Meet Venture Capital’s Baby Cousin, Venture Debt

Private credit -- on pace to grow to a $1.5 trillion market by the middle of this decade -- is one place investors are turning for the kind of healthy returns that have dwindled elsewhere in the debt markets. One slice of that asset class, though, is on pace for especially rapid growth as startups seek to stay private for longer and venture capital (VC) firms see record levels of activity: venture debt, also known as venture lending.

1. What is venture debt?

At its core, venture lending is debt financing for companies that are not yet turning a profit -- either because they’re using cash to grow until they can be sold or go public, or because their product or service is still in the startup stage.

2. How big is venture debt?

The market for potential venture debt-deals based on current venture capital investments stands at about $47 billion, according to an estimate from private lender Trinity Capital Inc. Looking at new lending, total activity grew to roughly $25 billion in 2019 from $5 billion in 2010, according to Pitchbook. The venture lending market has been on the rise, fueled by venture capital firms that both raised and invested a record amount of capital in 2020. Special-purpose acquisition vehicles, or SPACs, which go public themselves first and then buy other companies, also raised an eye-popping $79.2 billion in 2020, giving founders and VC firms a new and appealing potential exit strategy. Because venture loans can act as a bridge to an eventual SPAC deal, the boom in the space could speed up the growth of the venture debt market.

3. Does venture lending compete with venture capital?

Not necessarily. Some venture capital firms encourage the startups they invest in to borrow instead of raising more capital by issuing more shares -- which would dilute their own stakes. So the more money VC firms put to work getting startups up and running, the more opportunity there are for lenders to provide capital to keep them running on the road to profitability. The Covid-19 pandemic has also forced some startups to stay private longer, ramping up the need for them to secure debt to keep operating.

4. How does it work?

Venture lenders step in after VC firms have already snapped up equity stakes -- usually after two or three rounds of equity funding. Typically, lenders provide debt to companies when they’re past their very earliest stages, like after they’ve developed a product and their technology has been proven to work.

5. What are the deals like?

They can take many different forms depending on the borrower, but most lenders try to find something tangible -- either an asset, potential product value or projected future income -- to help secure the financing they’re providing.

  • Recurring revenue loans are provided to companies that anticipate regular, expected income -- for example, when a firm has landed a contract to provide services. Sometimes, lenders only allow companies to borrow a certain amount until they hit certain revenue milestones, or they make sure the deals include covenants, or contract provisions, that are based off those benchmarks.
  • Product-based loans -- These transactions, often in industries like life sciences, hinge on the future success of a product or service. Often, lenders invest once the technology has been developed and tested, and the company is trying to sell it.
  • Equipment financing -- Via these deals, lenders provide financing that is secured by equipment owned by borrowers, like routers for a telecommunications company or testing machines for a medical firm. These tangible assets can be liquidated if the borrower is unable to keep up with debt payments.
  • Equity warrants -- They allow the lender to buy shares in the company that’s borrowing at a specific price at a later date, which can pay off big if the firm is a success. These can also offset credit losses in a venture lender’s portfolio.

6. Who’s lending?

Banks, like Comerica Bank and Silicon Valley Bank, provide about half of this type of financing -- though the overall share these financial institutions have provided has shrunk in the last decade or so. Increasingly, alternative lenders called business development companies, including Hercules Capital Inc., Horizon Technology Finance Corp. and Runway Growth Credit Fund Inc., are stepping in to snap up market share. Other private funds also provide financing in the highly fragmented industry.

7. Who’s borrowing?

Borrowers that tap the venture lending market fall into a number of industries, including life sciences, technology or retail. Typically, they have been through one or more VC funding rounds and are working their way toward profitability, or an exit in the form of an IPO, sale or merger with a SPAC. Beauty product retailer Birchbox Inc. and telemedicine company Hims & Hers Health Inc. have also tapped the venture lending market in recent years.

8. What’s the appeal?

For lenders, it’s yields: They’re usually able to command interest rates of 7% to 14% on loans with three- to six-year maturities, according to Wells Fargo Securities LLC research. Venture lender Applied Real Intelligence estimates that non-bank financing providers returned more than 20% annually from 2005 to 2019 -- roughly double that of less risky types of private debt deals and about 10 times that of investment grade debt. Warrants that are attached to many of these transactions -- which can have a shelf life as long as a decade -- can also pay off handsomely when a borrower goes public. Borrowers, meanwhile, are able to get money to float them to their next funding round or exit without diluting existing equity holders further.

9. What are the pitfalls?

In this market, lenders are providing financing to companies that are not yet making money, inherently a risky bet that requires a lot of due diligence. VC-backed business may have minimal assets, meaning there is sometimes little collateral to secure financing, too. Increased competition among alternative lenders is opening the door for a loosening of covenants, the terms in debt documents meant to protect creditors. The market is also insular, meaning that new lenders may have a hard time establishing relationships with VC firms that will send deals their way.

10. Is it regulated?

Banks are the mostly highly regulated of the venture lenders -- a fact that limits the amount they can lend to each company and makes for strict covenants on the debt deals. BDCs are non-banks that have regular public reporting requirements and some constraints on portfolio composition. Private debt funds that step in to do this lending are largely unregulated. Regulators have warned about the growth of private debt in general, and its potential vulnerabilities. But despite harsh warnings in the early stages of the Covid-19 pandemic, most shadow banks’ portfolios fared better than market watchers feared -- buoyed in part by the flood of liquidity into credit, cost-cutting measures and equity owners’ contributions. In the U.S., the overall private credit default rate fell to 3.6% in the fourth quarter of 2020, down from a peak of 8.1% in the second, according to law firm Proskauer.

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