mind the gap
Throwing light on the gap in the lending ecosystem for early -stage lending platforms in Silicon Valley
Silicon Valley is obsessed with equity. It does not generally know about or understand debt to any deep degree. I know this because I have worked in, sold debt to, provided legal services to, or borrowed from, participants in the global debt markets since 2000. I came to the Valley two years ago and since then have learned about Venture Debt (which is nothing like East –Coast- ‘debt capital markets’ — debt).
Venture Debt does exist in the Valley but it is offered by a handful of firms, in very limited circumstances, to a limited subset of companies and seems to exist on the outskirts of Sand Hill Road. It is definitely not a mainstream source of capital for Silicon Valley companies. In any case Venture Debt partners have a schizophrenic mindset — of being both debt and equity investors. They are somehow factoring into returns, the chance of hitting the Facebook jackpot alongside factoring more dependable debt fees and margin payments.
Debt does seem to be coming more into favour. According to a number of recent articles, published and republished by numerous sites, US start ups are increasingly taking on debt. I’ve included a sample here:
What is the nature of this debt? It is plain and simple corporate debt, figures are dominated by large debt financings for Uber and AirBnB. It makes sense because the cost of debt to a company is cheaper than the cost of equity: to optimise tax efficiencies in a capital structure, companies need to carry a certain amount of leverage.
However in this article I’m talking about lending for another purpose — for early -stage lending platforms in Silicon Valley — and there is a gap here in the Valley.
Lending platforms need debt because they are either matching debt takers with debt providers, or they are themselves lending and receiving debt returns (which is best supported by cheaper debt capital).
And how do I know there is a gap? Because, having spent time at a fund in the alternative lending sector last year, a number of start-up lending platforms have approached me to help them raise debt. And what do you think is the answer to — was it easy to find lenders on Sand Hill Road?
Most alternative debt investors are on the East Coast. To throw some names out there Blue Elephant Capital Management, Direct Lending Investments, Echelon Asset Management, Colchis Capital, Greywolf Capital, Community Investment Management and the fund I spent time with last year Incline Fund could be approached as potential lending (debt investing) partners. I will expand more on this ecosystem in another article, the point being they are not all centrally located along a prominent road in the Valley. You can find them at expensive conferences like Context Summits — but which start ups can afford to attend or are being marketed to for attendance?
The other barrier to fundraising for lending platforms is that these platforms have barely scraped together seed money and they already need to raise debt as well as raise more equity, at the same time. Each type of capital provider will say that they are dependent on the other type of capital provider to show them the money.
Here is a window into one such conversation that I had with an early stage lending platform. I spoke with Craig* the CEO, of a real estate investments platform, connecting investors with borrowers who are seeking mortgages. He established his platform last year, and has been fundraising for 12 months. He is raising debt in order to on-lend to US borrowers for their home investments.
Through this process, he has experienced the phenomenon of equity investors requiring him to have evidence that he had raised debt and vice versa. He calls it the “fundraising dance”. Interestingly, the kind of debt that he is trying to raise is not debt that is being put to use in the corporate sense, but it is debt being put to use in the way that a bank puts it to use.
However Craig distinguishes his platform from a pure-play bank and a pure-play P2P lender.
A pure-play bank is required by regulation to hold at least 6% tier 1 capital (shareholders equity and retained earnings) compared to its total risk weighted assets — essentially meaning that a bank needs to be well capitalised to ensure there is enough equity buffer in place in case of insolvency. The remaining capital is comprised of hybrid securities and forms of debt.
A pure-play P2P lender doesn’t need to carry much, if any, debt on its balance sheet because it is simply a conduit or matchmaker between lenders and borrowers. It can quite easily be capitalised by Sand Hill Road like any other Valley software start up.
Craig’s platform is positioned in the middle of these two ends of the spectrum, as a hybrid model. The platform will make loans and keep some on its balance sheet and selectively distribute some where it creates value to do so. Why? Because Craig says investors are now wary of the pure-play P2P Lending Club model whereby the platform does not keep any skin in the game. All loans are distributed to investors leaving the platform shielded from any loan losses. Craig also wants to take advantage of offering and keeping longer term loans, and capturing value at the tail end of the loan (collecting interest at the tail end instead of just taking fees at the beginning of the loan).
What does this mean for Craig’s business? Craig needs to raise both equity and debt, rather like a bank.
From where? How? Which accelerators or VCs are set up to help with this?
How has Craig gone about this? He is lucky to have worked in US corporate banking and has a network of banking names to draw on, but he has had to work hard to bridge the distance between the Valley and old-school banking. The first thing an old-school banker will ask about is three year’s track record. Notably Wells Fargo, Silicon Valley Bank and Square1 Bank are also absent from the alternative lending scene and cannot help in this instance.
The positive end to this story is that one local alternative lending fund has stepped up and offered him both debt and equity (I’m not talking about the kind of venture debt with equity kicker offered by Venture Debt firms, it’s a secured lending structure — the collateral being the underlying debt which the platform is originating).
Once Craig’s business is up and running, the other debt investors will surely be crawling out of the East coast woodwork where they are well camouflaged.
In subsequent articles, I will be writing about possible solutions including the following
· Ways to find alternative lenders including information on some top players
· Exposé for a specialised fintech accelerator that has started in the Valley
· Better borrowing solutions for supply chain finance (SCF) fintech borrowers
· Demystifying securitisation and why this is a longer (rather than shorter!) term solution to accessing volume
*Name altered for anonymity
Louise is a current CFA Charterholder, and trained as a tech and finance lawyer (qualified in the UK and Australia). She holds an MS in Management from Stanford.