Understanding Venture Debt - Part II: Banks and Funds
In my first post in this series about Understanding Venture Debt, I provided a quick overview of the various types of debt facilities available to venture backed companies. With this post I will provide an overview of two types of institutions which provide the debt financing and the relative cost of capital of each, as this plays a vitally important role on overall venture debt deal terms.
The first type of lender – and the one nearest and dearest to my heart as I work for one of them – is no surprise: banks. There are somewhere around 8000 commercial banks in the United States. Of these, only an infinitesimal subset is active in the venture debt market. Silicon Valley Bank has been around for more than 25 years and is well known in entrepreneurial circles. My employer, Square 1 Bank, was founded in 2005 by industry veterans and is focused entirely on the venture/PE-backed market. Other banks with technology/VC groups include Comerica, Bridge Bank and RBC. And that’s about it (though I may be missing some who play in only certain markets – please feel free to fill in the blanks in the comments). Out of 8000 banks, only a handful are involved in the venture-backed space.
The biggest thing to remember when looking at banks as lenders is that they are just that – banks. This means they are regulated by the government and have to maintain various liquidity and leverage ratios as a result. In addition, the oversight from regulators means that bank debt terms typically are a bit more structured (i.e. covenants) than terms from debt funds.
While bank deals are typically more structured, they also tend to be cheaper in terms of interest rate and warrant coverage. This is mostly driven by the extremely low cost of capital for the banks. A standard debt term sheet from a venture bank will carry a provision requiring the company to maintain a total banking relationship with the particular institution. This means the VC-backed company will maintain operating accounts with all their cash at the lending institution. VC-backed companies, while often planning to burn cash, tend to be very liquid at the point in time right after raising a round of equity (which, not coincidentally, happens to be the best time to raise venture debt!)
By way of example, take Company X which raises a Series A round of $5 million and secures a $1.5 million line of credit from a bank. It’s unlikely Company X will use the line of credit in the near term. Their $5 million in cash sits in the bank accounts earning marginal interest in a money market account. These deposits, in essence, serve as the funding source for a different bank customer - who we’ll call Company Y - who has a working capital gap and uses its line of credit to fund operations. Company Y pays the bank an interest rate for the capital which creates the interest margin and (ultimately, after expenses) bank profit.
This isn’t exactly rocket science – in truth, I’ve just walked through commercial banking 101 – but the beauty of venture banks is this relatively low cost of funds. While larger commercial institutions are constantly seeking to “buy deposits” in an effort to reduce the amount of leverage they need to use, venture banks tend to have customer bases with more than adequate deposits to fund loan growth. This is important to remember if you’re an entrepreneur and unclear about the requirement to maintain all bank accounts with the venture bank – not only is this a mitigant to credit risk, it’s at the heart of the venture banking model itself.
An alternative source of venture debt capital is venture debt funds. These institutions can be public or privately held and can have varying funding structures. Many venture debt funds are captive funds of capital raised from limited partners (similar to a VC fund) and often use leverage as a multiple of the equity base to increase the total fund size. The result of using leverage is an increased cost of capital, especially relative to the banks. This results in a need to price facilities at a higher interest rate, with more significant warrant coverage, and many times fudns employ final payment fees which help achieve specific returns, while delaying the cash outlay until a point well in the future. To offset the increased cost of capital, debt fund facilities tend to contain few or no covenants and many times longer term deals (18-60 months). It is possible for debt funds to work side-by-side with venture banks, with the funds taking a junior creditor position to the bank’s senior lien.
There are quite a few players in the non-bank debt financing world. Firms that I’ve had experience working with or competing against include MMV, Escalate, WTI, Hercules, Velocity, Vencore and Oxford. There are plenty of additional players (Wellington, Lighthouse, etc), and if you check out the Wikipedia entry on venture debt you’ll see some more names.
The focus of the next posts will be on more specific terms, structures and the implicit factors which guide the venture debt process.
