Venture debt redux

Venture debt enjoys little of the upside of venture capital, but most of its downside. No wonder this remains a niche play. But with the recent uptick in deal activity in the past twelve months, the handful of venture debt lenders are shifting gears as demand for their capital accelerates. Art Janik provides an overview of the current state of the venture debt market.

During the roaring late 1990s and into early 2000, the lending style of the day was fast and loose as venture lenders poured their capital into the rapidly expanding venture-backed market. In some cases, venture debt providers gave rubberstamp approvals for the financing of high-risk companies after little more than cursory due diligence processes. Little surprise then that, when the tech bubble finally burst, worst case scenarios became reality, for example the collapse of tech investor Comdisco Ventures, which suffered humiliating losses as a result of its reckless lending habits (see also p.81).

It has taken a while for the venture capital industry to get back on its feet, the last few years having been spent working through portfolio failures. According to industry statistics, 2002 and 2003 have witnessed a return to sustainable funding levels as firms now look to deploy fresh capital. This resurgence is good news for venture debt providers, which operate in a symbiotic relationship with equity sponsors, providing loans to seemingly unbankable startup companies.

The origin of venture debt can be traced back to the 1960s, though the pace picked up substantially in the 1980s when a few institutions, chiefly Silicon Valley Bank, began offering debt products to venture-backed startups. Previously, these new companies were denied access to debt instruments due to – surprise – their lack of revenues and an operating track record. But with the advent of venture debt, startups could get their hands on debt as a supplement in between equity financing rounds.

It has become standard for many venture-backed startups, primarily in the capital-intensive technology and life sciences sectors, to include a small portion of debt – usually in a 1 to 4 ratio to equity – as part of their capital structure.

Venture debt comes in two forms: lease products and loan products, though there has been a noticeable shift to the latter recently. The debt is used to provide tangible assets such as computer hardware and software, equipment and furniture, as opposed to equity capital, which goes toward increasing the value of a company by building products, hiring staff or generating sales.

Upon first glance, these loans and leases seem to be standard fare – financing granted in exchange for interest payments. Many venture loans are for up to 36 months, usually spaced out to coincide with an equity round. However, venture debt, like the mezzanine debt often used in leveraged buyouts, also includes an equity kicker in the form of a warrant, which gives the venture debt provider a portion of the company's assets in the form of ordinary or preferred shares. This equity upside, though small – warrants generally account for a 1 to 2 percent dilution in the company – mitigates the high-risk profile of the cash-flow negative startup, making the capital deployment worth the venture lender's while.

Venture debt financing has developed considerably for more than two decades now. The sector, concentrated primarily in the US though also making inroads into Europe (see below), is characterised by a high attrition rate. The market today is dominated by only a handful of players that fall into three distinct categories: stand-alone funds raised in the traditional venture capitalstyle partnerships such as veterans Western Technology Investment (WTI) and Lighthouse Capital Partners; commercial banks such as Silicon Valley Bank; and large commercial finance providers such as GE Commercial Finance's Technology Finance business.

Founded in 1980, San Jose-based WTI leads the pack with more than $1 billion invested over its lifetime. Lighthouse Capital Partners, with offices in Menlo Park, and Cambridge, Massachusetts, is another widely recognised name, currently investing its $366 million fifth fund.

The industry is very competitive. There is no shortage of debt capital in the venture lending space relative to quality deals

Brian Best

The firm, incidentally, was founded in 1994 by Rick Stubblefield and Gwill York, both of whom joined from Comdisco's venture business. Menlo Park, California-based Pinnacle Ventures and West Newton, Massachusetts-based CommVest also operate in the US. In the purely venture leasing space, Menlo Park, California-base Dominion Capital Management, a spinout from Dominion Ventures, has been active in the US since 1985.

In Europe, only two firms are currently investing dedicated venture debt funds: European Technology Ventures (former known as GATX European Technology Ventures) and European Venture Partners, which solely provides leasing products and was also established by the founder of Dominion.

Despite the improved fundraising climate encouraging many new players to enter the field and raise their own funds, the niche profile of the venture debt market, as well as limited allocations from institutional investors, has left the playing field relatively unchanged over the last few years. At the same time, established venture debt providers say they are experiencing greater competition amongst each other as they jockey to finance new companies.

“Established firms with good track records don't appear to have a difficult time raising capital,” says Brian Best, an investment partner at WTI. “Newcomers can do it, but the industry is very competitive. There is no shortage of debt capital in the venture lending space relative to quality deals.”

Venture debt augments a company's existing equity, allowing entrepreneurs to continue to drive toward certain milestones to increase the value of the company. The allure of venture debt is that it does not significantly dilute the management's ownership in the company as does a pure equity investment. But make no mistake – firms that make loans to startups bear many of the same risks as do equity investors. Total wipeouts are a possibility. Following the manic valuation markups of the late 1990s, when early-stage companies faltered, many of them threatened to pull their venture debt providers down with them into bankruptcy.

In industry terms, the addition of venture debt extends the cash “runway” for companies, giving them more time to reach major valuation points before going for another round of equity financing. Most venture lenders require their customers to have gone through at least a series A round of funding before approving any type of loan or lease. Companies use their debt to finance asset buildups, saving costly equity dollars for expenses that can be used to grow the value of the company.

QuantumDot, a Hayward, California-based company that develops nano-particles that light up areas in living organisms during biological detection processes, received a loan from Lighthouse Capital late last year as it prepared for an anticipated product release in the second half of 2004. According to QuantumDot spokesman Andy Watson, the company was “burning through money as it was getting the technology ready for launch. Lighthouse allowed us to operate longer so we could add more value to the company and make it more compelling to the next round of new investors.”

As for interest payments, which usually hover in the teens but vary considerably, venture lenders tend to charge much higher rates than those offered through traditional financing – which should come as no surprise since the venture lender is probably one of a scant few choices available to an early-stage company for obtaining debt capital. With the higher expense comes a higher level of oversight – venture-backed businesses can benefit from the operational expertise of partners at venture debt firms, many of whom were once entrepreneurs themselves.

This entrepreneurial empathy also makes dedicated venture debt funds preferable to commercial banks offering similar products, according to advocates of partnership-based venture lending programmes. Commercial lenders are not driven by the same types of pressures to produce returns to their limited partners and tend to extend lines of debt that are much more restrictive and formulaic than those offered by their fund-based counterparts.

“Most banks include a MAC [material adverse change] clause that says if there's any material adverse change at a company, which is pretty generic and broad, they can go in and force the loan to be paid immediately,” says Ken Pelowski, managing director and founder of venture debt firm Pinnacle Ventures. “For a startup company, that's a dangerous clause.”

Dan Steere, vice president of marketing and acting chief financial officer for integrated circuits manufacturer Matrix Semiconductor, says his company spoke with a number of venture lenders before choosing WTI. Matrix had considered commercial banks, but Steere says WTI's loans were more flexible in structuring credit for an early stage company. He says WTI's partners' personal experience of working at earlystage companies reassured the Matrix executives. “Some commercial banks are more formula driven and less attuned to the needs of a startup,” Steere says.

Then there are venture debt providers such as GE's Technology Finance business, whose position under the GE umbrella means that the lending team can leverage GE's research and development resources to improve their ability to underwrite new technologies. In addition, according to managing director Bill DeMars, GE Technology Finance also “has in a number of cases been able to connect these companies to future customers within the GE network of companies.”

One of the perks of operating in the venture debt space is riding the coattails of venture capital equity firms – indeed, deal flow is not hard to come by when relations with a core network of equity sponsors are strong. The best venture debt firms, however, do not use the due diligence of equity sponsors as a proxy for their own work.

CommVest founder Dennis Cameron adds that despite venture debt's lesser role in a company's growth, venture lenders still go through a fastidious due diligence process, which includes meeting with management teams and examining the competitive landscape of that sector. According to a Silicon Valley Bank report, today's close attention paid to risk control has created one of the most risk-averse venture debt markets of the past 20 years.

Risk is reduced further by the venture capital firms, which now are more prone to constructing consortiums that will follow through subsequent equity rounds without calling in new investors, thus paving a safer road for their venture debt partners.

Risk-conscious venture lenders also make it a point to partner with top-tier equity firms when backing companies. This provides an extra degree of assurance about a startup's viability as well as its ability to raise equity in subsequent funding rounds. Nevertheless, partnering with a venture capital heavy hitter doesn't always guarantee success. “As a debt provider, you earn a small gain on the good deals, but can lose a significant portion of your loan on the bad ones,” says WTI's Best. “If you blindly follow the big equity players, you likely won't have the profits to cover the bigger losses.” Other criteria used to offset the financial risks of providing loans to earlystage companies include ensuring the existence of proprietary technology and intellectual property that can be claimed by the venture lender to recoup losses.

Venture debt providers say they see blue skies as deal flow continues to swell, particularly in the life sciences and technology sectors. That venture debt is only known to those in the venture-backed early-stage arena, which makes up only a quarter of the venture capital industry, makes it harder for new venture debt providers to join the existing players. Lighthouse's Stubblefield says newcomers trying to attract capital in this space will have a pretty tough time, since the limited amount of institutional investors that choose to invest in venture debt have already picked out their investment partners and are not interested in multiple plays.

Another peculiarity of venture debt that makes it relatively obscure in institutional investment portfolios is that it doesn't fit squarely into any existing asset class. Joan Parsons, the chief banking officer at Silicon Valley Bank, says that when institutional investment committees decide how to allocate their funds, “they are strict about what goes into an asset class. Venture debt is only a footnote – it's not corporate debt and it's not venture capital. It's lesser known, and as a result, fewer LPs invest in it.”

While mainstream investors continue to scratch their heads at this niche asset class, WTI's Best sees more understanding of venture debt among entrepreneurs now than in the past five to 10 years. “It's been an educational process of making entrepreneurs understand “Why does this make sense for me?””

Venture lenders active in Europe still serve as pioneers, but there are signs that the market may pick up.

If investors consider Europe's venture capital equity markets underdeveloped relative to the US, then its venture debt sector can only be described as downright immature. But that's not to say European-based venture lenders haven't been playing a role in European early stage investments over the last several years.

The two leading local groups with specialist venture finance expertise are European Technology Ventures (formerly known as GATX European Technology Ventures) and European Venture Partners (EVP). Both organisations are headquartered in London.

Last July, GE Technology Finance, part of GE Commercial Finance, also launched a London-headquartered UK and Ireland operation to provide equipment and working capital debt financing. The arrival of an American venture lender may suggest fresh US interest in European business opportunities, though most of the major US-based venture lenders say the market is still not big enough to be of interest to them.

The European venture capital market is still catching up with the US in terms of the financing tools that are available, says Humphrey Nokes, a managing partner at ETV. Still, that isn't stopping his firm from investing in Europe; to date they have deployed over $60 million. The firm had been operating in partnership with US-based GATX Corporation, the publicly traded specialty finance and leasing company, until ETV raised a new fund and bought itself out last year.

EVP too has been making inroads as it continues to fundraise for its second fund, which director Maurizio PetitBon says is working towards a &€105 million target. EVP is the oldest dedicated venture debt provider in Europe and commenced in 1998 when the firm was established by Geoffrey Woolley, the founder of ([A-z]+)-based Dominion Ventures, whose Dominion Capital Management arm is one of the oldest venture leasers in the world.

After setting up shop in London, PetitBon says that EVP – which also has offices in Israel and Sweden – spent most of the first 18 months of its existence educating both European entrepreneurs and the European venture capital industry as a whole about venture debt options. “It was a new concept for a fair amount of time, but now it is seen by most VCs and entrepreneurs as an interesting ingredient in venture funding syndication.”

The challenge for venture lenders active in Europe is convincing venture capitalists and entrepreneurs of the merits of venture debt – after all, taking on debt at a cashflow-negative company may seem counterintuitive to some. Jeremy Milne, an investment partner at UK-based venture capital firm Quester, sees venture debt as a “bit of an acquired taste” that requires careful structuring and the confidence of a company's board in order to work well for a business. “You raise the facility, you take in the cash and you put that corresponding liability on the balance sheet. It's not something you can do at the last minute and requires experienced planning.”

Milne says there are already enough risks involved in an early stage venture- backed business, and that the venture backers and entrepreneurs have not paved down a good enough track record to be confident about using debt.

Speaking from the point of view of the lender, PetitBon says venture leasing has a safety cushion compared to traditional venture capital. “In workout cases, we should be able to fare better than the venture capital [providers] because we own the core assets of the business. We can extend new leases with the new owners of the business, or we can resell the equipment.”

Still, PetitBon acknowledges that it hasn't been easy to fundraise in Europe, as European investors have had mixed results in their venture capital portfolios in the past and are still cautious when looking at early stage related investment opportunities, equity or debt. “Venture leasing may be less risky than traditional venture capital, but Europe is still not as mature a market for venture capital investing as in the US,” he notes.

However, now that the legacy issues of the tech crisis are being worked through, European venture capitalists say they are experiencing a moderate upwards trend in sentiment. Bill Demars, managing director at GE Technology Finance, says there has been a considerable amount of liquidity streaming into the European equity and debt markets, though not as pronounced as in the US. “Our deal pipeline has improved considerably, not only in the UK, but in other parts of Europe as well. We're encouraged by the overall level of activity.” Just how much potential the European market has at this stage will became clearer over the coming months.

Art Janik