Column

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

Building on last month’s discussion of milestone-based financing, incentive alignment, and proactive loan monitoring, I am now turning my focus to the importance of well-defined exit strategies, thorough qualitative due diligence and effective asset recovery methods to safeguard venture debt investments.

EXIT STRATEGIES

“Begin with the end in mind” is one of the key principles of excellent investors. In venture debt, having a clear exit strategy is crucial for lenders to ensure repayment.

Lenders meticulously plan for a variety of exit scenarios, with each tailored to match the startup’s unique trajectory and the volatile landscape it operates within. These pathways include repayment through internally generated cash flow, debt refinancing, equity financing, acquisition, or an initial public offering (IPO). However, the viability of these exits will vary significantly based on external market conditions and the startup’s internal performance.

The IPO market’s volatility, demonstrated by the significant decline in activity (from 1,090 to 171 IPOs) and value (from $338.7 billion to $26.2 billion) over the past two years, underscores its unpredictability as an exit strategy. Such dynamics highlight the complexity of relying on IPOs for exits, given their independence from a company’s direct control.

In contrast to the unpredictable IPO landscape, startups wield significantly more control over their own performance – including their ability to grow revenue, control costs, and generate cash flow. This self-driven growth facilitates various exit paths by enhancing the startup’s negotiation power with potential acquirers or with capital providers in future funding rounds.

QUALITATIVE DUE DILIGENCE

In venture debt, where financial histories are often scant, the qualitative assessment of a startup’s leadership and culture becomes crucial. In essence, it is necessary to look beyond the balance sheet to understand the startup’s soul.

A key focus is on the integrity and strategic alignment of the company’s leaders. Key to this evaluation is understanding how leaders navigate both triumphs and, more importantly, setbacks and challenges, ensuring the company’s ethos aligns with long-term success.

Lenders seek leaders who consistently fulfill their promises and exhibit a strong alignment between their actions and the company’s strategic goals. The evaluation focuses on whether the founders and board are synchronized in their vision and execution strategy, prioritizing the company’s success over personal gains.

Examples of misaligned interests, such as founders indulging in lavish personal expenditures before achieving profitability or returning capital to investors, are red flags. “It is very important that the company’s leadership does what it said it would do,” said Rachel Hobert, a general partner at Hivers & Strivers Capital, which provides financing to startups led by U.S. military veterans.

A thriving corporate culture, marked by a “fat” (fair, aligned, transparent) work force is indicative of a company that will exhibit innovation, operational efficiency, and resilience. This cultural health check offers lenders insight into the startup’s long-term viability and its capability to meet and surpass operational benchmarks.

Dan Espinal, co-founder of Rarebreed Veterinary Partners, a unicorn focused on veterinary services and animal health, highlighted the benefits of venture debt. “For startups, it is advantageous to utilize debt because it forces the company to be accountable in a way that equity financing does not,” said Espinal, who was a venture capitalist before he became a founder. “As an operator, it institutes a tremendous amount of discipline and alignment amongst the team, which increases their likelihood of success.”

ASSET RECOVERY

Unfortunately, not all investments sail smoothly to their intended destinations. Astute lenders, aware of this reality, adopt a proactive stance, meticulously evaluating potential risks and devising strategies to maximize recovery in the event of setbacks.

Discussions about venture debt often turn to the topic of potential losses. Due to the private nature of these deals, comprehensive default data is scarce. Instead, the sector relies on loss rates disclosed by publicly traded business development companies (BDCs) in SEC filings, which reveal an annual loss rate below 0.50 percent over two decades.

The disciplined repayment schedules of venture loans play a pivotal role in maintaining low loss rates, diminishing the lender’s exposure as time progresses. The first two years are particularly critical. Financial projections – usually based on current trends or contracted revenues – offer a relatively accurate forecast of a company’s performance over this short time frame. Moreover, before agreeing to a loan, lenders generally require a cash runway that will sufficiently cover at least two years of operations, ensuring the company has the means to meet its obligations during this period.

In the current economic climate, the benchmarks for a company’s financial runway have stretched, reflecting a more cautious funding environment. Kelly Perdew, managing general partner of Moonshots Capital, observed a shift from the pre-pandemic norm of 18 to 24 months of runway to as much as 36 months today.

Imagine a scenario where a lender extends a three year, $10 million first-lien loan to a company with $25 million in annual revenue and an enterprise value of $100 million based on a 4x revenue multiple. The loan terms include a 15 percent interest rate and an initial 12-month interest-only period, followed by straight-line amortization over the remaining 24 months of the loan.

If the company were to default 24 months into the term, the lender would only need to recover $2 million to break even, since it has already received $3 million in cash interest and $5 million in principal repayment. Given the company’s valuation and revenue profile, the chance of its value diminishing by 98% within two years is remarkably slim.

Thus, as the senior secured lender with comprehensive lien rights, the lender is well-positioned to protect its capital. This mathematical reality underscores a key principle: with judicious structuring, the risk of loss in venture debt can be tightly controlled.

The post-pandemic economic landscape has shifted the collateral value paradigm, with intellectual property (IP) emerging as a preferred asset over traditional “hard” collateral such as commercial real estate. Intangible assets – ranging from patents, technological know-how, customer lists, and brand equity – have demonstrated increased worth across a global market and offer increasing potential for recovery in venture debt scenarios.

NEXT UP

Future columns will dive into operational due diligence, the nuances of investment analysis, and the art of building and managing a venture debt portfolio, further demystifying venture debt as an asset class for institutional investors.

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