We all know about the fabulous returns from venture capital investing. If you were one of the early backers of Facebook, Google or Netflix, your return would be hundreds of times your initial investment. A common complaint among company founders is that early on, they sell too much equity for too little because they need the money for expansion. Venture debt is a long-standing alternative source of funding that satisfies both parties: healthy returns for investors and no dilution for founders when raising money. Here is a closer look at the asset class today:
The Venture Debt Market
Over the past decade, there has been a big change in the way companies go public. Companies are able to stay private longer due to robust private capital markets. Between 1990 and 2001 the average duration from company founding to a successful exit (acquisition or IPO) was 4.6 years. Between 2002 and 2018, the average duration from company founding to exit was 10.9 years. The growth of the venture debt market has coincided with the growth of private markets overall. Before completing its IPO in 2019, Uber raised more than $1 billion in venture debt. Airbnb raised $1 billion from Silver Lake Partners last April with warrants attached with the deal.
Most emergent growth businesses are not profitable until later stages and therefore must finance continuous growth through equity sales or through borrowing. Since venture equity-backed companies lack the assets or cash flow for traditional commercial debt financing, they borrow at market rates set by the venture debt market. Raising debt/borrowing money is a common alternative for companies looking for alternative financing.
Venture debt loans are issued to fund growth plans and are always based on milestone terms. Venture debt originators lend money to growing companies at high interest rates, typically 12-15%, for several years, based on their ability to hit their milestone targets. Venture debt is attractive to founders for a variety of reasons:
- Can generally be arranged much more quickly than equity financings, saving valuable management time.
- Does not establish a valuation for the company, which can be helpful ahead of a new round of equity financing where management and existing investors would otherwise need to negotiate a price.
- Provides a much-needed working capital source for high-growth business between traditional funding rounds
- Does not generally require board seats or observation rights.
- Entrepreneurs value flexibility, speed and the non-dilutive nature of this financing above all.
- Allows founders more time to achieve success metrics (more sales, employees, subscribers, active users, etc) which can be used to raise their next equity financing round at a higher target valuation.
- Non-dilutive. Founders do not give away equity the way they do during normal series B,C,D,E… funding rounds
Rates, Warrants, Returns and Risk
Founders are willing to pay a higher rate for the non-dilutive nature of debt financing. It helps them achieve higher future valuations for their equity share. Despite a low interest rate environment in the US, venture debt yields have been steady between 12-15%.
Venture lending has had an unusually low loss rate, especially in late-stage recurring revenue companies. Just like in any business activity, there will always be write-offs. One of the best risk management tools available today is to simply confirm the track record, deal volume and performance record of the venture debt general partner who is in charge of facilitating the deals.
In terms of risk management, the entire loan amount is not issued to the company on day one. Instead, payments are made as milestones are achieved. Most loans are secured by cash flow based on software contracts, intellectual property and or hard collateral. Late-stage private tech companies make ideal candidates for venture debt investing given their robust pipelines of customers and reliable revenue streams which help pay the loan back.
Some of the best venture deals include warrants for company stock. For those who are unfamiliar, warrants are like stock options and allow you to participate in the upside growth potential of a business.
Venture debt is not available in the public markets but can be accessed through private investment vehicles. For investors looking for different risk and return profiles, the yields and warrants related to venture debt may be an attractive option. Let us know if you would like to learn more about this topic and whether it’s the right fit for your portfolio strategy.
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