Venture Debt: Evaluating the Strengths and Weaknesses of VC-Backed Deals

In part 18 of his series on venture debt, Zack Ellison from Applied Real Intelligence shares the strengths and weaknesses of lending to VC-backed early-stage companies.

When institutional investors hear the term “venture debt,” they oftentimes conflate the risk of these loans with those inherent in early-stage equity deals. However, in this context, “venture” simply denotes that the companies have secured funding from venture capital firms, making them generally less risky than their non-VC backed counterparts. VC backing typically brings enhanced credibility, improved access to capital and strategic guidance from seasoned investors, translating into higher growth potential and lower risk.

That said, the involvement of experienced VCs is a double-edged sword. While their support offers substantial advantages, it also introduces challenges such as misaligned incentives, aggressive growth pressures and the risk of sponsor withdrawal, all of which require careful management.

Recent fluctuations in the VC market have pushed numerous early-stage, high-growth companies toward debt financing without relying on traditional VC backing, a segment increasingly referred to as “growth credit.” We will explore this evolving area in a forthcoming installment. This month, we focus on the unique dynamics of lending to VC-backed companies.

Strengths

– Access to capital and follow-on funding. A well-known VC sponsor significantly enhances a company’s ability to raise capital by creating the perception of strong growth potential and limited downside. This lower risk profile facilitates larger initial funding rounds and sets a solid foundation for future capital raises by bolstering the company’s credibility, making it easier to attract follow-on funding.

– Networking effects. Beyond capital, a good VC sponsor provides valuable access to an extensive network. Their established reputation opens doors to a broad range of deep-pocketed investors, strategic advisors and skilled service providers who can offer industry-leading expertise. This enhanced connectivity not only increases the company’s visibility in the market but also facilitates powerful partnerships.

– Strategic and operational support. Venture capital firms, having worked with numerous start-ups, bring valuable operational expertise and lessons learned from past experiences. Their guidance on governance, market positioning and operational efficiency can help steer the company in the right direction, which in turn reduces the risk for lenders.

– Ease of process and institutional oversight. VC-backed deals benefit from a high degree of institutional rigor. Established VCs bring with them a set of well-oiled processes and procedures, comprehensive due diligence frameworks and a streamlined execution framework. The professionalism inherent in these deals not only facilitates fast and seamless execution but also contributes to more consistent, reliable outcomes, improving the stability and attractiveness of the investment.

– Implicit downside protection. Another key strength of VC-backed deals is the layer of implicit downside protection they offer. With a reputable VC in the mix, lenders gain confidence that additional equity support may be available if the company encounters difficulties. This safety net can be crucial during economic downturns or periods of market volatility, as the VC’s potential intervention can help safeguard the lender’s capital.

Weaknesses

– Focus on short-term growth versus long-term value creation. Despite the many strengths, VC-backed deals are not without their drawbacks. One critical weakness is the tendency for these companies to prioritize rapid, short-term growth over long-term value creation. The pressure to achieve high revenue growth quickly, and raise more capital at higher valuations, can lead to imprudent cash management and aggressive spending.

– Misalignment of incentives. A further challenge lies in the potential misalignment of incentives among VCs, borrowers and lenders. While VCs are committed to the success of their investment, their objectives may not always align with those of debt investors or of the company founder(s). As equity investors, the VCs sit below lenders in the cash flow waterfall and typically favor strategies that prioritize equity upside over conservative debt protection.

– VC abandonment. In challenging economic environments or when a portfolio company underperforms, a VC may decide to withdraw support rather than commit additional capital. This abandonment can leave the borrower without a crucial safety net and exposes debt investors to heightened risks. The reliability of VC backing is contingent on their continued involvement, and if that relationship deteriorates, the credit quality of the deal may suffer significantly.

– Down-round risk. While high valuations driven by VC backing can create positive market buzz, they also introduce the risk of a catastrophic down-round if market conditions deteriorate. High initial valuations can lead to heightened expectations, and if the company fails to meet those expectations, subsequent financing rounds may occur at significantly lower valuations. This down-round scenario not only impacts the company’s overall financial health but can also have material adverse effects on the lender’s return.

– Less bargaining power for lenders. In VC-backed deals, the involvement of a strong VC can sometimes reduce the negotiating leverage of debt investors. Because the VC’s reputation adds significant value to the deal, lenders may find themselves with less room to negotiate favorable terms. This reduced bargaining power can affect deal structuring [venturecapitaljournal.com], potentially leading to terms that offer less downside protection for the lender.

VC-backed deals offer a powerful combination of enhanced capital access, strategic guidance and extensive networking benefits that accelerate growth and improve credit quality, which can boost company valuations and equity returns for the lender. However, VC-backing may lead to poor cash management, down rounds, equity investor abandonment and increased default risk, as evidenced in the challenging years following the 2021 market peak.

As we’ve seen, the very factors that drive rapid expansion and higher valuations can also create material risks for the lender. Knowing how to identify and then effectively balance these strengths and weaknesses is the key to unlocking strong risk-adjusted returns in the venture debt space.

In the next installment, we will explore how borrowers, lenders and investors should evaluate sponsors to determine whether they are a help or a hindrance.

Zack Ellison is the Founder and Managing Partner of Applied Real Intelligence and Chief Investment Officer 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.

Columns in the Series

Part 1: Venture Debt: A Lucrative Path for Institutional Investors

Part 2: Demystifying Venture Debt Deal Structures

Part 3: How to Structure Venture Debt to Maximize Equity Returns

Part 4: How to Manage Risk in Venture Debt

Part 5: Advanced Risk Reduction Techniques in Venture Debt

Part 6: Exit, Diligence, and Recovery Tactics for Venture Debt

Part 7: Venture Debt: The Critical Role of Operational Due Diligence

Part 8: Venture Debt: Debunking the Top Five Myths

Part 9: Venture Debt: How to Be a PEST When Analyzing Markets and Industries

Part 10: Venture Debt: How to Fundamentally Get It Right

Part 11: Venture Debt: How to Best Evaluate Leadership Teams