Bringing Venture Debt In-House
Venture debt is an asset class that I feel is ripe for new entrants with fresh models. I’ve long thought a fund under the umbrella of a VC, dedicated for only its portfolio companies would make sense for a number of reasons. As an existing investor, you have asymmetrical information about the company, you already have what should be a good/trusting relationship and the existing model leaves a tremendous void in the market, which I’ll discuss.
The existing venture debt space is occupied by a number of large, publicly traded banks as well as a few private funds. Their underwriting practices are reasonably similar, though there are some small nuances. One of the core factors is the VC syndicate. Particularly, if a startup is funded by a large fund who has the capital to continue to support the company down the line if need be, then getting venture debt is reasonably straight forward.. The lender has a relationship with the VC and trusts that if things get sideways operationally, the venture fund will support the company long enough for them to see a return of principle — even though the lender has first claim on the asset in the event of default, it generally has no interest in that scenario playing out. Because large funds tend not to get involved until later in a startup’s evolution, the earliest you see venture debt tends to be after a company has raised at least $5m (depends on industry and revenue model), but it’s far more common for the company to have raised $10m plus. What this means is there’s a large world of startups that are performing well, but have funding from early-stage funds, strategics, corporates, etc thus, are less likely to have access to debt. Having the ability to fill this void is a tremendous opportunity.
From the standpoint of the startup, venture debt can be confusing and often disconcerting. It’s not like equity, where an investor writes a check and hopes five or more years down the road he or she will receive a larger check in return. A lender requires a regular coupon payment, often controls when and how you can spend the funds and if you default, the lender essentially takes control of the assets until it’s repaid (it’s much more complicated than this, but not useful to discuss here). If the founder has past experience with venture debt, she will have an easier time evaluating the risk and understanding how to negotiate terms. If it’s her first time, it’s a lot to work through and she will generally rely on the VC for guidance. From the founders standpoint, I believe raising venture debt from a firm you already know and trust, would have an appeal.
Venture debt, when used properly, is fantastic. Particularly in the current rate environment. None of this is to throw shade on the asset class or the lenders. Our portfolio companies have raised debt from just about every lender in the space and most of them have been great partners. The banks and debt funds have their model and it works, many of them have been incredibly successful. That said, there’s a significant void in market left by these firms . It’s fairly simple for a VC to identify these opportunities within it’s portfolio and with a dedicated pool of capital reserved for debt (and a dedicated Partner who is not a traditional VC), capitalize on the opportunity in a manner that could be mutually beneficial. There is no shortage of conflicts and potential barriers and for every argument I make, I could easily make the counter argument. Setting this up as I describe would take careful thought and execution, but if done right, could be a big opportunity for both the lender and borrower.
