How to Manage Risk in Venture Debt
In part four of his series on venture debt, Zack Ellison of Applied Real Intelligence focuses on how to mitigate risk, starting with a deep understanding of the borrower’s industry, development stage and financial health.
In the nuanced world of venture lending, managing risk is as vital as identifying growth potential. Our series has thus far shed light on the venture debt landscape, its structures, and maximizing equity upside. We now turn our focus to risk mitigation, the cornerstone of venture lending that allows savvy investors to sleep well at night.
Risk Profiles
Venture lending, while potentially very lucrative, carries its own set of unique risks. Identifying these begins with understanding the borrower’s industry, development stage, and financial health.
The industry dictates the market dynamics and competitive landscape a company operates within. The development stage speaks volumes about the company’s trajectory and maturity. Financial health provides insight into how well-equipped a company is to manage rapid business growth.
Evaluating these factors holistically does not just indicate the potential risk but also informs the lender’s decision on the terms and structure of the debt. This assessment is not a one-off task; it’s a dynamic, ongoing process that adapts to the evolving contours of a company’s lifecycle and market conditions.
Valuations and LTV Ratios
Setting realistic valuations and maintaining prudent loan-to-value (LTV) ratios is foundational to a secure venture debt transaction. The LTV ratio measures the loan amount as a proportion of the borrower’s valuation. An excessively high LTV can leave lenders vulnerable in default situations, whereas an overly conservative ratio might deter growth-oriented companies.
Established lenders typically target LTV ratios in the 15-20% range, aligning with conservative loan sizing.
“The essential task lies in verifying the company’s enduring competitive advantage, which underpins sustainable growth and profitability, and modeling various future scenarios,” says Mike Ryan, CEO of Bullet Point Network LP, and former Partner and Co-Head of Global Equities at Goldman Sachs. “It is the expansion of enterprise value over time that facilitates loan repayment, minimizes shareholder dilution, and delivers robust returns for the lender.”
Unlike listed entities with market prices, private company valuations are not an exact science. They require a blend of artful forecasting, industry expertise, and a touch of conservatism to ensure that the loan remains appropriately sized against a backdrop of inherent uncertainties.
Covenants and Liquidity
Covenants in venture debt are not merely legal formalities; they are the strategic guardrails that guide the borrower and safeguard the lender’s interests. Financial covenants, such as maintaining a minimum cash balance or hitting revenue targets, act as early warning systems, indicating the health of the borrower and the need for possible engagement.
Jane Leung, the former CIO and Head of Modern Family Office at Silicon Valley Bank, highlights the crucial role of covenants and liquidity: “An important factor in reducing risk in a venture debt deal is ensuring that the covenants around the uses of the debt are clear. Additionally, comfort with the company’s runway – relative to general liquidity and the momentum towards the next financing round – is critical to the attractiveness of one deal over another.”
Leung’s perspective emphasizes that beyond the protection covenants provide, a lender’s understanding of the company’s liquidity and its path to additional funding rounds is essential. It’s not just about setting the terms but also about grasping the borrower’s capacity to meet those terms throughout the loan’s life.
Collateral
Collateral, the lender’s safety net, comes in many forms, from tangible assets like property and equipment to intangibles like intellectual property. The latter can be particularly valuable in a knowledge-driven economy where patents and trademarks can hold immense value. Ensuring that the collateral adequately covers the loan amount is a fundamental risk mitigation strategy. Thick “margins of safety” provide tangible reassurance that, even in the worst-case scenario, there is a path to recovery.
Interest Rates
Interest rates are not just the price of money; they’re a reflection of risk. Setting a competitive yet cautious rate is a delicate balancing act. It’s about finding that sweet spot where the cost of the loan reflects the inherent risk without stifling the borrower’s growth prospects. Most venture loans are floating rate, historically yielding mid-teens returns inclusive of interest and fees.
Equity Sponsors
The quality of equity sponsors – venture capital firms that have a stake in the borrower – can often be helpful in shielding the lender from adverse outcomes. A thorough analysis of equity sponsors, their track record, and their level of involvement can provide an added layer of protection. Strong sponsors do not just bring in capital; they bring governance, industry connections, and operational expertise, which can be critical in steering a company through choppy waters.
Christian Gannon, Director of Investments at Twickenham Advisors, underscores the critical nature of this relationship: “Alignment is very important. Ideally, lenders can rely on equity sponsors to step in with additional support, including follow-on funding, if needed, while sponsors can count on lenders to provide flexible financing solutions that don’t overly dilute their stakes,” he asserts.
Gannon, who previously managed over $11 billion in assets at First Citizens Bank, recognizes that “when both parties share a common vision for the borrower’s growth trajectory, and work constructively when problems arise, it greatly increases the probability of a successful outcome.”
Looking Ahead
As we delve into the intricacies of venture debt risk mitigation, it’s clear that a multi-pronged approach is necessary. From understanding risk profiles to setting appropriate LTV ratios, crafting strong covenants, requiring adequate collateral, assessing interest rate impacts, and ensuring quality equity sponsors – these are not just strategies but the very foundation of a resilient venture debt portfolio.
In next month’s column, I will explore advanced risk-reduction strategies that may fortify venture loans against losses. Stay tuned as we continue to navigate the complexities of venture debt, always with an eye towards prudent, yet profitable, investing.
Zack Ellison is the founder and managing partner of Applied Real Intelligence and CIO of the A.R.I. Senior Secured Growth Credit Fund. Send comments or questions to zellison@arivc.com and visit A.R.I.’s website at www.arivc.com.