Europe’s start-ups turn to increasingly complex debt deals as cash dries up

Ultra-low interest rates allowed growing companies to complete equity funding rounds at sky-high valuations during a boom in 2020 and 2021. But as venture funding has dried up, companies and their investors have been wary of equity funding rounds which risk establishing a new, lower valuation. Convertible debt, which changes into equity after a set period, can enable company founders to raise cash quickly and privately, without publishing an updated valuation.

The volume of convertible debt issued by European venture capital-backed firms hit a record $2.5 billion in 2023, up from $1.7 billion in 2022, Dealroom data compiled for Reuters shows.
But as the deals become more complex, they can offer investors more upside and create risks for the companies, according to Reuters interviews with lawyers, company founders and an investor familiar with the deals. “If you don’t know what you’re doing, structured debt can be a Trojan horse,” said Ali Niknam, CEO of Dutch digital bank Bunq, who has raised via convertible debt at a previous company. “If for whatever reason you don’t make it, and it gets converted, sometimes people lose control.” James Wootton, a partner at law firm Linklaters, said that as companies have found it harder to raise money, the power has shifted towards investors.

This means deals are becoming increasingly “structured”, including terms that favour investors such as handing them bigger stakes if management does not meet certain targets. Deals can be structured to create an incentive for the company to IPO or raise more funds, for example by having interest rates which accrue over time, Wootton said. Newer convertibles include clauses that grant investors more equity if profit margins drop below a certain level or if financial targets are missed, one venture capital investor familiar with recent convertible deals said, speaking on condition of anonymity.

Termsheets have also featured agreements whereby the more time that passes until an IPO, the bigger the discount at which the debt is converted into shares, the investor added. For some, convertibles offer an opportunity to secure alternative longer-term funding while waiting for venture capital market conditions to improve. Josef Fuss, a London-based partner at law firm Taylor Wessing who has worked on recent deals, said he had seen an increase in the size and duration of convertible notes. “You’re kicking the can down the road and you’re saying we’re all optimistic here, in 18 months, 24 months, the world’s going to be a different place hopefully and then we can have the valuation discussion then – that is the basic premise,” he said.

HARDEST MARKET

Venture fundraising in Europe has slowed sharply, from $130 billion in 2021 to $62 billion in 2023, PitchBook data shows, leaving some early-stage firms in a funding crunch as they burn through cash. “It’s the hardest market I’ve worked in my professional career,” said James Downing, who has worked in finance for 20 years and is managing director for Europe at Hercules, a venture lender.

Hercules loaned around $200 million in the UK and Europe last year, down from around $400 million in 2022. “(Start-ups) are not as lend-able as they were a couple of years ago when they were flush with VC equity,” Downing said, adding that fintech, software and consumer-focused companies were those running out of cash fastest.

Traditional bank loans are not available to everyone and can be expensive – market rates are around 9-13 per cent for earlier-stage and 7.5 per cent -10 per cent for later-stage companies, said Sonya Iovieno, head of venture and growth banking at HSBC Innovation Banking. To be sure, not all firms using debt are running out of cash or avoiding a revaluation, and convertibles are not necessarily risky, the industry participants who spoke to Reuters said.

Norwegian lithium-ion battery business Morrow is among the VC-backed companies which helped swell convertible debt issued by start-ups to last year’s record. Morrow told Reuters it placed a convertible loan last year among its main shareholders. “Like other start-ups, Morrow Batteries has found that the capital markets have become more challenging the last couple of years for companies in the scale-up phase as we are,” CEO Lars Christian Bacher said in emailed comments. Later-stage companies are also getting a taste for convertibles. Swedish battery-maker Northvolt has raised $3.5 billion in such debt since 2022 and listed companies in the U.S. are turning to convertible bonds to save on interest costs.

While venture capital firms are optimistic that equity fundraising will recover when rates fall, some companies may not be able to stave off lower valuations indefinitely, said Aberdeen University’s Chair of Finance, Gerhard Kling. “Delaying revaluations is not a good strategy because at the end of the day it’s the truth, it comes out, you can’t escape,” he said. “It’s a bit of a gamble, you hope the market condition improves but I’m not entirely convinced it will.”