Venture Debt: Debunking the Top Five Myths
In part eight of his series on venture debt, Zack Ellison from Applied Real Intelligence dispels five common myths about venture debt.
As the startup ecosystem has evolved, venture debt has become an increasingly significant funding option alongside traditional venture equity capital.
For those new to venture debt, my earlier columns serve as an introductory guide, providing insights into the workings and nuances of this fast-emerging alternative credit product.
Despite the growing relevance of venture debt, many misconceptions about it persist, largely because it is a newer concept compared to the more familiar venture equity. Drawing from discussions with industry participants and my experience building and launching a venture debt fund, this article aims to debunk five of the most common myths surround venture debt.
- Venture Debt and Venture Equity Have Similar Risk
Myth: Misunderstandings about startup finance have led some to mistakenly believe that venture debt is as risky as venture equity. This is due to investors conflating the speculative risks of early-stage equity with the reduced risk of later-stage debt financing, assuming a one-size-fits-all risk profile across distinct stages of company development and funding instruments. The visibility of startup failures, predominantly highlighting equity losses, reinforces this confusion, inaccurately implying that venture debt carries equivalent risk.
Reality: Venture debt and equity fulfill unique functions within startup finance, each characterized by distinct risk profiles. Venture debt is typically utilized by more mature startups that have demonstrated solid revenue generation and growth potential and have secured previous rounds of equity funding – presenting a much lower risk profile than equity. Mirroring the relative stability of corporate bonds versus public stocks, venture debt’s worth has significant stability due to predetermined repayment schedules, consistent interest payments, protective covenants, and priority in the capital structure.
- Low Debt Returns Come with High Equity Risk
Myth: There is a prevalent belief that venture debt carries the considerable risk of venture equity while offering only debt-like returns. This misunderstanding overlooks venture debt’s structure and its actual performance outcomes over the past two decades.
Reality: Venture debt has produced better risk-adjusted returns than equity over the past two decades. Its track record is robust, with venture loans consistently delivering a mid-teens yield and loss rates of less than 0.5 percent annually as I highlighted in a previous column.
The consistency of returns produces very high Sharpe, Sortino, and Treynor ratios that many portfolio managers use to measure risk-adjusted performance. More importantly, the drawdown risk of venture loans is very low, with no years of net losses over the past two decades, including the Global Financial Crisis. Furthermore, because the loans are floating rate and include equity warrants, venture lenders are hedged against inflation and rising interest rates.
- Outcomes are Binary and Recovery Rates are Low
Myth: Many investors mistakenly believe that venture debt outcomes are binary – and that a complete loss of the investment is possible, mirroring the all-or-nothing outcomes of many early-stage equity investments. This oversimplified view is influenced by high-profile start-up failures and does not accurately reflect the structure and risk profile of venture debt.
Reality: Binary outcomes are not mathematically possible with properly structured debt. As I detailed in an earlier column, venture debt is designed to mitigate risk through mechanisms like immediate interest payments contributing to Distributions on Paid-In (DPI) capital and aggressive amortization schedules that decrease the loan’s value at risk.
My “Four ‘S’ Rule” underpins venture debt’s safety: loans hold a senior position, are secured by the company’s assets, have short-term maturities, and are small in proportion to the company’s valuation. This strategic positioning ensures lenders are prioritized for repayment, enjoy asset-backed security, benefit from a reasonably accurate forecasting period, and face limited risk due to low loan-to-value (LTV) ratios – often below 20 percent – that insulate them from losses even if a severe equity devaluation occurs.
- Venture Lenders Compete with VCs
Myth: Some mistakenly believe that venture lenders and venture capitalists are in competition and that the introduction of debt can disrupt future equity investments by VCs.
Reality: Contrary to this belief, venture debt is not only complementary to venture equity, but often depends on it. Venture debt normally comes into play after a company has secured equity financing, acting as a strategic tool to extend operational runway without further diluting ownership stakes.
Venture debt’s appeal to VCs lies in its capacity to minimize equity dilution for all shareholders, including the VCs. This preservation of equity stakes is crucial for maintaining incentives for the borrower’s management team and employees while retaining equity to sell in the future.
Moreover, venture debt addresses a critical challenge for startups: the risk of running out of operational funds. By providing a vital capital infusion, venture debt significantly lowers this risk, thereby increasing the likelihood of a company’s success. This synergy is recognized by VCs who, understanding the value of venture debt, often introduce their portfolio companies to venture lenders.
- Venture Debt is for Struggling Companies
Myth: There is a misconception that venture debt is a recourse for companies in financial turmoil, serving as a final attempt to stave off failure when additional equity financing is unattainable. This view inaccurately portrays venture debt as a sign of weakness.
Reality: Contrary to the myth, venture debt is a financing option that is usually only open to thriving, venture-backed companies and is used to fuel their growth while minimizing further equity dilution. These companies leverage venture debt for its flexibility, using it to extend their cash runway, finance specific initiatives or bridge to the next equity round under favorable terms.
Venture debt’s appeal for successful start-ups is especially pronounced in times of market volatility or when equity financing becomes prohibitively expensive, as it has in the past two years. It provides strong companies with a means to sustain their growth endeavors under conditions that might otherwise necessitate selling more equity at less-than-ideal valuations in down rounds.
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.