Startups and debt (III): Venture debt

Spain - 
Rafael González-Gallarza and Alex Pujol, partners at Garrigues Corporate Department

In earlier articles in this series (see here and here) we explained the reasons and setbacks, for founders in particular, of startups’ dependence on equity as the only source of finance, together with the advantages that debt would have for them. We also described how the environment is right for opening up routes to obtain debt finance. Lastly we looked at the difficulty with providing general recipes for raising debt finance and a few routes that do not appear to be very promising options for startups, such as commercial banks and their ordinary channels and conventional bond issues. Now we take a look at a first form of debt finance that does look like a way forward.

Venture debt: well-established in the U.S. and taking its first steps in Europe

In the U.S., by contrast, there are banks that regularly lend to startups. Namely Silicon Valley Bank, Comerica, PacWest, Western Technology Investment, among others. These banks take advantage of the transactions to offer other kinds of banking services, including personal banking services, to founders and to executives. As the industry and each company grows, the bank broadens its business and introduces more conventional commercial banking products.

In this article we look at how this happens.

This venture debt option is not completely unknown in Europe where specialized funds are appearing. One example is Kreos Capital, operating in Europe and Israel. This manager’s fifth fund ended 2013 with committed funds amounting to €240 million which it lends to high growth technology firms. Although the fund is mentioned by several sources in the context of venture debt we do not know whether most of its transactions fall into this category as we have described it.

In Europe, however, commercial banks do not appear to take an active role in this product. We learned, however, that Barclays entered the venture debt arena in 2016/2017, although through a fund it marketed with a size of €200 million. European commercial banks are generally absent here for reasons ranging from unfamiliarity, to product aversion or small market size.

The ecosystem of companies backed by venture capital funds (a usual requirement, as we shall see, to access this type of financing) is growing, however, so the last reason cannot be top of the list. In Europe there are plenty of hungry venture capitalists and the idea behind and dynamics of rounds is not to drop the company so as not to lose invested funds and to reap what they have sown, until a sale or initial public offering. Against this backdrop, lending money is a very conceivable option.

Venture debt is generally repaid out of the proceeds of equity rounds

Venture debt loans are provided after the company has obtained the backing of one or more venture capital funds, and with the expectation and belief that other rounds of investment will follow, ending with the chance to exit in the form of a sale or IPO. So they do not lend against income or assets; these startups do not even have regular revenues: in fact it is often said that venture debt providers are only interested in the identity of the venture capital funds that have invested in the borrower rather than their business model or security for repayment. The lender will see its loan repaid when the startup is sold or out of the proceeds of the next funding round (or it will agree to refinance its loan in view of the confirmed backing and expectation of later rounds).

A lower finance cost than for equity

The interest on these loans is considerably higher than the rate offered by conventional banking institutions, and could easily go above 10% per annum (we should not forget that the risk accepted by the lender, in light of the borrower’s profile, is substantially higher then is usually the case).

Venture debt consists, therefore, of bridge loans tiding them over until the following round is concluded or provided in the belief that others will follow, or that there will be a sale or IPO: so, they are facilities, including medium-term ones, which besides advancing funds against capital contributions also partly replace them. They are senior to equity and this means that lenders can offer rates and fees that, although higher than those of conventional banks, are better value than the cost of equity from investors.

They usually include a warrant, however, which gives the finance provider the option to subscribe to a given number of shares at a predetermined price (the aggregate amount to be subscribed is usually equal to a small percentage of the principal of the loan provided and the unit subscription price is the price per share of the round immediately before the company takes on the venture debt). This is how, in addition to the pure return on the loan capital, the venture debt provider obtains another type of income, not always lower, equal to the difference between the price per share at the time of the company’s sale or IPO and its acquisition cost.

The overall result is that it is considerably less diluting for founders and the earliest investors than if all finance had come from equity.

The loans have security interests provided by the startup itself

Most of these loans have security interests (typically in the company’s intellectual property) and senior and junior lenders to each other may coexist. All of this is offered in the standard way on these banks’ websites and the transaction costs, while higher than for traditional financing, are acceptable.

Going beyond venture debt

Venture debt is very close to bridge loans tiding companies over until the following equity rounds or a sale or IPO and therefore is not a separate and independent method. No debt provider is indifferent to the borrower’s equity levels, although it is preferable for any solutions they offer to be conditioned as little as possible on obtaining or retaining high equity levels. We therefore need to explore methods that go beyond and distance themselves further from rounds and enable them to be reduced.

There has very recently emerged, in fact, a new company called Uncapped, which has announced that its business consists of providing 0% loans to startups, on which it charges a fee equal to a percentage of the loan. The lending company says it makes a prediction of its client’s revenues and the repayment schedule is flexed to fit that prediction. This might be the first interesting example of an arrangement that comes close to those we discuss in later articles in this series because rather than on the expected revenues of startups Uncapped appears to place the spotlight on future equity rounds. See Uncapped’s website here.

In forthcoming articles we suggest new methods of raising finance, apart from venture debt, along with their requirements and characteristics.