Your clients are probably familiar with the uses of venture capital for raising funds. But how aware are they of the advantages of using venture debt instead?
According to David Spreng, founder and CEO of Runway Growth Capital, the answer is probably, “Not very.”
How are the financial instruments different? For those less familiar with the world of venture funding, venture capital is the investment of money in a company for equity. Venture debt is a loan to a company for repayment with interest, which enables founders to retain more ownership.
Spreng feels that companies that aren’t checking out the value of venture debt are missing a lucrative opportunity.
Family offices have been legacy investors in the $130 billion venture equity industry and are now ramping up their investing into the smaller and growing $25 billion venture debt industry.
A Venture Capital Approach
Venture capital is generally most beneficial in the world of startups and immature companies. Here, the investor is banking on explosive growth and then reaping the rewards of a liquidity event, because the company initially likely has weak cash flow and little ability to pay back any sort of loan.
“Let’s imagine,” says Spreng, “that you’re an entrepreneur. There’s been good news! Your company is now worth $100 million! But you need $20 million to bring a new product to market. Or maybe you need that $20 million to be well-positioned for an IPO.”
You can go the venture capital route. If you do, you’d typically be giving up 16.67% of the equity in your business.
“Roll the clock forward,” says Spreng, “and your company has been an even bigger success. After a few more years, your company sells for a billion dollars. Your VC investor gets $166,666,667 of that.”
In Spreng’s view, “That $20 million you raised through venture capital was really expensive.”
Venture Debt
For a more mature endeavor with existing solid cash flow that can more reliably pay back a loan, venture debt can be a strong option. Here the investor makes his money largely through interest payments. The potential return for them is lower, but so is the risk and the amount of equity that the borrowing entity would have to give up.
According to Spreng, “The last thing you want to do is give up more equity. If you had financed your expansion through venture debt, it would only have cost you 0.5% of your business, as opposed to 16.3%.”
An example of this principle is Drawbridge, a Silicon Valley technology company that uses artificial intelligence to learn more about customers and target audiences. The founder, Kamakshi Sivaramakrishnan, was looking to raise capital to change direction and take advantage of a new market opportunity.
She decided to utilize debt instead of equity, and within roughly a year, she sold the company to LinkedIn (Microsoft) for just under $300 million.
“She was able to retain many millions for her team and for her early investors. These are millions of dollars that would have been lost if she had gone the venture capital route.”
Spreng has been in the venture investing space since 1989 and has used debt in more than 70 cases so far.
As he explains, “It helps entrepreneurs pursue their vision without giving up as much of their company, and it means innovative technologies are continuing to be built when otherwise they might not.”
What About Risk?
As Spreng points out, “People are shocked at the loss risk in our case. While putting out $800 million in loans, our losses have been less than 1%.”
The reason for the low loss risk in most venture debt is:
Typically, a loan-to-value ratio for venture debt is 20%. “Since the sponsors are putting up the 80%, they are highly motivated to get us repaid. They don’t make a penny until we are repaid in full, and that means our motivations are highly aligned.”
The loans are structured so that for at least a portion of them, the initial loans are interest only, given that initially the company is likely to have a better use for their cash flow than in repaying debt.
Spreng (unsurprisingly) thinks the future for this avenue is bright, “After the dislocations of 2020, innovation becomes ever-more important.” He hopes people will consider debt financing to make this happen.
Mitzi Perdue is the founder of WinThisFight.org and author of 52 Tips for Combating Human Trafficking. Contact her at www.MitziPerdue.com