Venture Debt: How Lenders Can Evaluate VCs to Mitigate Risks in Sponsor-Backed Deals

In part 19 of his series on venture debt, Zack Ellison from Applied Real Intelligence shares how lenders can evaluate VC sponsors to mitigate risk and maximize upside.

The magic of venture debt is that a strong VC equity sponsor can be so beneficial to the company that the lender effectively receives the equivalent of investment-grade credit risk but with the potential for tremendous equity upside. In fact, in certain cases, the gains from well-structured equity warrants can generate multiples on invested capital. This dynamic is virtually unheard of elsewhere in the credit markets, but it’s achievable in venture debt.

However, as we discussed in last month’s article, a weak or disengaged VC sponsor can do the opposite, destabilizing the company and significantly increasing the lender’s risk. For this reason, successful venture lenders take considerable care in evaluating not just the borrower, but the quality of its sponsors.

To navigate this challenge, I developed the “3F Framework” (Footprint, Fit, and Follow-Through) at Applied Real Intelligence. This framework offers lenders a practical lens to assess the quality and potential impact of VC sponsors. By asking the right questions, lenders can mitigate risks, enhance upside potential, and build stronger partnerships.

Footprint: Understanding the VC’s Track Record

A sponsor’s footprint reflects their experience, credibility and influence within the venture ecosystem. VCs with a strong track record often have better deal flow, provide meaningful operational guidance, and maintain strong relationships with co-investors and lenders.

Key questions to evaluate footprint:

1. Deal volume and experience: How many deals have they completed? Have they demonstrated a history of sound investments?
2. Capital deployed: How much capital have they allocated across funds? Have they demonstrated the ability to scale investments and support companies through multiple rounds?
3. Market cycle experience: Have they performed well through multiple market cycles? How did they perform during the post-2021 downturn?
4. Recent performance: Are their most recent deals aligned with current market conditions?
5. Exit track record: Have they led or backed groundbreaking companies that achieved major exits?
6. Domain expertise: What was their prior background (e.g., operator, technologist, marketer, financier)? How does that translate into actionable support for companies?
7. Capital network: Do they have strong relationships with institutional investors, family offices, ultra-high net worth individuals, or corporate partners?
8. Operational impact: Can they provide functional expertise in areas such as product development, growth marketing, hiring, or financial management?
9. Reputation: What is their reputation within founder, lender and investor communities? Are they known for being ethical and helpful?
10. Loss history management: How have they handled underperforming investments? Have they worked with lenders to recover value?

Fit: Aligning Philosophies for Mutual Success

A VC’s investment philosophy and expectations play a pivotal role in shaping a borrower’s trajectory. Lenders must ensure the sponsor’s approach fosters sustainable growth rather than encouraging reckless spending or unsustainable expansion. Alignment on long-term value creation, financial discipline, and strategic decision-making is essential for minimizing downside risk and maximizing upside potential.

Key questions to evaluate fit:

1. Growth strategy: Do they prioritize sustainable, profitable growth, or are they focused on hyper-growth and market share at any cost?
2. Capital discipline: How do they advise or influence companies on capital management? Do they promote responsible spending?
3. Burn rate management: Do they push companies to spend aggressively, or do they encourage more moderate cash burn?
4. Milestone setting: Are the performance milestones they set realistic and achievable?
5. Exit flexibility: Are they supportive of diverse exit scenarios (e.g., smaller strategic sales, buyouts) rather than solely aiming for big IPOs?
6. Operational support: How hands-on are they in day-to-day operations? Do they offer constructive guidance, micromanage or disappear completely?
7. Industry insights: Do they bring specific knowledge (e.g., sector, business model, growth stage) that enhances decision-making?
8. Founder relationships: How well do they support founders in challenging times? Do they offer mentorship and strategic counsel, or are they quick to distance themselves from struggling companies?
9. Collaborative approach: Will they constructively work with the company, other equity investors and lenders to solve problems during downturns?
10. Risk Management: How well do they understand and mitigate financial and operational risks?

Follow-Through: Assessing the VC’s Commitment and Reliability

Even the most promising companies will face unexpected challenges. In these situations, a reliable VC can be the deciding factor in whether the borrower is successful. Evaluating a VC’s likely follow-through ensures lenders partner with those who provide support when it matters most to navigate adversity effectively.

Key questions to evaluate follow-through:

1. Track record of support: How have often have they supported portfolio companies through financial or operational difficulties?
2. Follow-on capital: How often do they provide follow-on capital to companies that need more funding? Do they have sufficient reserves to participate in later rounds?
3. Exit support: Have they helped companies navigate complex exit scenarios, even when the outcomes were uncertain?
4. Decision-making speed: How quickly do they make decisions in response to changing circumstances (e.g., further investments or restructuring efforts)?
5. Problem-solving ability: Have they worked collaboratively with other investors and lenders to implement turnaround strategies or distressed exits?
6. Restructuring willingness: Are they open to restructuring deals to protect lenders while keeping companies afloat?
7. Transparency: Do they communicate openly with lenders and management during difficult times?
8. Ethical practices: Do they have a history of fair dealings in distressed situations?
9. Board influence: Do they provide constructive board leadership during challenging periods?
10. Alignment with lenders: Are they proactive in maintaining strong lender relationships to mitigate risk?

 A VC sponsor’s true value isn’t just measured in dollars invested but in their demonstrated judgment, experience, and willingness to stand by their companies in both good times and bad. By applying my “3F Framework”, lenders gain a structured, actionable approach to evaluating VC sponsors. This not only mitigates risks but also enhances the potential for strong returns.

 Ultimately, in venture debt, the right sponsor can transform a risky transaction into a well-protected, huge-upside opportunity. For lenders seeking to maximize returns and protect their capital, understanding the caliber of the sponsor can be as important as analyzing the borrower.

 Next month, we’ll explore the strengths and weaknesses of non-sponsored growth credit deals and how venture lenders can approach this evolving market segment.

 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.