Demystifying Venture debt price

How to understand the cost of a Venture debt transaction (amortization, interests and shares). Put yourself in the lender’s shoes.

I often come across entrepreneurs that find Venture debt expensive. I tend to think that they overestimate their companies (which is probably good) and notably their leverage capacity.

Venture debt may not be that expensive after all

As a loan, Venture debt is often priced at low double-digits or upper single digit interest rates. Taking as an example some of the most relevant Tech companies such as Uber (7.5%), Spotify (5-10%) or AirBnB (10%). I believe that a low double-digit interest rate doesn’t sound expensive for a European Series A/ Series B company.

The main problem for entrepreneurs is to benchmark Venture debt to commercial banks loans or public financing which are generally set at mid-low single digit rates (see Venture Capital-Bank Debt).

As a quick reminder, the asset class of Venture Debt shall be placed somewhere in between the High-Yield Bond and the Venture Capital and therefore the returns expected from taking such a risk are in the range of 10%-25%. Otherwise, investors would rather move their money onto other less-risky and/or more profitable assets.

Asset class strategies — Risk reward matrix

If we target a 15% IRR in the upcoming 4 years, calculation will be the following: (1+15%)⁴=1.8x. As a result, we need to make a 1,8x multiple on the investment (this is net of management fees).

As you may know already, the returns of a Venture debt fund come from these three different pillars (see Venture debt 101): (i) principal repayment, (ii) interests and (iii) shares. The two first pillars will be subject to the default rate (failure to fulfil their repayment in a timely manner).

  • Interest rates, principal and default. Why are they so many differences between different Venture Debt providers?

The probability of default is one of the key metrics on the credit assessment of lenders. If we focus on Venture debt target companies these will be rated below CCC given their metrics (negative Ebitda, Asset light and Negative Op. Cash Flow) and therefore we will find out that their probability of default in the 3/4 years (maturity of the loan) is c.44%.

Global Corporate Average Cumulative Default Rates (1981–2018)- S&P

As it can be seen for the table, probability of default dramatically increases moving towards the bottom of the spectrum (high-yield, other low credit profile companies).

In addition, the longer the maturity of the loans the more probability of default. Venture debt loans have typically a 3y-4y maturity.

This is broadly in line with the typical Venture capital distribution of returns were up close to one-third of the companies end up as write-offs for the fund. Venture debt funds will typically co-invest with other Venture capital funds and therefore they may have a similar portfolio outcome.

Interest rate is intended to offset the default that could possibly arise within a Venture debt portfolio. As it can be seen from the table below, the cumulated interests(set at 10%) plus the principal (1- default) hardly achieve to pay back 0,8x of the fund - 0,23x coming from interests and 0,56x of principal repayment - . Therefore, an additional remuneration in shares is required to become a profitable instrument to our investors.

Portfolio Metric with 10% interest rate and S&P (CCC) default guidance.

In practice, given the high level of expertise most venture debt funds have been able to reduce loss given default below c.20% and are able to generate marginal returns from their loan portfolio.

Differences in pricing between different funds are mainly due to different expectations on default (linked to different amortization schedule, covenants and/or collateral) and different expectations on the equity multiple.

  • What about the shares/warrants of the company?

In order to achieve the 1.8x multiple required by the investors of the fund equity upside has a critical role. The lack of substantial returns with the loan portfolio and the non-liquid nature of the funds make the attribution of shares necessary to become a competitive asset class.

Remuneration in shares balance the risk-reward profile of the investment.

In this example, we would need to achieve a 4x multiple on our 25% equity-kicker to achieve the targeted 1,8x multiple (as a reminder 0,8x are paid back from our loan portfolio).

Share multiple requirements at different default levels

These are all dynamic figures, if we had a performing loan portfolio giving back 1x the size of the fund (implicit default at c.25% not 44%) we would be able to seek a lower multiple on shares at 3x.

By definition Venture debt funds shall require a lower upside on the equity and will be able to finance a broader number of companies than traditional Venture Capital firms which are limited by the 10x mantra on their investments.

As you can see from the above chart, loan portfolio and shares remuneration are two communicating vessels pointing the same direction, to achieve a target return to investors c.15%-20%.

The lesser the default of a Venture debt fund the lower IRR requested on the shares (including the Equity kicker). However, one of the reasons behind Venture debt co-investing with VCs is the important upside required on the shares (3–5x).

As it can be seen from the tables above, we have several inputs as part of this calculation. This is the reason why different Venture debt funds will have very different Term Sheets concerning the equity-kicker, interest rates, maturities and collaterals.

Every Term Sheet has a previous structuring exercise balancing risk-reward of both sides of the table (equity and debt). This includes a credit assessment (default and loss given default) and upside expectations of the shares (equity kicker and exit multiple) targeting the expected IRR to the asset class c.10%-20%.

Venture debt funds may have very different default rates at different stages (series A, series B…) the more early-stage the Venture debt fund the more equity-kicker proportion and multiple expectation to offset the higher probability of default within the portfolio.

Setting a fair price on a Venture debt may not be an easy task

Shorter maturities and collateral may also reduce the risk of the trade and could release pressure on the equity-kicker. There is no easy solution on what the correct pricing should be from a Venture debt perspective given the high level of uncertainty on every transaction.

To sum up, Venture debt is a tailor-made solution for companies and should be considered as an exercise from both parts, companies and the debt providers. A thorough explanation of the company risks and possible ways to mitigate them will enable the Venture debt provider to achieve a lower pricing for the company in order to avoid further dilution.

This is a very simplistic approach to Venture debt. For calculation purposes loss given default has been accounted as the probability of default. This is often true to Tech companies which are asset light and present no residual value.

We chose four and not five as the blended duration of the fund. This is a blended number including the loans maturity (typically at 3 years ) and 5 years to the shares divestment.

A substantial part of the loans of a Venture Debt fund are subject to refinancing and/or changes in the amortization schedule. In addition, not all the loans have the same weights within the portfolio and these weights are dynamic due to the amortization of the loans.

Management fees of the fund were not included in the calculation. In order to achieve a 15% Net IRR the find may include a number of fees to the loans (i.e. opening fee, closing fee and/or structuring which may vary from 1–2%).

In addition, duration of some of the loans may be much lower in line with covenants and/or early repayments which could enhance the IRR.

For comprehensive purposes we have assumed no cost on the shares which are often linked to a strike price (i.e. Warrants)

Venture Debt investor @zubicapital. Opinions are my own.

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