A debt financing for startups and early-stage companies that lack assets or cash flow for loans
The most important thing for startup businesses is - access to capital. The lack of money is one of the main reasons new businesses fail. If wealth is too little, it may vanish. If it's too much, the firm may not keep up its growth with the pace of capital growth.
Cost is another central point. The founders and investors want to keep the cost of capital as low as possible.
Also, they prefer to retain their share of ownership as much as possible. To address those issues, founders sought new and convenient ways of startup financing besides venture capital.
Those issues raised the demand for startup financing options at a reasonable cost. Venture debt emerged as one of them and became an essential tool for every entrepreneur.
Venture Debt (VD): meaning
It is debt financing for startups and early-stage companies that lack assets or cash flow for loans from traditional financial institutions. It's an excellent tool for founders and investors not to dilute their ownership and raise the startup's valuation simultaneously.
In other words, it's a win-win for both founders and investors.
The VD is quite different from traditional loans. The VD is a debt for short and medium-term, typically no more than 3-5 years.
The principal amount of debt is calculated as a portion of raised capital on the recent round. Usually, the principal is 30% of raised money in the final round.
VD is considered a risky capital source, though less costly than equity. The availability of the debt depends on many factors such as raised capital, the reputation of backing venture capital firms, etc.
How they Make Money
The lenders in this industry have three sources of income:
Warrants give rights to a fund to get involved in the upside potential through options (priced at the current valuation stage). Then, lenders convert those options into stocks at the exit stage (IPO, acquisition).
That type of lending model differentiates VD lenders from traditional lenders. Typically the latter ones are not interested in the company's potential due to the risk young companies possess.
Types of VD
There are ten types of loans that venture lenders provide:
Lines of credit
Financing of Working Capital
MRR line of credit
Growth capital (one of the most popular types)
Senior term loan (first lien)
Second lien term loan
Revenue-based financing (excluding life sciences)
Equipment loan (term loan secured by specific equipment)
Royalty monetization (primarily life sciences)
Royalty-based financing (term loan secured by future royalty stream)
Venture Debt (VD) vs. Venture Capital (VC)
The venture capital fund makes money through its top-performing unicorns that cover all the losses from other startups, relying on big winners. In addition, VD funds try to ensure every investment in startups is less risky.
As a result, VD investors prefer stable returns to big shots. Overall, there are three main differences between VD and VC:
- The failure in VD is way lower - about 1-8% of the portfolio. It's explained that borrowers already secure VC funding before taking debt. Startups underwent due diligence from VC.
- The IRR of VD is measured by interest rates, repayment schedules, fees, and warrants. The expected payback period for which the capital is lent is the first 15-18 months of a 3-year debt. In VC, the return is realized by selling equity in 5 to 8 years.
- VD lenders check startups based on short-term viability. They don't focus on long-term growth potential as VC investors do. The ability to pay back the loan is an essential measure for lenders. However, the future growth potential is critical for VC investors.
Learn more about careers and compensation in VC by visiting our:
1. Guide to Private Equity Careers & Venture Capital Careers
2. Venture Capital Salary & Compensation, Average Bonus in Venture Capital.
The Genesis of VD
The roots of the VD industry come from the development of VC in the 1970s and 1980s. First, Pioneer VC firms such as Sequoia Capital and Kleiner Perkins built their expertise. Then, they tracked records of their funds via startups like Apple, Sun Microsystems, and Genentech.
However, the entire venture capital industry was short of capital. Although limited partners increased their committed funds ($104 billion in 2000), in the 1980s, they allocated a maximum of $3.8 billion.
That economic condition motivated entrepreneurs and investors to look for alternative financing. Initially, they focused on high-tech equipment leasing. They considered leasing as efficient capital in addition to equity and lowered the overall cost of capital.
However, there was one minor point. Lenders also looked at the creditworthiness of the borrowers, not just the value of leased equipment. Since many startups didn't have a financial history, they could borrow only half of the equipment value.
The other half was financed by guarantees for banks provided by the startups. That led to other problems. Investors demanded warrants in exchange for guarantees. They had to set some portion of the capital as reserves covering their obligations to the bank.
At that time, startups failed 8 out of 10 times. Based on that, banks and leasing firms were unwilling to fully finance the early-stage firms' equipment. All of these difficulties emerged the new concept of financing - VD.
Statistically, the venture-backed startup failure rate was much lower than the overall startup failure rate. Moreover, most failures occurred after four or more years of creation. Thus lenders thought it acceptable to offer 100% equipment financing for three years.
The warrant to purchase preferred stocks compensates for the incremental risk. In addition, the combination of warrants and statistical evidence made the risk profile more reasonable.
Overview of Venture Lending Industry
The industry has significantly revolutionized since the first venture leasing. Then, the equipment financing was a small part of the startup financing needs. The leases transformed into loans, and financing options have broadened to address various financing needs.
All of that led to what is now called VD. Today, venture lenders and entrepreneurs use debt more sophisticatedly compared with the historical usage of debt. The lenders also learned lessons from past failures.
Growth in Use - and in Thoughtfulness
Initially, lenders gave money only to capital-intensive hardware businesses such as semiconductor or computer manufacturers and biotechnology firms that needed significant capital for research and development.
There was the risk of the inability of the firm to patent the software. Lenders were unwilling to lend money to firms in other industries, including software development.
During the 1990s, many startups realized that using a small amount of debt could delay their next equity round and extend their cash runway.
Many lenders understood that the company's enterprise value would be enough to maintain the loan value and that the warrant coverage could easily be increased. The secured loan structure also eliminated such downsides as double sales taxation, personal property taxes, etc.
VD was widespread during the dot-com bubble. It was a coincidence that both events occurred at one time. Unfortunately, many lenders and borrowers deviated from the main principles of venture debt. That drift was vital to the venture ecosystem.
After the bubble, all players, from loan providers to companies utilizing debt, learned that they needed to consider the worst-case scenario and prepare their plans accordingly. Companies realized that although venture debt is cheap, it is dangerous if they can't utilize it properly.
Nowadays, the management of companies and lenders is more conscious about how to use debt and consider whether it's appropriate for them.
Firms focus on intangible aspects of the lender, such as the decision-maker, the dealing process with firms during hard times, and the long-term perspective.
The estimated market size is $2B-$4B/year, much smaller than the venture capital market. It's challenging to get an accurate picture since most debt providers are private funds that don't report their venture activities separately.
The market is represented as a certain proportion of venture capital investments. Thus, VD and VC industries are positively related. When there is a downturn in venture capital, the VD deals will decrease respectively.
In general, there are three types of participants in this industry. Let's review each one of them.
Some commercial banks have separate venture-lending departments. Due to regulatory limitations, the department's activities are considered a side business for the banks. That department deals with accepting deposits and lending to startup companies.
The range of debt provided is $100K - $10M.
Banks are interested in giving loans to startups. The large cash balances of startup companies derived after the new funding stage closure attract them.
The debt from banks has the lowest cost compared with other options. However, banks:
Demand to maintain cash balances to maximize the security of the loan.
Put financial covenants to manage the risk and prevent undesirable actions.
Require "material adverse change (MAC)" or "investor support" clauses. The last one permits the lender to judge at its sole discretion whether the company is under a material adverse change. Based on that, lenders decide when to demand the repayment of debt.
Venture lending finance companies are either solely doing venture lending or a department of large financial companies. The decision-making is centralized as in banks. They typically provide more capital and flexible terms compared with banks.
However, the costs of capital are respectively high. Since most of these companies are public, they are sensitive to short-term earnings. They can't incur unexpected losses. Thus, they are risk-averse.
The cost of capital from funds is also relatively high. The price is high due to the higher expected return for the risky businesses. Thus, this type of financing is more accessible.
Also, this type of fund is similar to VC firms. Both look for opportunities and make an investment decision.
Debt funds rarely use financial covenants or other restrictions. As a result, funds usually provide the most accessible source among all three participants in the industry.
Top Venture Debt Firms
Here are some of the top firms in this industry as of today. Of course, this list might change as time passes.
Silicon Valley Bank
Silicon Valley Bank (SVB) is a high-tech bank founded in 1983 in San Jose, California. They focus on software & internet, hardware & frontier tech, fintech, etc. SVB has already financed more than 30,000 startups.
In the mid-1990s, the bank invested in the early stage of Cisco Systems.
Trinity Capital - is a venture lending firm founded in 2008. The firm offers venture loans and equipment financing for companies operating in all industries. In 2018, The firm invested in Nexus Systems.
Nexus Systems provides invoice processing and vendors payments for real estate companies. It's considered one of the leaders in the real estate industry.
Pacific Western Bank (former "Square 1 Bank")
Pacific Western Bank is a bank headquartered in Los Angeles, California, and founded in 1999. The bank is wholly owned by PacWest Bancorp, the banking holding company. The firm's venture lending department (prev. Square 1 Bank) serves technology and life sciences startups.
The most notable clients of the venture lending department are Credit Karma, Pindrop, and HiveIO.
Hercules Capital is a publicly-listed Business Development Company (BDC) founded in 2003 in Palo Alto, California. The firm serves companies in technology, life sciences, and sustainable and renewable energy industries.
Hercules Capital provides funds in the range of $5M - $200M.
Comerica Bank is a financial services company founded in 1849 and headquartered in Dallas, Texas. The bank's Technology & Life Sciences Division, as the name implies, provides venture loans for startups operating in the technology and life sciences industries.
Wells Fargo is a multinational financial corporation founded in 1929 and headquartered in San Francisco, California. In addition, the firm has its venture lending division that provides debt capital for startups.
Parameters lenders look at
The valuation of startups from the lenders' perspective is similar to that from the venture capitalists. The lenders must check that the borrower is well-positioned for the next round. There are two main criteria based on which funds evaluate startups to give venture loans.
There are four business-related vital parameters of the borrowing company:
1. The personality of the founders and management personnel. The founders and management must be solid visionary experts in their industry. They must be great leaders who effectively manage their teams.
2. Venture capital firms and other investors backing the company. The trust from lenders is proportional to the support from VC firms and other investors. The more support startup gets, the more it's considered creditworthy.
3. The revenue model and margin indicators. High-profit margins and the established revenue model increase the company's ability to repay its debt without delay. The company must be close to its profitability phase.
4. Market opportunity. There must be a large market for the product of the company. The more the product fits the needs and wants of the target customers (its large market), the more reasonable the use of debt capital to scale its production will be.
Moreover, funds look at these operational parameters:
The liquidity position of the business. The more liquid the company's position is, the stronger its financial providence.
Scalability of the relationship. The fund establishes a strong relationship with the company as the company scales its business.
Protocols are set by the company to ensure data integrity. Trust is the key to successful relationships. One of the ways to ensure the trust is data integrity. In other words, the accuracy will prevent the information from being a diminished source.
Corporate governance framework. The interests of investors, management, employees, and other stakeholders are essential for any company. The transparent and objective way of balancing these interests ensures high governance standards.
Keep in mind that these criteria vary depending on the funding stage of the startup. So, for example, let's consider early-stage and later-stage companies.
The early-stage firms have a limited operating history. Thus, lenders weigh the founders' personality, the reputation of VC investors, and the cash burn rate more than other measures.
The high cash burn rate is a red flag showing that the startup is risky and dependent on external capital.
The later-stage enterprises consider debt as a source of non-dilutive capital from lenders. In addition, since the later-stage companies have already passed the product development stage and already generating revenue, it's easier for them to secure venture loans.
There are several ways for companies to analyze venture loans. The methods differ by the company's goals.
For example, an early-stage company aims to survive while a later-stage company targets expansion. That difference shows how much debt they are willing and can take.
As with any equity or debt, the firm must clearly state the financing goal. Here are the major points that every company or startup should look for and negotiate.
Covenants are measured via financial ratios. The accounts receivable or cash balance-backed loans are widespread and can be used to buffer the Balance Sheet. However, for early-stage companies that might at any time need cash the most, it's risky.
There are two types of clauses that debt providers ask for: "material adverse change (MAC)" and "subjective default clauses." They allow lenders to recall their loan in certain circumstances, like an existing equity investor deciding not to fund the future round.
The problem is that those certain circumstances are, in most cases, beyond the company's control and thus put high risk. That's why the company should protect its interests and make a fair agreement that doesn't disregard a lender's interests.
Back-End Loaded Deals
The back-end loaded deals work in the following way: the borrower pays the low interest during the loan period. However, he must repay the lump-sum principal at the end of the period. It's called "a bullet." That type of payment is complicated and pressures the growth of startups.
However, it would be handy for companies with stable revenue sources, considering that the timing helps them generate high revenues before paying the debt.
The company must check whether the lender has a good reputation. Borrowers can measure the reputation via the lender's behavior in its past deals. These are the significant points:
The lender's way of dealing with challenging loans
Accessibility of the debt from that lender
The willingness of restructuring the defaulting loans
The investigation solves almost half or even more of the startups' problems when dealing with venture loans. Thus it's one of the most critical points to consider.
Proposals Burdening the Company
The proposals must put a fair share of risk for both the lender and the borrower. The lender must allocate some of its capital at risk of not being repaid in the future.
Venture loan offers higher flexibility compared with traditional loans. As a result, it's a great way to minimize dilution. But, companies should remember that it's not free money, and if not used correctly with fair terms, they might lose their stake or their business.
The entrepreneur's point of view
The leading players in this industry are the loan provider, the venture capital firm, and entrepreneurs. So let's dive deep into the entrepreneur's view on the venture loan.
There are several benefits of using a venture loan. Here are the common ones:
Accelerated growth. Provides growth capital without sacrificing equity. In other words, it prevents equity dilution.
Extend the cash runway. Extends the cash runway and allows the company to achieve the next milestone without sharing equity. The extended cash runway also increases the chances to reach the profitability point.
Increase Valuation. The higher valuation in the next round means more financing will be available. The more financing the startup can get, the more likely it will survive and prosper.
Easier to obtain than a bank loan. Giving a loan is not based on positive cash flows or pledges of significant assets. Traditional loans are inaccessible using the cash flow and assets metrics for startups.
Flexible terms. Borrowers can negotiate the amortization, covenants, borrowed amount, and other factors of venture loans easily compared with traditional loans.
Quick process. The loan provision process can be as little as thirty days or even two weeks. Due to the thorough due diligence process, traditional equity requires three to six months. The venture loan is more beneficial.
Alternative to raising equity from VC firms. When the firm's growth pace is not as fast as VC firms require or the VC funding terms are inappropriate, this option is a great alternative. Therefore, there is no need to let others sit on your company's board.
Alternative to selling to PE firms. Even for mature companies, the debt is an excellent opportunity to grow without losing the controlling interest to the PE firm.
Enhance Liquidity. Strengthens balance sheet and provides liquidity through debt. Often, startups might need a large amount of cash as soon as possible. The availability of debt addresses those issues.
Let's examine the example of a late-stage, on-demand software firm. The fund provides the company with $1.25 million of venture loans for the sales expansion. The financing cost is $250,000 in interest and 0.79% company ownership as a warrant.
The new equity issuance in the last funding stage would lead to 10.7% ownership of the firm. Here the use of debt saved 10 points in dilution. These savings have a significant value. After 22 months, the company is acquired at a much higher valuation using a symbolic multiple.
As a result, the shareholders and the management increased the value of their ownership by $5.2 million. But, please, also note that they retained more of their shares.
When to Use it?
Knowing the benefits of venture loans is essential. However, the purpose of using the debt is no less critical. So let's examine when to use that type of financing. Generally, there are four cases where the use of debt would make sense:
With equity raise. The process of a new funding round or immediately afterward is the best time to get a venture loan. All factors are favorable and work for a company: strong momentum, in-hand diligence materials, and large cash balance.
Between equity rounds. As mentioned before, the venture loan extends the cash runway. It helps the startup achieve the next funding stage at a higher valuation and minimum equity dilution.
Fund to profitability. A venture loan is an excellent way for the early-stage startup to get to the profitability phase quickly. For a later-stage company, it's a great way to maximize already existing profits with financial leverage.
Insurance policy. All startups have one significant risk: being downgraded. The delays are dangerous for startups and might lead to an emergency bridge round (downgrading) and decrease the ability to raise capital. The venture loan protects startups from that case.
How to invest in VD?
VD funds are investment vehicles considered an alternative asset class. These funds are, in most jurisdictions, structured as limited partnerships (where investors are limited partners and the manager is a general partner).
Investors can invest in that instrument by being a limited partner and providing capital for a general partner who will manage all the money to give the debt. Typically, there is also a lock-up period, which is a period when you can't withdraw your investments.
Moreover, you have no right to manage your investments since you are a limited partner. Finally, keep in mind that it's a less risky investment than the VC. The reason for that is the nature of the debt.
The debt is more secure than the equity. In this case, you get exposure to startups without incurring high risks like equity investing.
Who can Invest?
The individual investor must be an accredited investor to invest in a venture debt fund. In other words, the investors must satisfy one of the following conditions:
Individual income > $200,000/year OR Household income > $300,000 in each of the past two years.
Net worth > $1,000,000 (excluding primary residence)
An insider in the company the person is investing in (being a general partner, CEO, executive, managing partner, director, etc.)
Accredited family office
Licensed investment professionals holding Series 7, 65, 82
"Knowledgeable employee" of the fund
For the legal entities, depending on the entity, the requirements are the following:
Owning investments > $5,000,000
Assets > $5,000,000
All equity owners are accredited.
Investment advisers / SEC-registered broker-dealers
Financial entities (bank, insurance company, registered investment company, etc.)
The Risks Investing
Although venture lending is considered a high risk/high return instrument. The risk, in that case, is derived from the risk of venture equity. However, VD and VC risks are fundamentally different.
VD is provided as senior secured debt. It has downside protection. In the default, the assets will be foreclosed to cover the debt. The borrowers are backed by VC investors, growing fast, and focused on transparent corporate governance.
The return comes in the form of fixed-interest income. The debt is high-yield and provides predictable and regular high returns. It's more attractive than low-yield public bonds or other unprofitable investments.
Warrants with an equity upside are another form of return for investors. It is a bridge for investors to structurally invest in the venture ecosystem.
How to Break into VD
It is possible to break into the venture debt fund straight out of university. First, however, you need to get deal exposure. So big four valuations or investment banking internships would be helpful to get some real experience.
The majority of people come from the following industries with 1-2 years of experience:
Another venture lender/debt fund
You have to complete 1-2 phone screens first. After that, you go to the Superday interview for 5 hours. During the interview, they ask both qualitative and quantitative/technical questions.
Qualitative questions will typically ask about your strengths and weaknesses, how you fit into the firm's culture, and your soft skills. They also ask technical questions such as industry knowledge, recent trends, and case studies.
If you talk about Uber or other famous unicorns, the recruiters will ask you to discuss lesser-known companies. You have to discuss how they use the venture debt, how they are valued, etc. That's how to show your genuine interest. Otherwise, you won't get an offer.
Roles and Salary
The salary information is provided below as of 2017 data.
The analyst is the most junior role in the venture debt fund. They get $60K - $80K as a base salary plus 50% of the base salary as a bonus. So, the total compensation is about $90K - $120K. That is less compared with investment bankers' salaries.
As you progress to the junior associate level, your compensation will be $125K plus a bonus of 50% of your base salary.
It's expected that employees will be researching the market, competitors, and products most of the time. You have to talk to potential customers, evaluate similar products, and assess the company's product development.
Also, you have to write a 50-100 page memo to get an agreement on the deal. You have to clearly state your thoughts on intellectual property, manufacturing, and other aspects of the company. That's needed to prevent the default risk.
In other words, the work is similar to the due diligence at the VC firm.
As the deal is closed, the working day depends on the portfolio. For example, if a single company is in trouble, you might devote all your time to rescuing that firm.
The hours are less than that of investment banking. Typically, people choose this career option for "lifestyle benefits." That is why they accept lower compensation for that. You should expect to work 60 hours a week (which is much lower than 100 hours/week at IB).
Many fresh graduates use the venture loan fund as a bridge to change their career options. In other words, they don't know where to go and decide to get some experience at that fund. Here are the popular exit opportunities after the venture debt:
Operational roles such as CFO at startups
Another venture lending/debt firm
Two trends explain why venture debt will be helpful for startups in the future.
First, since 1999, reaching liquidity through acquisition or IPO among startups has surged for three years. That increase magnified the need for alternative financing sources such as venture debt.
Also, capital-efficient startup companies with angel investments will likely boost the demand for alternative financing sources.
Nowadays, those startups are scaling faster than the funding rounds from traditional institutions. As a result, they are willing to use debt to prevent dilution and control issues.
Second, the venture loan industry has evolved through many historical phases. Those phases are the following:
1) inception of the venture leasing in the 1980s
2) the growth of the VD in the 1990s
3) dot-com bubble and financial crisis.
Today the venture loans industry is considered not as emerging but as a growing established industry.
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Researched and authored by Almat Orakbay | LinkedIn
Reviewed and Edited by Aditya Murarka | LinkedIn
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