Venture debt refers to loans made to start-up companies that do not qualify for traditional loans due to banking regulations. Corporate (or strategic) venture debt shares many of the benefits of corporate venture capital as equity, but debt may have distinct advantages with regards to risk, cashflows and capital efficiency.
Venture debt evolved from venture leasing and has become mainstream over the last decade. It should not be confused with convertible debt, since venture debt does not convert to equity and must be repaid.
Venture debt loans can vary but are typically in the range of $500,000 to $5m, with a term of 36 months, and at rates commensurate with the risk (typically 10% to 15%).
Warrant coverage is common in a venture debt contract. Unlike a traditional bank loan, venture debt relies on the probability that the start-up successfully raises a follow-on round, part of which is used to service the debt.
A study completed by Darian Ibrahim of the University of Wisconsin’s Law School estimated that venture debttotalled about 10% to 20% of the overall US VC dollars invested. Some publications claim up to 75% of start-ups use some form of venture debt.
Start-ups use the loans to improve or ensure progress prior to the next equity round, thereby increasing their valuations at lower costs of capital. Hercules Technology Growth Capital, a venture debt firm founded in 2003, is informative, as it is possible for analysis to cover six years of performance data through detailed quarterly and annual reports.
What makes venture debt attractive as a corporate venturing tool?
First, it can accomplish the same goal as corporate venture capital – attracting and securing innovation. Corporations and start-ups can still form the financial bonds that support a more strategic relationship via debt.
Dealflow can be maintained since, in addition to offering a type of financial support to attract start-ups, the corporation will also form relationships with many venture capital firms seeking venture debt partners. The advantages of debt become evident when examining the timing and risk characteristics desired by the respective participants.
Corporations and start-ups alike wish to manage relationship risk, especially at the early stage. Equity investments can be long-term, and if the business relationship does not work, neither side can exit easily. On the other hand debt has fixed timeframes and can be repaid early.
Venture debt loans are typically structured with the option to invest equity in a future round, perhaps when important information becomes available to help solidify the likelihood of a successful business relationship. Venture debt may be the right tool to complement equity based on the development stage of the start-up (see figure 1).
Corporations often struggle with the timing of cashflows in their venturing units since venture capital does not coincide with the corporations’ typical quarter-over-quarter reporting style. Cashflows from venture debt are much more frequent and predictable, and loan loss rates are surprisingly on a par with more traditional bank loans.
The loan principal can be recy-cled into new loans, which can have the effect of tripling the amount of capital available for deployment. This capital efficiency translates into a greater number of relationships for the same amount of capital. Of course, financial return potential is reduced along with the risk, but this is more than acceptable from a strategic perspective.
From a competitive perspective, traditional venture debt firms offer mostly financial benefits whereas corporate venture debt has the added strategic benefit. The same cannot always be said of corporate venture capital versus traditional venture capital, since traditional firms typically lead deals, have broader strategic views and take a more active role on the board.
Another key competitive point is that a corporation may have a cost-of-capital advantage over traditional venture debt firms since the corporation can tap the power of its own credit (see figure 2).
There are companies that employ a variation of this model (GE Capital, for example), but few, if any, are doing so for purely strategic reasons. Although the focus of this article is venture debt for strategic purposes, it is noted that corporations may also be able to compete favourably on a strictly financial basis.
There are possible downsides to the model, including the handling of intellectual property, the education of corporate and start-up decision-makers and the differing skillsets required for debt as against equity.
However, the potential advantages of corporate venture debt suggest more corporations may want to consider adding it to their innovation toolkit.
Peter Bastien leads the strategic technology business development for Toyota Tsusho America, and is examining the potential of venture debt as a strategic tool for the Toyota Group.