zack mansfield // venturebanker

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.

Understanding Venture Debt - Part I: What is Venture Debt

One of the great values of the web is the democratization of information – anyone can look up anything at anytime and likely find an answer.  Within the entrepreneurial world, and more specifically the world of venture capital, this has led to a surge of transparency in an industry which has historically had a bit of a black-box or club mentality.

Today there are a ton of fantastic resources out there for entrepreneurs looking at the inner workings of raising venture capital.  Some of the best ones are created and maintained by venture capitalists themselves – Mark Suster, Fred Wilson and Brad Feld come to mind.  Mark Davis has created an invaluable resource in his “Get Venture” blog.  And sites like Venture Hacks can help people navigate all kinds of aspects about the start-up process.

With all the resources out there, I’ve been surprised about how little information is available regarding the small subset of the VC world that I’m most familiar with: venture debt.  Sarah Tavel of Bessemer wrote two posts about venture debt a year ago, and if you do a Google Search for “venture debt”, you’ll see she’s prominently displayed on the first page of results.

As a lender for a Square 1 Bank, I spend parts of everyday explaining to entrepreneurs and those involved in our industry some of the intricacies of debt financing to venture-backed companies.  Based on the above-mentioned facts, I thought it would make sense to run through a series of posts about venture debt: what it is, how the process works, the in’s and out’s of terms, etc.  I’m not yet sure how many posts will be in the series, but I’m hopeful it will allow those involved in the entrepreneurial world to have a better understanding of the part venture debt plays in VC-backed companies.

Understanding Venture Debt – Part I: What is Venture Debt?

There are several different forms of venture debt and stepping back and viewing the issue at a high level makes sense in helping to understand the whole.  Venture debt ostensibly refers to debt financing which is offered to companies who have a professional investor as a significant equity-holder in the company.

The reason the venture investor is important is because most often, companies in the market from venture debt do not have the underlying levels of financial performance (namely a history of profitable performance) that a traditional lender (read: regular commercial banks) looks to when underwriting a loan.  Venture-backed companies tend to be cash rich after raising a round of funding, but often have plans to burn through a portion or all of the round of equity financing in order to rapidly grow product development or (hopefully!) sales.

In general, “normal” commercial lenders are scared silly by the idea of a company planning on burning through their cash.  Over the last 25 years or so, a variety of institutions have popped up who understand the dynamics of the venture world and have gone out of their way to establish carefully cultivated relationships with the venture capitalists and entrepreneurs who are part of the ecosystem (in my next post I will provide an overview of the players in the space).  By leveraging the relationships and understanding of the dynamics which are at play with venture-backed companies, venture-lenders can effectively provide loans to companies who are burning cash while minimizing loan losses, leading to a workable business model.  Thus, an alternative form of capital is available for entrepreneurs called venture debt.

Within the broad umbrella of venture debt, there are a few different types of loans which are available and appropriate for different stages of VC-backed companies.

• Accounts Receivable-based Line of Credit – this type of debt is useful for companies that are generating revenue and assets in the form of Accounts Receivable.  Many times, companies will see a working capital gap caused by the time it takes for them to collect accounts receivable and the terms under which they must pay their vendors.  It is possible to leverage the billed accounts receivable, often at a discounted rate of 80% of the AR base.  There are many types of lenders who will finance AR, and I will touch on the various aspects in a later post to get into the details.  This is often the cheapest and least risky form of venture debt as the loan is tied to a quick asset.  Other names for this type of loan facility include AR Line, Formula Line, and Receivables Line.
• Equipment Term Loan – If a company has the need to purchase a significant amount of capital equipment, it’s possible to finance the purchase.  This allows the company to use the proceeds of the equity round for the purpose of funding growth in sales and marketing.  Lenders sometime require the advances on the loan to be supported by invoices for equipment to specifically tie the loan to equipment, though not always.  If the company’s plan shows continued cash burn, it’s likely any long term debt such as this will include covenants related to minimum liquidity or a requirement to raise additional equity (a discussion around covenants is certainly an issue I will address in future posts). 
• “Venture Debt” Term Loan / Non-Formula Line of Credit – Often this is what people think about when they hear the phrase venture debt.  This type of capital looks and feels in many ways like equity in the short term, with the obvious caveat that it’s debt and will have repayment terms associated with the note.  Term loans typically have multi-year terms (3 years is the norm, though some are longer) while Non-Formula lines of credit (i.e. not tied to AR) typically have a 1 year term.

That’s a good overview for now of venture debt.  In my next post, I’ll look further into the types of institutions which provide these various types of financing: venture banks, debt funds and the like.  Feel free to provide feedback in the comments section about particular aspects of the venture debt landscape which you’d like to know more about.

So What is a Venture Banker?

I love what I do.

It’s nice to be able to say that.  I’ve been on the other side of the happiness equation, pounding the phones doing cold calls for a venture-backed start-up.  I was young and eternally optimistic and had just the right amount of naivete and enthusiasm to think I could change the world by selling a SaaS CRM application that was “way better than Salesforce.com”.

Or so I thought.

It turns out the start-up had a flawed go-to-market strategy, no clear idea of how to grow sales and a significant cash burn.  After a few months it was clear to me that my personal role was not a great fit, and that the company’s prospects for success for slim to none.  So I ended up leaving the start-up and switching industries altogether.

That’s how I found myself at a bank.  But not any old bank.  A bank which focuses entirely on the type of companies that I had grown to love - entrepreneurial companies that have raised venture capital.  At that point in time, Square 1 Bank was still very much a start-up in its own right, having opened its doors a mere 15 months earlier. I had been familiar with the bank’s story and ended up finding a job as an analyst.

In retrospect, if I’m truthful about things, I didn’t have a great grasp on exactly what a venture bank was when I took the initial job.  I was very familiar with the venture capital world but didn’t totally understand how a bank and venture debt fit into the equation.  There was not (and still isn’t) a ton of information available breaking down the industry.  But what I did know was this - Square 1 billed themselves as “entrepreneurs serving entrepreneurs” - and that sounded like something I wanted to be a part of.

My banking education was fast and furious, like that of many who join an entrepreneurial organization.  There were times when I felt like I was just treading water as I soaked up everything I could about credit risk, covenants, and the other various and sundry details which make the industry work.  Before long I found I was able to swim a bit, and then I graduated on to life not as an analyst, but as a lender.

And that’s where I find myself today - as the commercial banker to a number of fantastic venture-backed companies in the New York metropolitan area.  Everyday I get to interact with entrepreneurs and the investors who fund the “next big thing”.  I see tons of business models, countless applications of technology, and the nitty gritty of what does and doesn’t work in a start-up.  And along the way, I help to finance the dreams through venture debt facilities.

I’m a venture banker and I love my job.  Still have no clue what a venture banker is?  Well stay tuned, and you just may find out.