Venture debt is typically employed by emerging companies that may be currently small, are well-backed by professional venture investors, and are expected to grow rapidly. Funds are deployed to bridge rounds of equity funding and to acquire capital equipment used to develop technology and generate revenue and growth. As venture capital is increasingly accepted worldwide, so too is venture debt.
Venture debt, also known as venture leasing or venture lending, is a special form of early stage credit financing for growth companies that have raised outside capital from professional venture capital firms but are too early in their development to access traditional debt markets. This may be due to their being pre-revenue, illiquid, and/or with substantial negative cash flow, dependent on additional rounds of venture equity for their survival.
Venture loans or leases are frequently, but not necessarily, secured by equipment and do not typically require personal guarantees. They provide a flexible form of financing that is less risky to the creditor, due to monthly return of principal and interest. Therefore, they are less expensive for high-growth emerging companies than venture equity. Similarly, they leverage equity investments, providing higher rates of return for venture investors. This win-win scenario results in lower dilution for all participants. As such, the growth of venture debt has kept pace with the growth of venture equity in the USA over the last three decades. It typically represents 10-15% of emerging company capital raised or about $2B-$3B in the US in 2016, provided by more than 15 firms.
Average portfolio rates of return to venture debt investors are comparable to those of venture equity, but with far lower risk. Venture lending is symbiotic with venture equity, but must, of necessity, follow equity. As venture capital has spread from the US to Europe and Asia, so too has venture debt, albeit more slowly. Venture lenders do not evaluate risk in traditional ways as do more conventional lenders…cash flow, hard collateral, balance sheet, profitability, sticky capital deposits, etc. Rather, early stage lenders rely on the far more extensive due diligence on markets, technology, and management undertaken by venture capital investors, track performance in meeting company milestones, analyze the likelihood of further investor equity support through additional rounds of funding, and look to prospective liquidity through exit strategies generally determined by equity investors.
The benefits of venture debt include, but are not limited to:
• Less expensive financing than equity (less dilutive) to both entrepreneurs and equity investors
• More flexible financing than conventional debt, typically without covenants other than making timely payments
• No personal guarantees
• Acting as a bridge to the next milestone and/or financing with increased equity valuations, lessening dilution
• Maintaining liquidity between rounds
• Providing insurance in the event of stumbles or delays in the next round of equity
• Increasing investor rates of return since targeted venture lender rates of return are less than half the IRR sought by equity investors
• Not requiring Board representation
• Closing time typically less than half a new equity round, since little due diligence is required (outsourced to the known equity investors) and partially by avoiding discord over valuations
Typical deal structures frequently include full payout or FMV operating leases secured only by equipment or senior loans secured by all the business assets (sometimes excluding intellectual property). The interest rate is more akin to credit card rates than bank loan rates. An equity upside is provided by the issuance of net warrants (no cash to the issuing company), with an exercise period equal to the sooner of an exit or 7-10 years, generally with a collective exercise price equal to 5%-10% (in the US) to 10%-20% (outside the US) of funds invested by the lender. The term (tenor) of the transactions is typically 2-3 years with monthly repayment of principal and interest. The leases/loans are nominally not cancellable, but can be can cancelled with a penalty. Financial statements are required annually or more often as reasonably requested by the lender. Board seats and covenants are rarely required.
Where venture capital is sure to tread, venture debt is sure to follow.
Article was written by Sandy Garrett, Partner of ONEtoONE Corporate Finance US