note that “venture capital” almost exclusively refers to equity rather than debt, and therefore excludes venture debt. An exception within venture capital is the convertible loan agreement, simply known as convertible or CLA, which is technically a hybrid debt instrument but still considered equity rather than venture debt due to its conversion into equity.

Unlike traditional bank loans, specialized venture debt funds are willing to lend based on the expectation of future positive cash flows or the potential to raise equity in upcoming funding rounds, even if the current P&L shows a loss. As almost all debt instruments venture debt includes an interest rate component, which can be structured as cash payment, PIK or a hybrid solution. In addition to interest payments, an equity warrant (or exit fee) provides lenders with additional upside to their investment.

Which companies should consider venture debt?

Venture debt is suitable for high-growth start-ups with a proven business model, significant revenue traction, a clear path to profitability and ideally exhibiting (the potential for) cashflow stability in the context of debt servicing. Especially start-ups that have already raised equity financing from a VC fund and are seeking low to non-dilutive capital to supplement their growth initiatives can leverage venture debt to optimise their capital structure and preserve equity ownership. It is also particularly beneficial for companies in sectors with capital-intensive operations, such as technology or life sciences. In the Swiss market we currently observe lenders preferring tech companies with a SaaS business model, as the market assumes that these companies can provide sustainable and scalable revenues in the short- to medium-term with high cashflow stability.

 Benefits of venture debt financing:

  • Minimal dilution: By accessing low to non-dilutive capital through debt financing, start-ups can preserve equity ownership for founders and existing investors, maintaining greater control over the company's ownership structure. Equity warrants as part of venture debt can result in minimal dilution.

  • Capital efficiency: Venture debt allows start-ups to leverage their existing equity capital more efficiently, providing additional runway to execute growth strategies without immediate equity dilution, paired with higher equity returns (IRR) for existing investors.

  • Flexibility: Start-ups benefit from flexible repayment terms, no need for a valuation reset and, in general, faster access to venture debt compared to equity financing.

  • Complementary funding: Venture debt can complement equity financing rounds, enabling start-ups to extend their runway between equity rounds or bridge financing gaps during critical growth phases.

  • Valuation and exit: A sustainable use of venture debt can increase equity returns and hence overall valuation for the next equity round and a potential exit.

Considerations before pursuing venture debt as a start-up:

  • Debt servicing: Start-ups must assess their ability to service debt obligations, considering factors such as revenue visibility, cashflow projections, and market dynamics. This increases the overall financial complexity of the start-up.

  • Covenants: Venture debt agreements often include financial covenants and performance milestones, requiring proactive financial management and communication with lenders to maintain compliance. This further adds to the financial complexity and requires careful planning.

  • Cost of capital: Evaluating the total cost of capital, including interest rates, fees, and potential warrants, is essential to determine its long-term impact on the company's financial health. In particular, heightened interest rate levels need to be taken into account as well as structures with floating rates. In general, however, the use of venture debt should reduce the total cost of capital.

Venture debt market size in Switzerland

Switzerland is well known for being a thriving hub for start-ups and innovation, attracting both local and international investors. The Swiss venture debt market, although relatively nascent compared to more established ecosystems like the U.S., has been evolving to meet the growing demand for alternative financing options.

Although not considered venture debt in the narrow sense, we observe a generally growing need for debt financing in the Swiss market which can have similar benefits as venture debt. Notably, the Swiss booking platform GetYourGuide closed a revolving credit facility of USD 109 million in 2023. For its lending business TP24 received a credit line of CHF 400 million and Wefox raised USD 50 million through a convertible (startupticker.ch, 2024; Venturelab, 2024).

Despite the opaqueness of the venture debt market, which varies heavily by definition and source, the total volume of venture debt in Switzerland is estimated to be around CHF 104 million in 2023 according to Statista (2024). Relative to the total venture capital (VC) investment volume of ca. CHF 2.6 billion in 2023 (Pitchbook, 2024; startupticker.ch, 2024), this would suggest a ratio of ca. 4% venture debt (VD) penetration (i.e., VD/VC ratio). This relatively low figure underscores the emerging nature of the Swiss venture debt market.

In contrast, detailed data for the U.S. market implies a venture debt penetration of ca. 18% in 2023 (NVCA, 2024). Such a ratio underlines the maturity of the U.S. venture debt market and is in line with anecdotal evidence suggesting that venture debt funding should be between 20% to 40% of the last equity funding round. Figure 1 illustrates the venture capital and venture debt market size in different geographies in 2023 as well as the corresponding venture debt penetration in percent.

Venture capital, venture debt and VD/VC ratio across geographies in 2023 (CHFbn)

Chart-VDVC-ratio_EN_rgb

Sources: Pitchbook (2024), Statista (2024), startupticker.ch (2024)

Despite positive venture capital developments, the Swiss venture debt market still faces certain challenges and limitations, including:

  • Limited awareness and education: Many start-ups and entrepreneurs in Switzerland remain unaware of the potential benefits of venture debt financing or lack understanding of its mechanics compared to traditional venture (equity) financing options.

  • Availability of specialized lenders: The number of specialised venture debt providers in Switzerland is very low compared to more mature ecosystems. Addressing the financing need, we observe venture debt providers from the U.S. and U.K. offering their services to Swiss start-ups. However, this comes at a relatively high cost starting with a higher interest base rate compared to Switzerland as well as higher risk margins compared to what is typically expected in Switzerland. Hence, Swiss start-ups rarely find a suitable lender who provides venture debt tailored to their specific needs.

  • Risk perception and appetite: Venture debt, like any form of debt financing, carries inherent risks, and start-ups must carefully assess their ability to manage debt obligations amidst uncertain market conditions and growth trajectories.

Despite these challenges, the Swiss venture debt market presents significant opportunities for start-ups looking to diversify their financing strategies and optimise their capital structure. As the ecosystem continues to evolve and mature, collaborations between start-ups, investors, and financial institutions will play a crucial role in driving innovation and fuelling growth across Switzerland's dynamic start-up landscape.

Success Story

Artemon does not operate a dedicated venture debt fund as such for the Swiss market, but our advisory business structures selected venture debt transactions on a deal-by-deal basis. Most recently, we structured a venture debt transaction for an innovative software start-up after its successful series A funding round to support its growth ambitions without equity dilution. The company’s management team saw the opportunity to leverage venture debt as a strategic financing tool to drive shareholder value.

Conclusion

Venture debt financing offers start-ups a compelling alternative or complement to equity financing, providing flexible capital solutions to fuel growth while preserving equity ownership and control. By understanding the benefits, considerations, and market dynamics outlined in this article, entrepreneurs can strategically leverage venture debt to unlock their company's growth potential and navigate the intricacies of the Swiss start-up ecosystem with confidence and resilience. Especially during a challenging funding environment venture debt allows to bridge short-term liquidity needs without conversion or further dilution.

 

Sources

Disclaimer
This commentary is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities or financial instruments. The information contained herein is not intended to provide investment, legal, or tax advice, and should not be relied upon in making any investment decisions. Investing in securities involves risks, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, investors should carefully consider their own investment objectives, risk tolerance, and financial situation. The views and opinions expressed in this document are those of the author(s) and do not necessarily reflect the views of Artemon Capital Partners. Artemon Capital Partners does not guarantee the accuracy or completeness of the information provided herein, and disclaims any liability for any errors or omissions. Investors are advised to consult with their financial advisor or other qualified professionals before making any investment decisions.