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Startup Investing with Guard Rails: Gaining Exposure to Growing Businesses with Venture Debt Investments

The always-expanding world of venture capital investing currently represents a market in excess of $2 trillion. Venture capital firms, investor syndicates, and individual investors deploy hundreds of billions each year to capitalize private companies across various stages of their development.

Venture debt investing is a less-utilized strategy than its venture-equity counterpart. While these approaches share some similarities, crucial differences set them apart. Among these differences is a focus on structure and consistency of returns, as venture loans feature cash yields in addition to warrant coverage (on a case-by-case basis). This aligns investors and their portfolio companies while providing potential upside beyond the expected coupon notional rate. Through a venture debt investment, investors can access exposure to growing, privately-owned businesses (as with venture equity investing), with the added benefits of a clearer exit strategy plus current income.

Why Companies Raise Venture Debt

At certain points of a company’s lifecycle, utilizing a venture debt option is a smarter decision than approaching the equity markets for funding. By raising debt, the company can secure the necessary growth capital without diluting current shareholders. The use of proceeds for debt capital can be as flexible as equity, allowing everything from acting as acquisition financing to extending a company’s runway, or even bolstering the utilization of an asset-based debt facility.

Venture Debt: A Subset of Corporate Loans

Investors may be familiar with the concept of a large corporation approaching the capital markets to issue a bond with the aim of financing a variety of corporate expansion activities. Publicly traded companies often raise debt through banks or credit funds to acquire real estate or top talent, expand into new markets, close an acquisition, or simply scale business pipelines. Sources for financing this kind of “corporate grade” debt is fairly widespread and appeals to a wide investor audience — from individual investors to mutual fund companies, pension plans, family offices, and everyone in between. This is commonly referred to as “corporate loans” or “corporate debt.”

Venture debt is a subset of the overall corporate loan market. Whereas venture-backed companies raise debt between fundraising rounds, non-venture backed and/or publicly traded companies can raise debt to pay for a variety of growth activities. In the case of venture-backed companies raising debt, it behooves the equity backers (i.e. owners) of the company to raise debt early in their company’s history to help spur growth without the downsides of seeking equity capital. Venture-backed companies typically seek smaller amounts of capital to act as a bridge to the next round of equity funding, whereas large corporations do not continually need to go to the equity markets to seek expansion capital.

Growth Ahead

Global venture debt investments totaled $30 billion in 2021, a fraction of the $643 billion in venture equity investments deployed in the same year. This rather wide gap between investment types is due to a more mature market for venture equity and the historically outsized returns for certain investment vintages lucky enough to capture significant value creation for the top quartile of equity investors.

Venture-backed companies have increasingly turned to less dilutive financing in recent years. These young companies have come to realize that equity is not always the most efficient capitalization strategy. That realization among startups has created tailwinds for venture debt strategies and their related investments. The increased demand for a different capital solution by companies coupled with ability to provide investors with clarity around expected returns and increased investor protections through covenants has created a rise in acceptance across both investors and young companies to explore venture debt as a viable alternative to equity.

Venture debt investments vary in their tenure. However, irrespective of this variance, a defined timeline provides a clearer line-of-sight to the return of principal than ‘hope-filled’ liquidity events. While venture equity investors assume greater duration risk by investing in a company for a long duration of its lifecycle, venture debt investors only assume risk during a single stage of a company’s lifecycle.

Gaining Exposure

Just as venture equity investors gain exposure to growing companies in emerging fields, so too do venture debt investors. Unlike VCs, debt investors can enter a company’s story after seed, Series A and early rounds of fundraising. Debt investors are not forced to compete with other notable VCs over limited allocation. As a result, debt investments can happen after a priced equity round and VC diligence, giving debt investors the opportunity to get involved in well-capitalized businesses, well-poised for growth (though the investment cases can vary).

Unique Protections

Venture debt is a form of private credit that affords its participants certain protections in the event of a default. If the company raising debt fails to repay the debt, investors can be privy to any assets and/or collateral the company has (defined by the investment/debt agreement), as they frequently take the senior-most position on a company’s assets. These assets potentially include intellectual property, tangible goods, and largely anything else of verifiable value as negotiated between the lender and the borrower in the initial debt agreement. Additionally, in the event of a company’s liquidation, seniority provides debt investors to typically be paid off first, regardless of the liquidation preferences of a company’s existing shareholders.

Venture loan terms commonly prevent the startup from securing additional debt facilities senior to the signed debt agreement, thereby solidifying a venture debt investor’s senior-most position in the startup’s capital stack. These companies are bound by pre-negotiated covenants, and when a subsequent round of venture equity is raised, the company may be required to pay off all existing loan obligations. This feature provides venture debt investors with an extra layer of protection uniquely from equity investors.

Risks and Challenges

As with more traditional venture equity investing, repayment of one’s principal investment is never certain. This is why, like venture equity, venture debt investments are considered high risk. Defaults can and do occur, which could lead to some or total loss of principal — even after attempts to recoup said losses are made. Collateral quality and security can vary across deals, limiting potential recoveries in a downside scenario and creating a greater need for experienced investor scrutiny.

The limited upside of a venture debt deal can also be seen by many investors — especially those heavily entrenched in venture equity — as a negative. A double-digit yield is significantly less than a successful venture equity exit at a potential 100x return.

Venture debt is not immune to major economic events and market risk. A volatile or recessionary environment can adversely impact a startup and result in a loan default or principal erosion. According to data provided by Preqin, venture debt markets experienced a negative internal rate of return for the first time in several years during the Great Recession, demonstrating how such investments are as vulnerable to sweeping macroeconomic changes as a variety of other investment vehicles.

For investors in search of a combination of a yield-generating investment and exposure to a high-growth company, it is clear that venture debt merits a hard look. Venture debt not only provides a layer of portfolio diversification but interplays with other types of investment vehicles available to investors in the capital markets. Like the world of venture equity, there are risks to this form of investment, but the rewards reaped can make for a smarter, more robust, and better-calculated investment experience.

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