Venture Debt: How to Best Evaluate Leadership Teams

In part 11 of his series on venture debt, Zack Ellison from Applied Real Intelligence explores the critical importance of evaluating leadership teams when lending to early-stage, high-growth companies.

Imagine identifying the next industry leader based on vision, capability, and drive instead of just historical data. This is the hallmark of the best early-stage investors and requires venture lenders to use a unique evaluation lens.

Unlike mature corporations, startups often lack extensive audited financials, ample free cash flow, and hard asset collateral. Their strength lies in the dynamism and potential of their leadership team. As legendary VC investor Peter Thiel said, ‘We live and die by our founders.’”

A Harvard Business Review article reveals that 95 percent of over 900 surveyed venture capital firms consider founders a crucial factor in pursuing deals, surpassing even the business model, which ranked a distant second at 74 percent. In my experience at Scotia Bank, Deutsche Bank, and Sun Life, leadership was always part of the evaluation process but rarely decisive. In venture debt, the leadership team’s quality is a primary driver of investment decisions, underscoring its critical role in steering early-stage companies toward success.

Throughout this series, we’ve detailed how to holistically evaluate venture debt opportunities, including market analysis, company fundamentals, deal structuring, and advanced risk management strategies. This installment focuses on evaluating a company’s leadership team for successful venture lending decisions.

Will the Founders Deliver on Their Promises?

In venture lending, the leadership team is as critical as the broader organization, particularly in early-stage companies. The key question is: Will the founder(s) deliver on their promises? Assessing this in advance is challenging and requires a nuanced approach to identify the signal through the noise. Evaluating people is more subjective than any other part of the investment process. Essential factors to consider include the founder’s past achievements, their ability to attract and inspire talent, and their resilience in overcoming obstacles. Here are some strategies to effectively evaluate these critical elements.

Charismatic Vision

Vision is the ability to see and articulate an innovative, compelling, and strategic future for the company. However, vision alone isn’t enough; leaders must have the charisma to share this vision in a way that excites and inspires others.

Charisma transforms vision into a driving force. A charismatic leader compellingly communicates their vision, motivating employees, attracting top-tier talent, and convincing investors to support their endeavors. An ideal leader acts like a magnet, drawing positive attention, great people, and significant investments. This ability ensures the business has the human and financial resources to thrive.

In today’s digital age, the ability to build a brand is incredibly important. The technical barriers to entry are lower than ever, making brand trust and visibility critical differentiators. Charismatic leaders who can leverage social media and other digital resources to grow organically bring immense value. Their marketing and branding abilities make it far easier to scale their business, attract talent, and create partnership opportunities.

Footprint of Success

Evaluating early-stage companies requires a different approach than evaluating mature public companies. Public companies are often judged by their historical financial performance, but early-stage startups are driven by innovation and future potential. As I often say, innovation doesn’t come with a track record. Iconic companies like Kodak and Xerox, which once seemed invincible, failed to adapt to new technology paradigms, highlighting that “past performance is not indicative of future results.”

Instead of relying on a traditional track record, venture lenders should seek a “footprint of success.” This means identifying founders who have demonstrated excellence across various domains such as school, sports, military service, or prior professional experiences. It’s about finding individuals with a “can-do, will-do” attitude who have consistently overcome obstacles and excelled in their endeavors.

Execution Capability

Start-up success requires different skills than those in large corporations. Founders need to be industry experts with the ability to operationalize ideas. Resourcefulness and quick learning are crucial, as success often lacks a clear playbook.

For scalability, it’s essential to have a well-rounded team capable of executing all critical functions – operations, finance, marketing, technology, HR, and fundraising. In the early stages, team members typically act as generalists, handling multiple functions to meet the diverse needs of the business. As the firm grows, roles evolve, and employees transition to specialists, focusing on specific areas of expertise. Regardless of team size, covering all critical functions is vital for effective scaling. Often, loan proceeds are used to make key hires and build out the team, ensuring continued development and success throughout the loan term.

Relevant industry experience is essential for understanding market dynamics, customer needs, and the competitive landscape. Founders with industry-specific knowledge and teams with the right mix of skills and experience are more likely to scale successfully. Ultimately, execution capability is about having a founder and team that can turn vision into reality.

Relentless Drive

Founders must be adept at pivoting and adapting, given the immense volatility and challenges of scaling a young company. This requires unwavering passion and relentless drive to succeed, no matter the obstacles.

Founders need to demonstrate a “never quit’ attitude, showing full commitment to their venture. This commitment is often reflected in having significant “skin in the game” – a deeply vested economic and personal interest in the success of the business. They should be all in, “burning their ships” behind them to ensure they persevere through challenging times and stay focused on their goals.

Compatibility with Stakeholders

In venture lending, the relationship between the lender and the start-up is much more hands-on compared to that with large public companies. Venture lenders often play an active role in shaping the company’s direction, frequently holding board observer rights, and engaging in regular discussions with the leadership team. A strong personal fit between the lender and the founders can generate significant synergies, making collaboration smoother and more effective while generating opportunities.

Establishing FAT (Fair, Aligned, and Transparent) relationships with stakeholders – team members, customers, and investors – is crucial for long-term success. Stakeholders have many opportunities to choose from, so founders must be engaging and ethical, consistently doing the right thing, especially when no one is looking.

Next month, we will analyze portfolio management strategies for venture debt, including how to properly diversify across various dimensions such as stage, sector, business model, vintage year, geography, loan size, and debt versus equity exposure.

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.