Israeli startups switch to loans as valuations fall

Growth Photo: Shutterstock

As the market cools, privately-held tech companies increasingly prefer raising capital through loans rather than venture capital equity deals.

The cooling of tech company valuations is considered the almost exclusive preserve of publicly-traded companies, as stock exchange market caps plunge by tens of percentage points - in many cases to below IPO values. Privately-held companies seeking to go public through a SPAC merger, like eToro, have been forced to postpone their merger, while others like Gett have canceled it altogether. Companies already planning an IPO like Forter and Yotpo have been compelled to rethink the way ahead. For Israeli tech companies based in Silicon Valley, the window of opportunity on Wall Street seems firmly shut.

The cooling of the tech market now seems to have trickled down to the privately-held tech company market and venture capital financing rounds. Startups that chanced their arm by raising capital last year remain with bundles of cash in their coffers. But companies seeking to raise capital over the past few months that do not have especially impressive revenue or exceptional growth are complaining about lower valuations than they expected in financing rounds. There are reports worldwide about valuations being cut in the midst of financing rounds and even the cancellation of investments by funds like Tiger Global and D1 Capital Partners, which confirm these concerns.

"Invesors are not prepared to pay 2021 prices"

Many companies expected that 2022 would exceed last year in terms of economic performance and be another record year. They built on an IPO or at least the continued flood of cheap money into the market, which would help them continue to increase the value of their companies. Now with inflation on the rise, interest rates climbing and a fragile geopolitical environment, 2022 is looking more like a lost year.

Companies that have not raised money recently and need to continue to feed their development, operational, and marketing and sales machinery in order to increase their market share will need to do so soon. But if their numbers do not let them become profitable quickly, something most tech growth companies have in common, then they have no choice but to raise money. But meeting with venture capital investors is likely to pose a risk of lower valuations for startups. Investors are already not prepared to invest larger amounts at higher valuations and startups may need not only to settle for a lower valuation but also to sell a larger stake of their shares to investors.

"In the past two years, the valuation of companies has climbed to high levels, which in some cases are unrealistic," a senior investor who specializes in loans to tech companies, who prefers to remain anonymous, told "Globes." "Companies have not always been able to close the gap between revenue and their valuation. A company that raised money at a valuation of $1 billion can forget about an IPO at a $2 billion valuation. The market has now cooled and investors are not prepared to pay the price from a year or 18 months ago, until the company closes the gap between sales and valuation and the business grows."

"Everybody is under a magnifying glass this year"

Tech companies are frequently required to raise millions of dollars, usually every 18 months, in order to maintain their rapid growth rate and capture market share. But at the intersection of the need to take a decision about raising capital, they have the choice of raising capital from venture capital funds in exchange for shares, or taking a loan in exchange for interest rate repayments. In other words, the companies must choose between relinquishing shares and later down the line major remuneration following an exit, or keep the shares but pay out costly money on interest for the next year to 18 months. This latter option is only available to those growth companies that generate enough revenue to allow them to pay interest.

Raoul Stein, a general partner at Kreos Capital, a credit and loans investment bank backed by venture capital, says that growth companies are seeking flexible deals. "While the market is in its current state, they are interested in debt in order to not have to raise private capital. But in the event that the market will again surge, they are building for themselves the option of resuming raising regular capital. It is clear that this year everybody is under a magnifying glass because of inflation, the war and low pricing of tech companies. Companies want to draw on a bit more and perhaps have more time to repay it. We usually provide them with this flexibility but also take more on it."

"Investment bankers tempted them to go public"

Former Bank of Jerusalem CEO and Bank Hapoalim VP Uri Paz has identified the potential in the tech market. He is currently CEO of Michlol, which provides non-banking finance to companies that dreamt about an IPO but were forced to postpone their plans by at least a year or two. "Since last September, we have seen a wave of companies that have understood that it is not worthwhile for them to embark on an IPO because their revenue is too low for market expectations, which are only becoming tougher," Paz told "Globes."

"This happened after a year in which investment bankers tempted them into holding IPOs in Tel Aviv, Canada or Nasdaq. A company that was given a valuation of $200 million in April 2021, was valued at $150 million by June and $70 million by September.

"These are companies that already have revenue of several million dollars and know that they will continue to grow in the coming year or two, and so it is worth their while raising debt in order to not lose shares. If we take a company that is worth $50 million today and wants to raise $10 million, and believes that within four years it will be worth $200 million, the cost of the loan that it raises is one sixth of the cost of raising capital from a venture capital fund."

Viola Credit general partner Ido Vigdor claims that the need for debt for Israeli companies has grown in recent years, among other things, because of the way in which they were initially structured. "Today companies are not built that are focused on technology but large companies around a product, with marketing, sales and product departments, and therefore raising capital not only serves these technologies but full economic systems."

Banks have stopped going easy on entrepreneurs

2020 and 2021 were the best years for banks that extend credit to startups, with annual loans totaling about $33 billion in the US market in each of the two years, despite the abundance of capital that was available to entrepreneurs from other sources. This is a huge historical rise from the $4.4 billion in loans that were extended to startups in 2010. The proportion of startups lending more than $100 million out of those raising debt climbed from 3.4% in 2020 to 5.7% in 2021.

While money was cheap and available in the tech sector, the banks made things very easy for entrepreneurs, who received flexible repayment schedules for the loans, comfortable interest terms and large amounts of credit. But research by PitchBook has found that a reverse trend has begun over the past six months.

Uncertainty in the market and growing demand for loans has made the banks toughen terms by shortening repayment schedules, typically from five years to 24 or even 18 months, or reducing the amount of the loan. Interest rates are rising following the US Federal Reserve's recent announcement. Banks are also linking release of the loan gradually when the startup reaches milestones and targets, and they are demanding more guarantees.

All this is happening, of course, while there is less venture capital available for investment in startups. Although Israeli startups raised $5.6 billion in the first quarter of 2022, this is still 14% below the quarterly average for 2021.

"The scale of available investments from traditional venture capital firms has been reduced in the past few months from reasons that mainly stem from the stock exchanges. This means that the number of companies prepared to consider financing through debt has risen," explains Moshe BenBassat, the founder of ClickSoftware, who is today a serial investor. "In this situation with a growth in demand, the usual mechanisms of balance give more power in negotiations to financiers to improve their terms both in interest rates, and accompanying conditions such as the number of options included in the deal and criteria for filtering."

Tech companies supporting early-stage startups

In Israel the loan industry for tech companies is controlled by companies specializing in loans backed by venture capital, like Kreos Capital, Viola Credit and Silicon Valley Bank, which tailor transactions that combine venture capital and loans and knows how to convert the debt to shares in certain circumstances, like for example, when a company asks not to repay the loan. Israeli banks have also begun to offer loans to startups and non-banking credit organizations have also entered the fray. There are also some tech companies offering loans to startups as part of the huge growth in the fintech sector.

One such company is Brex, a US company that has raised $12 billion and last year acquired an Israeli startup. The company began providing a sort of virtual credit card to companies, and over time has also developed in the world of financing through its asset management division, which today operates in Israel. As part of this division, Brex provides short-term credit and loans that can reach $15 million for early stage startups. Brex, like Capshift and Pipe is part of a growing fintech market offering targeted loans focused on unique characteristics, such as an increase in the number of customers and users, revenue growth and an inventory examination in the case of e-commerce companies.

"In the past few months, we have seen a significant rise in demand by companies seeking to raise debt, despite the rise in interest," observes Brex Israel general manager Nadav Lidor. "this is probably motivated by the macroeconomic uncertainty such as geopolitical risks and concerns about recession and inflation. The volatility on stock markets has also begun to push down valuations in the private market, and slow the pace at which venture capital investors participate in financing rounds. More and more teach companies see debt as a way to protect themselves from market conditions and allow themselves greater room in which to maneuver in a period of uncertainty."

Published by Globes, Israel business news - en.globes.co.il - on April 20, 2022.

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Growth Photo: Shutterstock
Growth Photo: Shutterstock
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