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The Future of Venture Debt
Friday, March 17, 2023

Cash is the lifeblood of any business. Venture-backed companies without a financial history or proven track record are often unable to qualify for a more traditional loan with a big bank. Historically, venture-backed companies have looked instead to the venture debt market.

Venture debt helps early stage companies bridge the gap between fundraising rounds and scaling their businesses. Venture debt lenders offer more favorable terms than traditional banks (e.g., secured facilities with lower fees, looser financial covenants, etc.) and in return for taking on the additional risk associated with an emerging growth company, typically receive some form of equity kicker, often a warrant.

In the wake of the recent banking failures of Silicon Valley Bank and Signature Bank, the venture community may be wondering if venture debt is dead. In our view, an opportunity exists for national banks that are “too big to fail,” regional banks, and nontraditional lenders to serve or continue to serve this important market.

National Banks Too Big to Fail

National banks have had difficulty attracting venture clients for smaller debt facilities. Their interest rates, fees, and covenant packages have not been competitive with traditional venture lenders. National banks have an opportunity to service this market and retain these clients as they grow, but they must rethink their approach.

  • Flexibility: Emerging growth companies need flexibility in their loan documents. Stringent financial covenants and restrictions on M&A activity are not workable for these borrowers as they pivot often and aggressively pursue high-growth opportunities. Many venture debt deals happen without financial covenants at all. If financial covenants are required, the covenants have to be flexible and loose enough to permit the borrower to grow rapidly.

  • Relationships Matter: Banks should aggressively hire the key relationship partners and underwriters from venture banks to run or advise on this business model and give them autonomy to provide loans. This is a relationship business, and companies will be frustrated if they cannot call their banker (or if their banker continuously changes). The bottom line is that companies looking for venture debt are looking for a true banking partner that they can reach out to with questions and concerns.

  • Measuring Risk: Banks need to understand the signals for when a borrower is truly at risk for going out of business versus running out of runway before a new round of equity fundraising. A commitment to understanding the business and working with a borrower that relies on regularly raising capital is critical for success.

  • Simplified Loan Process: Complicated and lengthy loan agreements and stringent closing requirements must be simplified for this market so that the documentation process is streamlined and efficient. Emerging growth companies will not tolerate a four- to six-week closing process and paying hundreds of thousands of dollars in legal fees to close a loan.

Regional Banks and Venture Debt Lenders

Venture debt lenders have built relationships for decades in the venture community and understand this market and how it works most efficiently. Venture companies and their boards, however, are wary of parking all of their cash in bank accounts at these lenders, particularly in light of recent bank receiverships. Regional banks and venture debt lenders can use their relationships and continue to service this market, but they will need to be creative with their business model.

  • Syndication Opportunities: Regional banks should work together to syndicate loan opportunities. A group of lenders experienced in this market can come together to provide the funding, and the borrower can split its cash into bank accounts at each regional bank to diversify its exposure among those banks. Participating banks could also split any equity kicker.

  • Simplified Loan Process — Again: For syndicated loans, it will be critical to create one simple form loan document to use on all loan transactions agreed on in advance by the regionals banks and one “Know Your Customer” process for efficiency. This will enable loans to close quickly with lower transaction costs to allow the regional banks to compete against the big banks.

  • Depository Requirements: Venture lenders that want to be the sole lender need to eliminate the requirement that the borrower hold all cash in a bank account at the lender’s institution. In order to collateralize the loan, lenders will need to rely on deposit account control agreements. In return, emerging growth companies should expect higher interest rates and upfront fees to close the loan if the bank is not able to use the cash on hand to lend to other customers (and thereby earn revenues from those deposits).

  • Movement of Cash: For loans that are already in place, lenders should proactively reach out to their borrowers and confirm that they will not face consequences for temporarily moving their cash to larger banks during the crisis so long as they are otherwise in compliance with their loan documents.

Venture Lending with Nontraditional Lenders

Nontraditional lenders, like private equity funds, venture capital funds, and finance companies, can capitalize on the venture debt market due to their flexibility on underwriting criteria, deal structures, and terms.

  • Repayment Terms: Nontraditional lenders should be creative in structuring drawdown or loan repayment terms based on the borrower’s growth trajectory and revenues. The flexibility in structure and repayment will help a nontraditional lender differentiate itself from traditional banks’ more stringent underwriting and structuring criteria.

  • Equity Kickers: Nontraditional lenders should consider removing any requirement for an equity kicker because founders can have an allergic reaction to any extra dilution. Having the flexibility to move forward without an equity kicker might help the non-traditional lender win the deal.

  • Covenants: Nontraditional lenders will likely be in the middle on terms between big banks, and the regional and venture debt lenders. It will be important for the nontraditional lender to remain flexible on covenants and highlight the fact that the borrower can keep their big bank as their depository bank.

  • Defaults and Guaranties: Nontraditional lenders will need to be creative when considering alternative protections to help minimize their risk and exposure without scaring away the potential borrower. In return, borrowers will need to get comfortable with additional default protections for the lender if a founder dies or leaves the company. Those lenders seeking personal guaranties from founders or investors will likely lose the potential transaction.

  • Relationships Matter — Again: It will be important for nontraditional lenders to establish strong relationships with venture capital firms and service providers in the venture community. Because nontraditional lenders often limit the business verticals where they lend, it is often difficult for founders to locate an appropriate nontraditional lender. Referrals from board members and service providers will be critical to grow nontraditional lenders’ presence in this space.

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