Venture Debt Funds: The Best Alternative to Growth Equity for Startups?

If you work on larger deals with more mature companies, do you do more technical analysis?

Your immediate response might be “Yes, of course” – and in most cases, it’s true.

But there are exceptions.

One is in the world of venture debt, which we covered in a previous article on venture lending jobs.

There, you could easily find yourself doing more qualitative analysis if you work on larger deals at venture debt funds.

This point surprised me, so I recently asked a reader who’s been in the industry for years to share everything he could about the world of venture debt:

Venture Debt: Equally Attractive Alternative to Investment Banking?

Q: Can you take us through your story and explain how you got into venture debt?

A: Sure. I went to a non-target school and initially wanted to get into investment banking.

But I hadn’t completed any investment banking internships, so it was an uphill battle from the start. However, I looked to alternative finance-related internships (e.g., accounting and valuation) to gain relevant skills and make myself more attractive to banks.

I used that experience to network with bankers and cold call/cold email boutique banks across the U.S., but I still didn’t get much traction.

Then, I randomly saw a job posting from a venture debt fund on my university’s career website, and I applied.

I went through interviews quickly, won an offer, and have been at my firm for several years.

Q: How common is your story?

Would most venture debt funds hire an undergrad or recent grad?

A: You would need some valuation or deal experience to work at a venture debt fund, but yes, you could potentially get in right out of university.

For example, if you’ve completed previous Big 4 valuation or IB internships, you could win a full-time Analyst offer at a venture debt fund.

Most people here tend to come from one of three backgrounds:

1. Venture capital.
2. Another venture debt fund or a venture lender.
3. Investment banking.

Most IB Analysts who join venture debt funds do it as a “lifestyle move” – they work far less than in banking.

At the senior level, around 50% of our Managing Directors come from investment banking, 33% come from a lending background, and the rest are former VCs.

Many of the former VCs took operational roles at companies but wanted to get back into investing and saw venture debt as an attractive option.

Q: Thanks for explaining that.

What should you expect in the recruiting process?

A: Generally, you’ll complete 1-2 phone screens and then go through a Superday interview over 4-5 hours.

Questions range from the standard “fit” ones (Your story, strengths/weaknesses, leadership, etc.) to technical ones on accounting and the financial statements to industry/market questions about venture debt.

Writing is very important at venture debt funds, so you’ll often have to complete a written test as well.

For this test, they might show you a company’s financial statements, ask you what’s missing or unusual, and ask you to guess the company’s industry based on the statements.

They could also describe a theoretical “Company X,” ask how you might value it, and ask you to discuss the most appropriate methodologies.

Finally, there might be a case study where you recommend investing in one of two similar companies or assets (e.g., Facebook vs. Google+ or Uber vs. Lyft).

Modeling tests are less common since you spend more time on qualitative analysis on the job.

But if you want an example, check out this site’s Uber valuation.

Finally, venture debt firms test your enthusiasm for tech or life sciences by asking you to discuss lesser-known companies.

If you cite Airbnb, Uber, or any other “Unicorn” company, the interviewer will ask you to discuss another example.

If you can’t do that, the interviewer might conclude that you’re not especially interested in the industry.

Venture Debt vs. Venture Lending: Showdown

Q: Great, thanks for that overview.

How do you approach deals differently from venture banks and venture lending firms, and why would a startup raise capital from a venture debt fund?

A: The basic difference is that venture debt is closer to growth equity than venture loans.

On the surface, there’s little reason for a startup to choose us over a venture lender.

We charge higher interest rates and we tend to include warrants on loans; if a startup just needs bridge funding, it should almost always choose a venture lender.

That said, we do offer startups two main advantages:

• Size – We can lend significantly more capital than venture lenders. They typically lend up to 1/3 of the company’s most recent VC round, but we can go up to 50% or even 100%. This means that anything above $20-25 million is in the form of venture debt.
• Flexibility – Our loans rarely have covenants, and we offer more pricing options than venture lenders do (e.g., higher interest but a lower back-end fee, lower interest but a higher back-end fee, etc.).

A venture bank can make money from treasury services and monetizing deposits, but we want our loans to stay on the company’s Balance Sheet for as long as possible and essentially become a permanent part of the capital structure.

We’ll even lend the company additional funds as it scales and reaches certain milestones.

That’s because our only source of income is interest and fees on these loans – we cannot afford to lose much money, and we need the interest rates and fees to be relatively high.

A startup might approach us if it wants to leverage its recent growth equity round, thus avoiding further dilution and extending its cash runway in order to hit additional value-enhancing milestones before it must raise another equity round.

Q: OK. Let’s say a company approaches you about a deal. How would you evaluate the company?

A: One similarity to venture lending is that the syndicate – the set of existing investors – is very important. We care about their reputation and how much “skin in the game” they have.

Many banks will say, “If Sequoia has invested, we’ll do this deal.”

But we’ll take a critical look at how the previous VCs have invested.

We look at two main quantitative criteria:

• The Liquidity Profile – The company’s Cash, Receivables, and Inventory, and how much “runway” it has. For example, could it last for 8 months? 12 months? What if it doesn’t raise more capital?
• Enterprise Value Coverage – We’ll look at the company’s Enterprise Value relative to its Debt and estimate how it might change as the company reaches new milestones, wins partnerships, or passes clinical trials.

To evaluate the Liquidity Profile, we might calculate liquidity ratios, such as the current ratio, quick ratio, and cash ratio, and see how they’ve trended over time.

As with other credit analysis, we always look at multiple scenarios:

• What happens if the company does or does not get this partnership?
• What happens if the equity or debt raise is smaller or later than expected?
• What if the company’s average revenue per user falls?

If we lend additional funds, we want to ensure that the company’s Enterprise Value and Liquidity Profile are both increasing.

Typically, we target a pre-warrant IRR of 11-15%, and sometimes a bit higher than that for riskier deals.

Our loans might have a 1% upfront fee, an 8-12% cash interest rate, and a back-end fee of 3-7%.

There are generally no covenants, but we might occasionally put in a requirement that the company must raise funds of $X by Day Y.

Prospective borrowers include venture- and private equity-backed companies ranging from pre-revenue, development-stage firms to companies flirting with break-even cash flow.

Many deals are refinanced or restructured within 18-24 months as the company achieves or does not achieve its milestones, so the terms provided on Day 1 are often not the final terms of the facility.

Q: How would you compete with another venture debt fund that’s offering lower interest rates or fees?

A: We can’t reduce interest rates too much because interest is our main income source; we need to charge at least 8-9% for the math to work.

Also, some venture debt funds are publicly traded and issue regular dividends, so they have even more restrictions on interest rates.

Since we can only compete so much on pricing (e.g., adjusting cash interest, back-end fees, and PIK interest rates), we typically win deals by adjusting financial covenants, modifying structuring milestones, and extending interest-only periods.

We could also compete by changing the terms of the warrants.

Around 90% of our deals use warrants – typically for 0.5% to 1.0% of fully diluted equity – but some funds have begun offering non-warrant deals due to increased competition.

We might compete by offering a “success fee” based on the company’s stock trading at a certain price or the company being sold for a certain amount rather than a simple percentage of equity.

“Success fees” are similar to earn-outs in M&A deals: They help align the interests of the buyer (or investor) and seller (or portfolio company) when there’s uncertainty over performance.

We’ll almost always offer 2-3 different pricing options for companies: One with higher interest and lower fees, one with lower interest and higher fees, and ones with warrants vs. success fees.

For more, please see our full tutorial to venture debt (with a sample Excel file included).

Q: Thanks for explaining all that.

Who are the major players in this market?

A: It’s a fairly competitive market, and no single firm dominates (unlike venture lending with Silicon Valley Bank).

You can divide the firms by type and deal focus.

Some venture debt funds are private; examples include Trinity Capital, ORIX, Oxford, TriplePoint, and Lighthouse.

Then there are publicly traded specialty finance companies, such as Horizon and Hercules.

Many of these firms do early-to-mid-stage deals, and some focus on one industry (e.g., Oxford does only biotech/pharma/healthcare deals).

You’ll still see some of these firms in later-stage deals, but several new firms join the list as well: HealthCare Royalty Partners, Solar Capital, SWK Holdings, and Deerfield, for example.

Later-stage deals tend to be for $50 – $100 million USD, though that varies by industry and region.

Q: Thanks for that list.

You mentioned earlier that writing is extremely important for this role. What does the day-to-day work consist of, and how it is different from what you do at a venture lender?

A: We spend a lot of time on market, competitor, and product research.

That includes speaking with potential users/customers, evaluating similar products in the pipeline, and assessing the milestones for the company’s products.

The team at a venture lender might write a 5-10-page memo to get a deal approved, but our memos are often 50-100 pages.

We cannot afford to take the risk that a bank can, so we go in-depth into all aspects of the company: Intellectual property, manufacturing, and, for life sciences companies, the science.

It’s more like the approach that VC firms take when completing deep due diligence on a company.

At our firm, the deal team is responsible for origination, deal evaluation, and portfolio company monitoring, so we complete all the steps in the process.

After a deal closes, the average day depends on your portfolio: One person here might support 7-15 companies, so if a single deal goes south, he/she will spend all his/her time working to rescue that single company.

Q: Thanks for that description. Are you saying there’s minimal quantitative work?

A: No. We do financial analysis, but we spend less time on it than venture lenders because we don’t have to analyze covenant compliance or credit stats and ratios.

We create different scenarios and forecast a company’s future Enterprise Value and Liquidity, but we tend not to build complex debt schedules or credit analyses.

Our main concerns are liquidity and general performance to plan, so we focus on those rather than metrics like Debt / EBITDA or EBITDA / Interest.

Is Venture Debt Right for You?

Q: Fair enough. Can you comment on the compensation?

A: Base salaries are similar to those in venture lending (around $60K to $80K), but the bonus is significantly higher, at around 50% of your base salary.

That’s lower than in investment banking, but it’s significantly higher than the 10-15% bonuses common in venture lending.

As you move up, you’ll top out at around a $125K base salary with a 50% bonus at the junior levels.

(NOTE: Compensation figures as of 2017.)

On average, it’s a 60-hour-per-week job. I might spend 9-10 hours in the office on weekdays and then go home to finish up a few more tasks.

Facetime is less of an issue, so you could easily come in later or leave earlier as long as you get your work done.

If a deal is blowing up or closing on a short timeline, it might go well beyond 60 hours, but that is not too common.

From what I have heard, the hours are longer than those in venture lending – but your interviewee there gave similar estimates, so who knows.

Q: So, the compensation is fairly generous, and the hours aren’t too bad.

Do most people stay in venture debt for the long term?

A: There’s a surprising amount of turnover.

At the highest levels – Junior Partner and Partner – you need to bring in deals. If you don’t, you get pushed out.

And it is not easy to sell our product since it’s more expensive than the one venture lenders offer.

At the junior levels, turnover is high because many people join out of university and don’t know what they want to do in the long term.

Many recent grads work here for a bit, but then move into operational roles at startups or join other finance firms.

Quite a few have also moved to venture lenders for reduced hours and stress.

Q: I see. Is it possible to get into venture capital or investment banking?

A: I haven’t seen anyone move directly into venture capital afterward.

A few people have moved into investment banking, but they’ve usually had IB experience before, switched into venture debt, and then returned to IB.

Other exit opportunities include startup accelerators or incubators, and sometimes angel investing.

I’m planning to stay here for the long term and advance to the top levels, but I could see myself moving to a different firm eventually.

Q: Great. Any other points you want to mention that we haven’t already covered?

A: There is A LOT of writing in this role. Being good at finance is not enough; you also need to articulate yourself well on paper.

You would be a good fit for this role if you like tech or life sciences, but you want to do something a bit more quantitative than venture capital.

But you must be able to write clearly and cohesively and present it in a way that will please your superiors.

That point surprised me since Associates tend to do most of the writing in IB – but here, everyone contributes. And people actually read those 50-100-page memos.

Q: Thanks for your time!

A: My pleasure.