The rise of Venture Debt
With the upcoming of the venture industry in the 1970s and 1980s, pioneered by firms such as Sequoia Capital and Kleiner Perkins, entrepreneurs and investors started to explore new alternatives to traditional equity financing. Fueled by the emerging need for capital and a limited access to financing from banks, venture debt started to emerge as an attractive solution to extend a company’s runway with limited costs to the business.
Simply put, venture debt consists of a financing provided to venture equity-backed companies that lack the assets or cash flow for traditional debt financing or that want greater flexibility. The financing is typically structured as a senior term loan collateralized by the company’s assets and with warrants for the company’s stock. On top of greater flexibility, the greatest benefits for entrepreneurs consist in not being diluted and not having to give up a board seat.
When comparing venture debt with venture capital, it is essential to bear in mind that venture debt is mostly a topic for mature (ventures) companies, which make a continual profit, whereas venture capital (equity) is for still early-stage companies. The typical company exploring venture debt financing is growing at a strong pace, already raised $1m+ in previous rounds and has annual revenues above $1m while still making losses. Generally venture debt is then employed by the company to accelerate growth without losing equity and to reach additional milestones while raising its next equity round at a higher valuation. Also, purchasing equipment collateralized by the equipment itself can represent an interesting case for venture financing,
What makes venture financing attractive for investors is the high interest rate associated with these loans (~15% in USD) senior debt collateralized by the company’s assets, as well as a dispersion of returns which is much lower than for equity investments:
As opposed to venture capital funds, venture debt funds are expected to deliver about half the returns of VC funds, which translates roughly in a 1.5x return over a 10-year period. This also implies that the failure rate for a venture debt fund is much lower than its equity counterpart. In addition to the recurring interest rate payment, the venture debt fund also profits from warrants providing an equity upside, which can significantly impact the multiple. A US venture debt fund can then generate ~15-20% IRR on debt alone and ~25% (and up to 30% or higher in certain cases) when including warrants from successful VC exits.
Also, the hurdle rate for growth in business value is much lower as a result of this fund model – in most cases, 20% will suffice.
In conclusion, we view venture debt as an opportunity that with high yields and equity kickers can still provide very attractive returns in the current low yield environment while providing a cushion to downside risks.
(1) Venture Debt Asset Investors
(2) Raising Venture Debt, Medium
(3) Venture Debt: A capital idea for Startups, Kauffman Fellows