A Case for Venture Debt

Venture capital isn’t the only form of financing startups today are angling for, and that’s good news for both founders and investors.

How familiar are you with venture debt?

Chances are, not very.

This form of financing has historically been underutilized in the world of startups, and isn’t splashed across headlines nearly as often as venture capital. However, venture debt has a strong value proposition to startups and investors alike under the right circumstances, and it‘s increasingly prevalent.

As we continue to work through volatile market conditions as a result of the coronavirus pandemic and the following economic downturn, my colleagues at Fuel Venture Capital and I elected to review the venture debt market and evaluate whether it could have a place at our firm. Ultimately, we’ve determined that we’d be doing a disservice to our LPs — ultra-high net worth investors, family offices, RIAs — if we did not offer the exposure to venture, debt given its myriad benefits. For both sides of a venture debt deal, however, venture debt can be a great tool. For founders, it enables fundraising while minimizing dilution and maximizing potential returns of equity already invested.

Growing, growing, growing

According to Pitchbook, roughly $26 billion of venture debt was issued in 2019, compared to $132 billion of venture capital (VC). Part of the reason for this discrepancy is that venture debt is not a fit for all startups. It is also not a substitute for venture capital.

However, venture debt has seen enormous growth, in terms of both deal size and deal count, in the past 15 years. This growth is driven by the hot VC fundraising market, from both sides of the table.

On the demand side, venture debt has seen increased adoption from startups at all stages of development in recent years. On the supply side, the growth of venture lending has come from not only dedicated venture debt funds, but also from interest in direct lending and extended loan programs from lenders not focused on startups such as banks and other institutions.

Venture debt amid COVID-19

Since the global outbreak of the novel coronavirus and the economic downturn that materialized as a result, startup companies have implemented drastic cost-cutting measures and explored venture debt to increase their runway.

Anticipating a slowdown in VC funding, most founders have planned to delay or even skip equity financing altogether to avoid facing a depressed valuation, which would dilute their ownership more than previously forecasted in pre-COVID 2020 projections.

Post-COVID 2020 dilution would be particularly painful for companies that were given inflated valuations prior to the coronavirus outbreak. Since the ensuing shelter-in-place guidelines have hurt the global economy, these companies have seen revenue drop-offs and struggled to provide the evidence needed to justify their valuations. A down round is almost a guarantee for these companies if they find it necessary to raise new capital amidst the downturn.

This scenario is one where debt can be a powerful tool. On the back of low-level interest rates, debt provides extra funding at a cheaper cost than a down round. The extra cash from debt allows startups to wait for a more favorable valuation environment without suffering outsized dilution.

Venture lenders are already seeing an increase in new borrowing requests, while their existing clients call down credit lines and extend current debt facilities.

Value proposition to founders

Startup founders have eventually shook off the negative feelings toward debt and recognized that venture debt is a smart and critical source of capital as it offers a balance between flexibility and dilution.

Compared to senior lines of credit, which are secured by accounts receivable, inventory, or minimum cash levels, venture debt is less restrictive and is covenant-free, or covenant-light. On the other hand, venture debt normally dilutes equity less than 1–2% total, an appealing route for founders who want to retain control of their company.

Venture debt can be used for numerous purposes. Below are a few common use cases:

• To fund value-enhancing transactions, such as acquisitions, specific projects or large capital expenditures
• To accelerate growth with low-cost and less dilutive capital
• To persevere a tough period without setting an unattractive valuation, or raising a downround, both of which sends negative signals
• To act as an insurance policy or provide a buffer against operational glitches or fundraising hiccups
• To extend runway to hit milestones for further fundraising at a higher valuation

Value proposition to investors

As the Great Recession reached its trough at the end of 2008, the Federal Reserve took bold steps, including purchasing trillions of dollars in bonds in an attempt to stimulate the economy, leaving interest rates at historically low levels ever since. As a result, fixed-income investors have faced the predicament of extremely low yields. In addition, fixed-income investors have also been exposed to rising interest rate risk, as at the near-zero level, interest rates can only linger there or go up.

Given the negative relationship between bonds and interest rates, when interest rates rise, the value of a bond will decline, resulting in investment losses. Investors have been forced to “reach for yield” in the high-yield market, because they offer significantly greater yields than government bonds and many investment grade corporate bonds. High-yield bonds also have lower interest risk because they’re more sensitive to the economic outlook and corporate earnings than to day-to-day fluctuations in interest rates.

However, the high-yield market has recently struggled with the double whammy of COVID-19 and the ensuing oil crisis. Fitch Ratings believes that 36% of high-yield corporates are likely to face rating downgrades, which are usually accompanied by bond price declines. Worse yet, tumbling oil prices have been hitting an already-battered energy sector, which makes up a big chunk of the high-yield market.

Looking beyond traditional assets, investors are seeking alternative fixed income investment opportunities. Compared with other fixed income products, venture debt stands out as an attractive option to help investors maintain their fixed income targets and increase the yields of their fixed income portfolio in the asset allocation framework.

Return: Target net returns of venture debt are in the 15%-20% range for early-stage companies and fall to 10–15% for late-stage companies. Returns for venture debt are driven by four components: (i) interest payments, (ii) closing/transaction fees, (iii) repayment schedules, and (iv) warrants. The first three really drive the IRR (i.e. yield) while the last variable, warrants for company stock (options to buy stock in the future at a fixed exercise price), is a sweetener that allows the lenders to participate in the upside should the company do exceptionally well. This mezzanine structure enables venture debt providers to moderate risk from the regular interest income and earn superior returns from the add-on equity kicker.

Risk: For the seemingly exceptional risk taken by lenders, it is estimated that the venture lending industry realizes just a 2% loss of capital. As a comparison, roughly 17.4% of SBA loans awarded from 2006 to 2015 went into default, according to a study of SBA loan data.

Fuel Venture Capital’s venture debt offering

Fuel Venture Capital seeks venture debt financing for our portfolio companies solely to reduce the inherent riskiness of lending to early-stage companies.

Before investing in a company, our leadership team spends months conducting comprehensive due diligence and continues to acquire business knowledge during the curation process. Our understanding about the founding team, business model, market traction and other potential value drivers allows us to assess the company’s debt worthiness, its capacity for repayment, its liquidity position, and its ability to attract future funding to manage the risk nature of debt lending. More importantly, given our position on the cap table, we can ensure that the company will not borrow additional money and have any material actions that may affect its ability to repay the loan.

Our stance mirrors that of our most prominent industry peers, and that is: a company should take on debt based on its own market opportunity and creditworthiness, not based on who its VCs are. Our role as the VC fund on the company’s cap table is not to be the venture debt payer when debt is poorly used. Our role is to monitor the progress of the company using our proprietary KPI dashboard trackers to protect the venture debt holders and enhance the value of the investment from using the debt leverage for our equity holders.

Within our fund, not all portfolio companies are a target for venture debt. We will not recommend our portfolio companies to seek a venture debt financing if they answer ‘yes’ to any of the criteria below:

Fuel Venture Capital favors the use of venture debt financing as funding for a specific value-enhancing project with a specific repayment plan, as growth capital, or as a tool for leverage which allows the company to get to a better position with higher milestones set up for a more attractive valuation in the next round.

The venture debt structure and terms have become increasingly flexible with diverse constructions used for different industries and investment stages. Our typical venture debt construction includes basic and reasonable terms to protect debt holders but still provide founders with the flexibility.

The structure and terms vary based on the assessment of credit risk which are driven by investment stage, business model, company performance, cap table quality, etc. Some companies are better positioned for venture debt financing than others, thus can negotiate more favorable terms or lower loan costs.

For example, companies with recurring-revenue models are much more attractive to lenders than those with one-time revenue models. Likewise, companies with an entrepreneurial customer base and long-term contracts are less risky investments than companies in a consumer marketplace with high churn. Other factors are listed below:

Venture debt vs. venture capital

Venture debt can be supplementary to venture capital, providing value to both founders and investors.

As a funding capital source fueling impressive growth trajectories, venture debt, along with combined debt and equity deals, has played a key role in the development of prominent companies, such as YouTube, Uber, Facebook, Square, Box, and many more. As an investment in a diversified portfolio, venture debt complements venture capital by offering a superior return, income generation, and moderate risk.

However, venture debt is not a substitute for venture capital.

It is important to avoid too much leverage. When times are good and capital is flowing freely, more debt does not seem to be such an issue. But if the market constricts or the company isn’t performing quite up to expectations, debt can quickly become a burden. Therefore, it requires a solid risk-governance structure and advanced skill set to identify the companies that are in an appropriate position for venture debt financing, and thus are lucrative investment opportunities for investors.

This post was authored by Fuel Venture Capital General Partner and Chief Investment Officer Maggie Vo, CFA. Maggie manages investment activities, leads due diligence for prospective investments, and performs valuation analysis for existing portfolio companies. To reach Maggie, email her at maggie@fuelventurecapital.com. Follow Fuel Venture Capital on social media, via Instagram, Twitter and LinkedIn.

Disclosure

Information provided in this paper is for educational and illustrative purposes only. The material presented represents the opinions of Fuel Venture Capital, as of the date of this report. The information and opinions presented have been obtained or derived from sources believed to be reliable; however, the accuracy and completeness of such information expressed herein cannot be guaranteed. Opinions are subject to change without notice, and Fuel Venture Capital assumes no responsibility to update or amend any information or opinions contained herein. Keep in mind that past performance is not indicative of future results, and there can be no assurance that the Fund will achieve comparable results, achieve its investment objective, implement its investment strategy or avoid losses.

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