Venture Lending: More Runway for Venture Capital Liftoffs

May 05, 2015, 07:00 AM

Filed Under: Industry Trends

In this twenty-first century phenomena of cheap money, interest rates have never been this low for such a long period of time. American business has been sitting on cash with some estimates placing the amount at $1.8 trillion. But now, with continued signals of U.S. economic improvement, investments by businesses are now forecast to reach a record $1.5 trillion in 2015 (1). Combine low interest rates with a growing number of increasingly confident small- to medium-sized businesses focused on making equipment improvements and the result: more capital moving to specialized niches of the debt capital space.

Venture debt lending has often been associated with outsized current pay interest rates not pegged to commercial bank pricing indexes (i.e. Prime rate or LIBOR). Very simply, banks and investors continue to seek out more yield and to do so, are willing to accept more risk. This scenario is typical of a prolonged, improving economy combined with consistently low levels of loan defaults. Lenders tend to have short memories when stakeholders and stock analysts are putting pressure to accumulate strong earning loan assets.

In the venture capital area, investments have grown from some $23 billion invested in 2010 to $48 billion in 2014, with the number of deals increasing from 3,800 to 4,400. (2) The last four years of venture capital investment have seen 73% of the capital go to early stage and expansion stage. To protect the investors in these rounds, venture debt/leasing helps these companies get access to more capital “around the fringes” as they get revenue traction, scale products & services, and have cash flow to potentially start servicing the debt rather than needing to raise more capital to pay down their obligations. By being the first institutional lender to a VC backed portfolio company, venture lenders can take senior secured collateral interests in all of the company’s assets (even IP if permitted) and combine this risk mitigation with attractive double digit interest rates and most times a small equity warrant in the business.

Venture debt/leasing helps move the business from early to expansion or expansion to a major event (IPO or change of control). The lender’s injection of additional liquidity for financing of fixed assets further propels the business in revenue growth, at times improves profitability and can enhance valuations for the next capital raise or positioning for the major event.

The aggressive run up of the public equity markets the past couple of years has provided VC’s and their lenders exits and liquidity that had not been available between 2007 to 2012. In a 20-year period of 1994 – 2014 saw VC hold periods almost double -- five to eight years. In 1994, it took an average five years for a company to IPO; in 2004 it took six, and in 2014, the average crawled up to eight. VC backed businesses have been required to pivot from the “grow to an exit” to more “grow and demonstrate profitability to an exit.” The nuance of typically needing to introduce new management and generate positive cash flow have essentially doubled the hold time that VCs need before realizing their investments and at the same time provided investment bankers the required financial fundamentals for underwriting a more attractive IPO. The exception is the sighting of the Silicon Valley Unicorn.

Where $1 Billion is the New Million

Welcome to the age of the “Silicon Valley Unicorn.” In a November 2013 TechCrunch blog post, Cowboy Ventures founder Aileen Lee coined the term for billion-dollar start-ups -- fast-flying high tech companies with large accumulations of stock and cash, billion dollar valuations and a glut of private capital. Big data, cloud, enterprise, e-commerce, mobile, media and social networking … these are the arenas in which Unicorns are spawned.

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Technology companies getting billions of dollar valuations from seed or early stage rounds used to be myth – now there are over 70 tech companies that fall into this category. Venture lenders facilitate working capital and expansion needs of seed and early stage VC-backed businesses further assisting in Unicorn transformations. Are Unicorns here to stay? Maybe, but then again tulip bulbs once were priceless and the Earth has not once, but multiple times, been about to run out of oil.

Venture Lending – Changes in the Landscape

This past month in a $425 million deal, Western Alliance Bancorporation acquired Bridge Bank. Durham’s Square 1 Financial was acquired by PacWest Bancorp in a deal valued at $849 million. Ho-hum: just another couple of middle-market bank mergers? Not quite.

These two deals could signal more activity in venture lending as these new owners may seek to expand their platforms to justify their acquisition. City National is another example. City National expanded its growing technology and venture capital banking business to the East Coast, opening a loan production office in Boston, a city where more than 100 venture capital firms invest in fast-growing tech firms throughout the East Coast. In 2012, Boston received the third highest amount of venture capital investments of any metro region in the United States ... continued proof of an emphasis among banks and non-bank lenders on growing their venture capital business and focusing on tech companies.

Non-traditional funding sources such as investment bankers, venture capitalists, insurance companies, crowd funders and others, are exploring opportunities in the equipment finance sector, getting additional funding and either starting new firms or expanding their platforms to do more. New players have popped up on both coasts as well as in the southwest. Veteran venture debt professionals have been successful in raising new funds or expanding existing ones. CapX Partners is operating out of its Fund IV and raised $225M (versus $150M in Fund III) to continue its strategy of allocating up to 30% of its capital to venture debt/leases.

Investors continue to seek outsized returns. Returns have never been tied to bank lending rates so the cash on cash returns remain very attractive to other fixed income investment alternatives. As the markets ebb and flow, venture lender returns move with either smaller or healthier warrant allocations to their debt investments. These warrants provide the yield enhancement that can make an already attractive return assumption really outperform.

Moving Forward

Sectors attracting venture lending are typically tech/software, biotech and medical. Clean energy and water-focused technology had been quite strong, but investment seems to have tailed off with valuations and exits not reaching investor timing/assumptions.

Tech/software is leading the VC investment sector and the desire to find the next Unicorn attracts both equity and venture lending to these companies. Biotech typically has long lead times for the ample trials and proving data required by the FDSA and other regulatory prior to the commercial launch of a product. The implementation of the Patient Protection and Affordable Care Act created hesitation for many hospitals and systems, as well as providing new technology to deal with the changes that these new regulations create.

Venture lenders look to follow the best of class VC’s investing into the sectors described above. The expectation of established GP experience, ample follow on capital and tracking sectors producing outsized exits will continue to attract venture lenders looking to stake their flag early into these types of risk/reward investments.

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