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The Seduction of Venture Debt

Summon up your picture of a VC:  insouciant air, expensive casual clothes, youthful with a touch of gray for gravitas, cruising the 101 in a Porsche, thinking about moving up to a Tesla.  Does this guy have a sub-prime mortgage?  No way, you think!  But probably he does, not on his house but on his portfolio.

Source: Capital Advisers Group (quoted in The Wall Street Journal)

A big expansion of venture debt occurred along with the credit bubble of the “noughts”.  For a while it was common, if you raised $10m of venture equity, to put a couple million of venture debt on top.  The debt represented extra runway:  “recap insurance”, and much less dilution than equal dollars of equity.  Entrepreneurs and VCs were confident that they would be able to raise new money at much higher valuation before the debt would have to be repaid.  Do you hear the echo?

Those of us who did this (me included, a couple of times), forgot some key things:

• Both VCs and entrepreneurs are optimists by nature.  We buy into the vision and the upside.  But, it’s really rare that things go as planned.  My rough rule of thumb is that only about 10% of venture-backed companies actually make plan in a given year.  Those that get above 70% of plan are in the top half of the class.  It goes down from there.
• Markets change.  The credit bubble was followed by the credit bust.  The hedge fund industry (which supplied a good part of the venture debt capital) has shrunk dramatically.  Major banks were another big, underlying source of funds to this sector, and they have cut far back.  Lenders’ prudence is mounted at the end of a long pendulum.
• To paraphrase F. Scott Fitzgerald:  venture lenders are not like the rest of us [VCs], they really expect to be paid back.  VCs tend to assume that everyone invested in a company is in the same boat, everyone will have to take a haircut when things get tough, and everything is negotiable.  Lenders don’t think that way.  They are not as concerned about maintaining relationships as VCs, their business model tolerates very little credit loss, they usually do what they have to do to get paid back, and they can have a lot of leverage to accomplish that.

A company I know raised a big equity round in 2005 and put a thick slice of venture debt on top of it.  They believed this would be the last round, but it was not, by a long way.  They raised an even bigger equity round in 2007, and the venture debt guys agreed to extend payback, but there was a price:  tougher terms, including “account control” which gave the lenders the right to take the company’s cash if they believed a default had occurred.  Two years later the company needed cash again, and while a raise was in process, the lenders declared an [arguable] default and took all the cash, a week before Christmas, forcing employees to be furloughed/laid-off, and triggering a recap that wiped out all prior equity value.

Lots of heat came off this fire, but realistically the lenders were doing their job.  My point is simple:  debt is dangerous.

When would I use debt again:

• To finance receivable growth or provide a buffer against cash fluctuation for a company that is profitable.
• To finance equipment that has collateral value that can pay off the loan.

What am I determined to not do:

• Take on debt to “extend the runway”.  This is just too risky, particularly because if you do have to raise equity again, it’s twice as hard.  The interest-only period will be over and debt amortization will be a major cash drain.  The equity round needs to be much larger to fund this cash need, and equity investors will be less eager because they hate putting in money that is immediately paid out to another investor.  So valuation will be lower, if the round can be raised at all.
• Use debt that was raised to fund receivables growth to fund operating losses instead.

Debt is seductive, especially when mixed with optimism and momentum.  But putting more risk in the funding strategy seldom makes sense.  Let’s focus on the basics.  Success in VC is mostly about picking the right companies, teams, and business models.