Recently, several students from the Babson College MBA program called requesting an interview. They were researching the venture debt market and wanted an inside look at how this segment stacks up against venture capital. Your questions were thoughtful and I thought the discussion was worth sharing. An excerpt from the interview appears below:
Q. How do Venture Loans (VL) differ from Venture Capital (VC) when it comes to fundraising expenses?
A. Fundraising expenses for venture loans are generally lower than for venture capital transactions. Legal fees are one of the largest expenses in many transactions. Lenders often negotiate risky loan agreements using their standard documents. Venture capitalists, however, often use newly created stock purchase agreements. These agreements add considerable expense to these transactions as outside legal counsel is used. Other VC expenses include a more expensive and comprehensive due diligence process.
Q. What about the flexibility of the terms of the agreement?
A. It is difficult to compare the flexibility of the terms between the two forms of financing. Flexibility may vary from lender to lender and from VC to VC. In general, venture capital is a more flexible form of financing than venture debt, since the proceeds are allowed to be used for many purposes. Collateral is generally not required and there are fewer settlement agreements than are required by lenders. Venture loans often limit the use of proceeds to capital assets purchased or for specific working capital purposes. Sub-prime lenders generally require collateral and may incorporate various covenants and conditions into their loan agreements.
Q. Are there any VL companies that focus on segments other than technology or life sciences (eg, retail, restaurants)?
A. Currently, there aren’t many sub-prime lenders that specialize outside of those areas. The universe of venture lenders is relatively small, particularly in comparison to the venture capital industry. There are probably less than thirty American companies that specialize primarily in venture lending or leasing. Most are involved in the segments you mentioned.
Q. How long does it usually take to get money from a risky lender? How many visits does an entrepreneur have to make to a venture lender before making a final decision?
A. Most venture loans take at least thirty days to complete from the time the prospect is assembled to actual funding. The completion time can vary up to sixty days or more, depending on the complexity of the credit. Most lenders will meet with the prospect several times before committing.
Q. Can an entrepreneur continue to window shop if a risk lender has initiated due diligence?
A. Yes, but lenders discourage purchases due to the time they commit to processing the transaction. The norm in the business is to tie a transaction to a letter of commitment and a fee. If the borrower/landlord continues to buy and chooses another provider, he or she generally loses the fee.
Q. Ideally, at what stage would a start-up company be considered safe for venture loans (for example, a start-up looking for the first round of financing, or a company that already has a first round of capital and is looking for a second round?) )?
A. Most VC lenders get involved after the company has successfully raised at least $5 million or more from a reputable VC backer, i.e. after the A round.
Q. What are the collateral requirements for a “growth capital” loan?
A. Warranty requirements vary. Some risky loans/leases are specific guarantees. The lender requires collateral in the form of the equipment being financed. Other transactions are more flexible, allowing proceeds to be used for general growth and working capital purposes. In the latest arrangements, lenders may require an all-assets (‘general’) lien on the borrower’s assets.
Q. Would venture lenders invest in a company not sponsored by venture capitalists? Are there any exceptions?
A. Venture lenders typically invest only in companies backed by venture capitalists or accredited investors with future capital to commit. The reason these backers are needed is that the business is typically not near breakeven and will require additional rounds of funding. There are exceptions and it depends on the other credit strengths. For example, a particularly strong cash position and strong collateral may entice a lender to relax the requirement for ongoing venture capital support as long as the lender has confidence in the management team. Other factors may also influence the decision.
Q. What are the top four or five characteristics you consider before deciding whether to fund a startup?
A. We are looking for talented and experienced senior managers, strong VC sponsorship of accredited VCs, a compelling business plan and track record of business from start-up, an acceptable cash position and burn rate, and acceptable collateral quality.
Babson MBA: Mr. Parker, thank you very much for taking the time to talk to us about venture loans. His talk has given us the opportunity to gain valuable insight into this exciting industry.
George Parker: It’s been a pleasure. I hope you find this information useful and that you consider risk loans as you shape your career plans. Good luck in your research and give me a call if you need any more information.