In my first two posts on Understanding Venture Debt, I provided a general overview of different types of venture debt facilities and a brief look at the banks and funds who are actively involved in the space. With this post I hope to shed some light on one of the less-obvious but highly important aspects of the venture debt landscape: the “implicit contract” between venture capitalists and venture lenders.
Before going any further, I should pause to point out that my use of “implicit contract” here is borrowed from a fantastic academic paper put out by Darian Ibrahim last year entitled “Debt as Venture Capital”. Ibrahim is an Assistant Professor at the University of Wisconsin Law School and conducted a great deal of research in the venture debt space for the paper – I’d recommend that everyone spend the time to read it. His work was certainly part of the inspiration for writing this blog – at best I hope to expound on more than a few of Ibrahim’s ideas; at worst, I hope this blog will serve as one more anecdotal data point for those, like Ibrahim, hoping to better understand the venture debt space.
At the core of the implicit contract between venture lenders and venture capitalists is this: the vast majority of venture-backed companies are burning cash and do not have sufficient financial fundamentals to secure traditional commercial debt financing. In the absence of future cash flows from operations, venture debt firms underwrite many of their loans based on an understanding of the likelihood of the company’s ability to raise additional equity capital in the future.
This reliance on future equity financing is one of the reasons that venture lenders spend so much of their time developing and nurturing relationships with the venture capital firms who serve as the professional sponsors of entrepreneurial companies. While offensive to some first-time entrepreneurs, the reality is that for many venture lenders (especially for early-stage or cash-burning companies), the capitalization plan in the eyes of the venture investor/Board member is far more important than the exact details of the business model of the company itself. (There are exceptions to this rule, of course – asset-based lending and cash flow lending being prime examples. For the purpose of this discussion it’s most appropriate to think of true “venture debt” designed to bridge to an additional round of equity or to eventual cash flow breakeven or an AR based loan to a company which is still burning cash and in need of future equity.)
As a venture debt provider is conducting due diligence on a potential loan, a conversation with the sponsoring VC firm will be the most important aspect of the diligence process. The lender will want to understand the details of the VC’s involvement to date and future plans for financing: how much capital the VC has into the company; the amount of capital specifically reserved for the company for follow-on investments; metrics the VC is watching for valuation or continued support reasons; the total capital need expected over the life of the company. In addition to these company-specific questions, the lender will want to understand the dynamics of the specific VC fund: how much dry powder is remaining at the fund level; how the VC ranks the company within its own portfolio; whether or not the entire voting contingent within the partnership is supportive of continued funding.
Venture lenders rely on the direct comments from the equity holders along with macro-level statistics around probabilities of future equity financings when assessing venture debt risk. Venture capitalists tend to be rather smart individuals and understand the dynamics at play and therefore are aware that their statements hold considerable weight in the evaluation of a portfolio company’s credit-worthiness. Yet in the vast majority of venture debt loans, there is no explicit or legal promise by VCs to repay the venture loan. Thus, the “implicit contract” which exists between venture lenders and VCs revolves around the mutual understanding of future equity funding, which is ostensibly the primary source of repayment in many venture debt transactions.
Negotiating the dance which is the implicit contract is of paramount importance for both the lender and equity investor and has far-reaching implications for both parties as well as the entrepreneur running the company. It’s particularly important to note the following when considering venture debt:
1. Importance of Clear Communication: Because all parties involved in the transaction are relying on implicit indicators, it’s imperative that transparency and truthfulness win out above all else to maximize long term value for all parties. This starts from Day 1, when a discussion begins around venture debt. Honest communication around the capitalization plan and intended use of debt will help to avoid a situation in which debt is misused or too much leverage is employed. Remember: an inappropriate use of debt in a venture-backed company is not good for anyone. It exposes the lender to losses and can serve as the albatross weighing a company down from potential success.
2. The Impact of Implicit/Explicit contracts: Venture lenders must understand that VCs who serve on the Board of a particular shared portfolio have both the implicit contact with the lender and the explicit contract of their fiduciary responsibility to maximize shareholder value. These explicit-implicit considerations will serve as the drivers in Board decision making and need to be considered by the lender. The complication with this reality is that the scenario in which explicit-implicit contracts can be most at odds with each other (in a down case when the company has not performed as well as planned) is precisely when the implicit contract is of most importance. In these cases, more than ever, clear and open communication is needed in order to navigate the situation in a manner which minimizes value lost on all sides.
3. Implicit Contracts still have consequences when broken: In a world in which there was no future repercussions for near term actions, implicit contracts would have no weight. But how we act today does have implications on the future. Venture debt can be an attractive, efficient, non-dilutive source of capital for VCs and entrepreneuers as they grow companies. But it only works if the actions of the parties involved are in line with expectations. As Ibrahim noted, this is largely enforced by the market – if a VC fails to live up to their implicit agreement for continued support, the likelihood of securing additional debt financing down the road for a different portfolio company is unlikely. Similarly, a venture lender which develops a reputation for taking an overly heavy-handed approach to managing credits is a lender who will have trouble finding new business from top tier VC firms.
The implicit contract dynamics of venture debt are pervasive, and surely are not limited to the points outlined in this post. Rather, the intricacies are complex, not unlike the relational dynamics which define all relationships we have in life. Not surprisingly, the VC and venture debt providers who are able to successfully “dance the dance” together tend to enter into deeper and deeper relationships over time - with more interconnected portfolio company relationships and more aggressive (and valuable) debt terms. It is for this reason that the implicit contract is perhaps the most important facet to understand in the entirety of any discussion around venture debt.