The Rise of Venture Debt: Past, Present, and Future
Utilization of debt for venture capital backed firms has become an increasingly popular strategic component of young companies’ capital structure. These emerging growth companies often view debt financing as a means to augment their cash position without having to give up as significant a portion of their ownership as required by additional equity financing. Ideally the debt will extend their cash runway allowing them time to reach certain milestones that increase their valuation. As noted in a past issue of the Young Venture Capital Society newsletter, “For a start-up company, venture debt is often a good first experience with VC’s [that have recently joined the board of their portfolio company] because it allows the company to retain ownership (no dilution) and can extend the amount of time, or runway, before needing a new round of financing”.
Today, due to increased competition from the growing number of funds and lenders, loan terms have become more competitive and advantageous for borrowers. The venture debt market, however, is constantly evolving causing it to be difficult for CFOs to keep pace with the ever changing lenders and loan structures.
Venture debt emerged in the 1970’s in the form of simple equipment financing transactions. A large number of equipment leasing firms were well prepared to maximize the value of certain types of equipment as collateral. The typical companies that required equipment financing were primarily semi-conductor firms that produced large quantities of computer and military hardware2. In its early form, venture debt was entirely collateral driven and never reached the 100% financing level. In the mid 80s however, Equitec Financial Group developed a leasing and loan product which offered 100% financing. Equitec devised the concept of using an “equity kicker” to increase yield in order to balance higher risk profiles and offset the resulting increased loss ratios when compared to bankable credit profiles. In these early transactions the “equity kickers” were typically success-based fees or warrants. Warrant coverage still remains the most common form in today’s structures. The market grew and flourished in the late 80s and 90s. It reached its pinnacle during the infamous dot-com era. At that time, venture capital equity financing reached its height and venture debt mirrored this trend, as it reached a record high of nearly $5 billion in total financing during 2000 to go along with over $100 billion in VC investment. The bottom fell out of both these markets in 2001 as the Internet bubble burst. Many of the long term venture debt providers such as Comdisco, TransAmerica, and GATX abandoned this niche market. The remaining lenders then adopted a much more conservative approach. Some required full cash collateralization and others significantly reduced their risk appetite. The venture capital and debt markets began to rebound and regain their momentum in 2003. This trend was noted in a recent Dow Jones report, “Since the bubble, venture investors have been conservative about the use of debt, but as money floods the debt market lenders are being more aggressive”. The venture capital equity market is again thriving as VC funding reached the highest quarterly level in six years with over $7 billion in investment during the first three months of 20075. As seen in the past, the venture debt market followed the equity lead and has regained its pre-Internet bubble popularity.