Venture Debt

Darian Ibrahim —  19 February 2007

Thanks to everyone at TOTM for having me.  I’m a big fan of this blog, and look forward to visiting here for a short time.

I was intrigued by a recent article in the Wall Street Journal on venture debt, or the practice of lending to start-ups as opposed to the standard practice of investing for equity.  According to the article, debt made up 7% (or nearly $2 billion) of the money invested in venture-backed companies last year, up from 2% the year before.  The article also shows that venture debt was nearly $4 billion at the height of the venture capital market in 2000.

Venture debt is interesting — and puzzling.  Investments in start-ups are risky, plagued by extreme levels of uncertainty, information asymmetries, and agency costs.  A VC fund invests in a number of start-ups in the hopes that its portfolio will contain the next Google or eBay, to offset the inevitable duds.  VC-fund investors expect a better-than-market rate of return, and most profits come from the IPOs of a small number of highly successful start-ups (like Google and eBay).  The VC model works because of the potential for a huge upside.  Can venture debt work, when by definition it does not offer this huge upside?

Perhaps.  While the start-up is solvent, venture debt commands a high interest rate (double digits, according to the WSJ article).  The article also mentions that lenders get warrants, convertible into equity, which allows them to share (to some extent) in a huge upside.  Also, if the start-up liquidates, debt has first priority over the preferred stock of VCs.  Therefore, venture debt makes sense by offering some upside, although of a different makeup, and by limiting the downside.  But venture debt also presents problems.  First, the typical high-tech start-up must spend available cash on R&D and other growth activities, not interest payments.  Venture debt is unlikely to be the “patient capital” that start-ups need for long-term success.  Second, and perhaps more importantly, venture debt is likely to complicate a start-up’s chances with VCs.  VCs fund relatively few companies.  If a start-up comes with venture debt, I can’t imagine it’s very attractive to the VCs, whose money would go to pay off the debt during solvency, and who would now be second in liquidation preference during insolvency.  Unless the amount of venture debt is sufficient to eliminate the need for venture capital – and by current levels it is nowhere close – do start-ups carrying venture debt really have a chance for long-term success?  Venture debt may make sense for some companies, but in general it seems like a bad idea.

2 responses to Venture Debt

  1. 

    I agree that venture debt can introduce the problems you pose, and I’m curious how it plays out in practice. On your first point, I wonder what sort of repayment structure the venture debt firms require. It would seem sensible that they require reduced/no payments initially when most of the start-up’s cash flow should be re-invested in the company’s growth, and more later on when it can afford it.

    As to your second point, I agree with Bill that it seems that the amount of debt assumed would be important. I also wonder if the presence of venture debt (to the extent it induces investments that would not be made otherwise) could attract some traditional VCs, depending upon the strength of the venture debt firm. Like any VC, the venture debt firms could bring industry know-how, valuable networks, and credibility to the start-up. Other VCs may find that an invaluable asset. Of couse, depending upon the venture debt holder’s contractual rights and degree of influence, VCs may also worry that the venture debt firm will push the start-up toward excessive risk aversion.

    Just some thoughts…

  2. 

    I think the attractiveness to VCs issue will depend largely on how much debt we’re talking. Some VCs may actually like the additional managerial discipline that comes from having some debt on the balance sheet.