Column

In part five of his series on venture debt, Zack Ellison of Applied Real Intelligence digs into the strategies lenders use to mitigate the risk of lending to venture-backed start-ups.

 

In last month’s column, I delved into the framework for managing risk in venture debt. This month, I am focusing on milestone-based financing, aligning interests among stakeholders and the importance of rigorous loan monitoring and active management for effective risk mitigation.

 

“One of the pivotal elements in structuring venture debt transactions is the careful calibration of the company’s future leverage over a range of scenarios,” said Adrian Mendoza, founder of Mendoza Ventures, which invests in early-stage AI, fintech and cybersecurity companies. He underscores that maintaining an optimal balance is vital for both the lender’s security and the borrower’s growth trajectory.

 

In this context, delayed draw loans have become a cornerstone risk reduction tool for lenders. These loans release funds incrementally, contingent upon the borrower meeting specific milestones linked to revenue growth or other critical performance indicators.

 

This strategic approach ensures that capital disbursement is synchronized with the company’s evolving needs, maintaining a debt level appropriate for the company’s size at each stage of development. This method not only streamlines financial management for the borrowing company but also provides lenders with a gradual, performance-based exposure to risk.

 

Historically, maximum debt-to-annual revenue thresholds across the industry have ranged from 50 percent to 150 percent, depending on the risk tolerance of the lender and the strength of the broader market. Given today’s market tight conditions, lenders are increasingly focused on maintaining low leverage relative to revenue, equity and cash-on-hand.

 

Ensuring sustainable leverage is crucial, and it is also wise for lenders to seek companies capable of adapting their operations to maintain value during economic downturns.

 

Dan Zwirn, CEO and CIO of Arena Investors, and an authority in credit structuring and risk management, advises focusing on businesses beyond their nascent stages “with cashflow from either a diverse or otherwise entrenched customer base” that provides sticky revenue. In adverse situations, these companies will have a clear “path where marketing and other general and administrative spending could be cut and that cashflow could be used towards principal recovery; or other hard asset value could serve a similar purpose,” Zwirn notes. He also champions the use of springing deposit account control agreements as a vital tool for recovering cash effectively.

 

ALIGNMENT AND INCENTIVES

 

At the heart of any effective venture debt strategy lies the alignment of interests among all parties involved. Lenders should seek relationships that are “fat” (fair, aligned and transparent), a term I coined while reflecting on the pivotal role that robust, positive relationships play in business success.

 

It is crucial for the leadership team, the board, employees, customers and both equity and debt investors to have shared goals and understandings. The recent drama between OpenAI’s CEO and board is a good reminder that maintaining alignment is not always easy, even for highly successful companies.

 

Sherman Williams, managing partner of AIN Ventures, a VC firm that focuses on investing in dual-use technology companies and veteran-led start-ups, emphasizes the importance of an aligned team. “Investors often focus on technology and the ‘art of the possible’ when really they should be focused on whether the team can function as a tight unit, day in and day out, to gain market share,” Williams said. “Founder-market fit is the first thing to focus on prior to product-market fit.”

 

He added: “Employee stock ownership plans should be paid close attention to. Particularly in hard-tech start-ups, founders take on a great deal of dilution, and ESOPs ensure proper incentivization.”

 

Mike Ryan, CEO of Bullet Point Network, who served as head of public equities and absolute return for the Harvard endowment, points to the need for a broader perspective on risk management. “Surprisingly, investors often under focus on board governance and alignment within different investor classes on the cap table.

 

“Many credit investors obsess over cash traps, escrow accounts, covenants and collateral – all good things to be sure – but they sometimes miss the big picture and nuance of how governance and cap table gymnastics will determine the company’s ability to make the right decisions and take the right actions when the chips are down.”

 

Zwirn echoes the importance of alignment among investors, particularly around material terms that could affect vital creditor rights, noting that “misalignment amongst investors is what is causing issues in venture lending now, as has been the case historically.”

 

In my December column, I highlighted how the quality of equity sponsors can shield lenders from adverse outcomes. However, this protective effect is contingent upon a harmonious alignment between equity sponsors and lenders. Misalignment can lead to uncomfortable and risky situations, undermining the very foundations of the venture debt arrangement.

 

PROACTIVE MONITORING

 

A profound lesson I learned in 2016 from Sun Life’s now CIO, Randy Brown, previously co-head of FIG Asset Management at BlackRock, continues to influence my approach: “I never want to be surprised. Ever.” This principle is fundamental to venture debt management, emphasizing the need for vigilance and foresight.

 

Richard Hillson of Hillson Consulting, a firm that guides wealth advisers on integrating alternative investments into portfolios, emphasizes the critical role of “regular and insightful monitoring coupled with robust reporting requirements” as pivotal in maintaining a pulse on venture debt investments.

 

Unlike most public market deals that track quarterly, venture lenders usually have monthly oversight through board observer rights and stringent financial reporting and covenant compliance. This approach grants lenders direct, real time insights into the company’s performance, allowing them to take prompt action to rectify any deviations from plan. This might involve advocating for additional equity or modifying loan terms to increase the company’s short-term liquidity – all while protecting lender interests.

 

An experienced venture debt transaction attorney affirmed that the most significant risk reducer is this elevated level of ongoing oversight, which helps maintain the trajectory of these high-velocity ventures. Furthermore, the integration of technology tools now allows lenders to connect directly to a company’s financials and operating metrics, enabling them to engage in regular, constructive dialogue with borrowers. It is crucial for lenders to be aware of both successes and potential issues, ensuring there are no surprises. This strategy of proactive engagement and technological leverage is what distinguishes top lenders in the field.

 

NEXT MONTH

 

Next month we will continue the discussion on advanced risk management considerations, including qualitive aspects of due diligence, thoughtful portfolio management, exit strategies and asset recovery techniques when companies fail to perform.

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