A small but active group of venture debt funds can make strong returns from Silicon Valley’s next tech stars. David Spreng of Runway explains why profitability is not a prerequisite.
What is venture debt?
We define “venture debt” as term loans to loss-making venture-backed companies. These loans can be from banks or non-bank lenders. Unlike most business loans which are supported by assets or cashflow, venture debt loans are backed by, in the early stages, the expectation of future equity infusions and, in the later stages, the enterprise value of the business.
Could you explain its main applications?
Most venture debt funding fits into one of six primary use cases, all of which serve to minimise dilution to allow founders, early management, and early investors to maintain a larger share of the company:
1. Extend the runway for the next funding round / valuation point;
2. Extend the runway to reach sustainable cashflow positive and avoid the final round of venture equity;
3. Extend the runway to reach an IPO or M&A event;
4. Substitute debt for what otherwise would have been equity capital without any runway extension;
5. Finance acquisitions or major equipment purchases;
6. Overcapitalise in anticipation of an economic downturn.
The common thread is that debt is cheaper than equity and, in these six circumstances, the primary risk of debt (that it is first money out in a liquidation) is mitigated by the fact that equity investors could pay off the debt at any time and return the preference stack to where it would have been had venture debt never been used. From the perspective of a common equity holder (or optionee), who sits below both debt and preferred stock, it doesn’t make much difference which it is. The fourth use case, where debt is substituted for a portion of the equity in each round, provides a compelling example of the power of prudent leverage in financing venture-backed growth companies. In this situation, no additional capital is raised and the runway in each round could be potentially shortened by approximately 5 percent (as a result of interest expense and fees on the debt). However, if management can find a way to save 5 percent in cash burn, they can own up to 10 percentage points more of the company at exit, which could be worth hundreds of millions, if not billions, of dollars.
How much competition is there; and how is the market broken down?
The venture debt market is still relatively small (probably less than $4 billion) with a small number of competitive players. Successful participation in this market requires deep entrenchment in the venture capital ecosystem, especially in Silicon Valley, as well as the skills and resources to evaluate, monitor and work with volatile, unprofitable companies. Active players include venture debt funds (“non-bank lenders”) and “venture banks” such as Silicon Valley Bank, Comerica, Square 1, and Bridge. These banks provide traditional banking services, revolvers and occasionally term loans. Term loans are most often offered by banks only to borrowers funded by top-tier VCs. It is only in the context of term loans that venture banks compete with non-bank lenders in the venture debt market. In fact, the two groups are more often partners than competitors as The lenders who target the loss makers A small but active group of venture debt funds can make strong returns from Silicon Valley’s next tech stars. David Spreng of Runway explains why profitability is not a prerequisite most later-stage venture debt term loans are done alongside a bank line of credit.
Non-bank lenders which provide venture debt include:
• Runway Growth Capital
• Hercules Capital
• Western Technology Investment (WTI)
• TriplePoint Venture Growth
• Horizon Technology Finance
• Wellington Financial (recently acquired by CIBC)
• ORIX Capital Partners
• Pinnacle Ventures
• Tennenbaum Capital Partners (recently acquired by Blackrock)
• Trinity Capital Investment
• Eastward Capital Partners
• Escalate Capital Partners
• North Atlantic Capital
• Oxford Finance
How do venture debt lenders mitigate risk; and what sort of return is it possible to make?
Most traditional lenders aren’t comfortable lending to unprofitable companies. Venture debt lenders, on the other hand, make a living providing loans to fund growth at loss-making companies. They are comfortable with the risks associated with loans to unprofitable companies because:
1. Each loan represents a very low percentage of the value of the business (generally no more than 20 percent, often much less at early stages);
2. The loans are senior (or just behind a bank line of credit) in liquidation, in other words, they are first money out;
3. There are multiple potential sources of repayment (existing cash, future equity or debt raises, M&A, IPO, sale of assets).
4. Venture equity sponsor support.
5. Collateral (intellectual property, etc.) is a factor but not nearly as important as those above. Of course, venture debt lenders are compensated for taking extra risk. We estimate that as of Q3, 2018 venture debt lenders target returns (including interest, fees and warrants) are roughly:
• Seed/Angel >20 percent
• Early stage VC 15-20 percent
• Late stage VC 12-15 percent
The combination of: 1) low losses (historically <3 percent) as a result of conservative structuring; and, 2) high returns, provides attractive risk-adjusted returns to investors in venture debt funds.
How are these deals typically structured?
Venture debt lenders evaluate earlystage and late-stage companies differently. For early-stage companies, underwriting is based on the expectation of future equity infusions. For late-stage companies, underwriting is based primarily on the enterprise value of the business and the likelihood that the enterprise value will increase over time. For early-stage companies, venture debt lenders are typically willing to lend an amount equal to a third to a half of the most recent equity round — so long as: 1) the last round was within the past six months; 2) six months of cash remains on the balance sheet; and, 3) the venture equity investors affirm verbally that they intend to continue to support the company in future equity rounds. The VCs’ commitment to continue funding is not in writing; it’s an unwritten “moral” contract between the sponsor and the lender. For later-stage companies, venture debt lenders will typically lend up to 20 percent (potentially more) of the enterprise value of the borrower depending on the quality of the VC sponsors, their commitment to future funding and the perceived ease with which the company can continue to raise capital, achieve sustainable positive cashflow or complete an M&A transaction.
As of Q3 2018, terms that a later stage venture-backed company might expect to see are:
- 1 percent upfront fee (application and closing);
- 10-12 percent interest rate adjusted monthly based on a spread over LIBOR or prime;
- 3-5 percent backend fee (paid with final payment; also known as end of term or exit fees);
- Repayment penalties of 4 percent, 3 percent, 2 percent, and 1 percent in years one, two, three, and four, respectively;
- 5-10 percent warrant “coverage” (eg, on a $10 million loan, 10 percent “coverage” would give the lender the right to acquire $1 million, 10 percent of the loan amount, of the latest round of preferred stock for 10 years);
- 36 to 48 months term;
- 12 to 18 months interest-only (“IO”) period; principal amortization begins after the IO period;
- Covenants vary greatly depending on the situation.
Are there situations where venture debt should be avoided?
Absolutely. Venture debt can play an important role in funding growth but there are times when it’s not recommended. The most common non-use case is when early-stage companies are out of cash and hope to use venture debt instead of equity. Venture debt can play a role in this situation but must be in combination with new equity.