Entrepreneurs borrow between equity funding rounds with a strong record of repaying debts
Lending to cash-burning startups might at first glance seem like a chump’s game. Most lenders want commercial borrowers to show positive cash flow or at least enough liquid assets to cover any debt. Young, venture-backed companies rarely have either.
Yet loans to these companies are on the rise. In a working paper, Juanita González-Uribe of the London School of Economics and UCLA Anderson’s William Mann aim to explain why.
Based on an analysis of more than 1,800 venture loans, along with loan contracts from three of the largest venture lenders, the authors suggest that venture loans have a relatively low risk of default and are nearly always backed by collateral, typically the intellectual property of the borrowers. Venture loans give borrowers a way to cover short-term cash needs and “extend the runway” until the next round of venture-capital investment, which is usually more than enough to repay the debt fully. In effect, it isn’t the seemingly high-risk startup that guarantees the loan. It’s the startup’s deep-pocket venture backers.
“Thanks to the implicit guarantee of a venture capitalist, venture loans achieve remarkably low loss rates on invested capital, despite the high-risk nature of their borrowers,” the authors write.
Venture debt constitutes 15 percent of total venture investments since 2009, according to the authors’ analysis of data from Preqin, a market-intelligence firm. For the 3,400 companies in the Preqin database that have tapped the market, venture debt accounts on average for almost a quarter of their total financing, coming largely between the series A and series D rounds. Annual volume of venture debt was more than $8 billion in 2015 and 2016.
Most loans in the database come between the Series A and Series C rounds, but rarely before the seed round or after Series D. This, the authors say, suggests that venture debt isn’t used to replace an equity round but helps to carry companies between rounds. The next VC round typically comes within three years of the loan, and rarely longer than five years, and is always more than sufficient to pay off the loan — amounting, on average, to five times larger than the loan size.
Despite the view that startups rarely have the assets to provide the collateral lenders like to see, the venture loans in this study are always collateralized, typically with either patents or trademarks.
The authors also looked at loan-contract data from three business development corporations, or BDCs, that provide venture loans and that have to file detailed reports of lending activity to the Securities and Exchange Commission. These contracts, the authors say, suggest that venture loans have notably low loss rates. One of the lenders, for instance, reports only five nonperforming loans in its portfolio, worth $44 million; if completely written off, this would amount to a loss rate of only about 3 percent.
It turns out that prepayments and refinancing pose a greater risk to lenders than default; in the Preqin data, prepayments match or exceed scheduled payments in every year. To manage this risk, lenders rely on various origination and prepayment fees and relatively large end-of-term interest payments. With these fees, returns for lenders from venture debt are still quite high: In BDCs, interest rates run about 10 percent, with an effective yield after end-of-term payments and other fees of around 13 percent a year.