Venture Lending Jobs: Tech Startups Elope with Leveraged Finance Bankers?
Do you benefit from being a contrarian?
If you’re Peter Thiel, the answer might be “yes,” but it’s less clear for the rest of us.
But one area where contrarianism might deliver great benefits to financiers is venture lending.
Amidst the hype over startups and traditional venture capital, a major change has gotten lost in the shuffle: many tech startups now raise debt in addition to equity.
No, not zero-coupon convertible debt – traditional debt with interest payments.
On the surface, this seems ridiculous.
Lenders look for companies with stable cash flows that can support interest and principal payments.
So why on earth would they lend traditional debt to companies with no cash flow?
I was stumped as well, so I asked a reader who’s currently working in venture lending.
He was nice enough to explain how you break in, the logic of lending money to companies with no cash flow, and a whole lot more:
Venture Lending Beats Venture Capital?
Q: Can you tell us a bit about your background?
A: Unfortunately, no.
Since venture lending is such a small industry, I would expose myself too much if I went into detail on that, though I’m happy to share how most people get into this industry.
Q: Sure, I’ll bite… but before we get into that, how does venture lending work, and why do banks lend to pre-revenue startups?
A: Sure. To be clear, “venture debt” is traditional debt with interest and principal repayments – not zero-coupon convertible notes that convert into equity in the next funding round.
Lenders fund startups with debt as a bridge to future rounds of equity.
The startup needs more funding to hit its next milestone, but it doesn’t want to dilute itself further by raising another VC round right away.
However, it does plan to raise more venture capital in the future.
This is the perfect scenario for venture lending firms: they might offer the company a loan and then rely on future equity investments to repay that loan.
It’s like a bridge loan in a leveraged buyout, but the repayment comes from future equity funding rather than debt.
Q: OK, but what if the startup fails, as most startups do?
Aren’t venture lenders going to see incredibly high default rates?
A: Most startups fail eventually, but a high percentage of funded startups survives until the next round of funding.
So from a lender’s perspective, it doesn’t matter if a startup fails in Year 4.
As long as the firm invested in Year 1, earned interest, and got its principal back in Year 3 when the company raised another round of equity funding, the investment was a success.
Q: OK. We’ll delve into the mechanics later on, but I wanted to explain the motivation for venture debt first.
Going back to my original question, who gets into this industry?
A: Anyone who knows a lot about debt.
Some top-tier undergraduates enter right after graduation, but it’s more common to see people with 2-3 years of experience doing this.
MBA hires are less common, but venture banks do recruit MSF candidates at career fairs.
Sometimes, professionals with 10-15+ years of PE/VC experience enter the industry as well.
Often, they maintain their equity investments in startups, and they move to the debt side to make money there while waiting for the equity payoff.
Q: So what drew you into the field?
Venture lending appealed to me because it wasn’t quite as “fuzzy” as early-stage VC roles, and it would let me work with startups and do analytical work.
I knew my role would be similar to that of a second-year analyst at an investment bank, but also that it would give me exposure to VCs.
So I figured I would gain skills that might be useful for multiple exit opportunities.
Q: What should someone expect in the venture lending recruiting process?
A: It depends on the type of firm you’re going to, but my interviews focused almost 100% on my knowledge of the industry.
They asked some of the standard “fit” questions, but they didn’t ask traditional investment banking technical questions.
Instead, they asked questions about how venture lending works, market trends in debt capital markets and venture capital, and how venture debt deals might be structured.
- How would the covenants differ for startup debt vs. a Term Loan to a manufacturing company?
- If we’re competing with a big bank, how might we structure the debt so we can win the deal?
- If a company fails and has to shut down, how might we recover some of our principal even if the company has no tangible assets?
(The next section will answer these questions.)
Debt vs. equity case studies are very common as well.
Debt is almost always cheaper than equity, but not all companies can support additional debt.
So you have to check the leverage and coverage ratios and the company’s liquidity and cash flows, and see if it can reasonably take on more debt
For example, if the median Debt/EBITDA ratio in the industry is 4x, and the company’s ratio would be 3.5x after it raises debt, and everything else is in a reasonable range, you might recommend debt.
Otherwise, if it cannot raise more debt, or if equity is cheaper because the company trades at extremely high multiples (e.g., Amazon), you might recommend equity.
The Industry Landscape
Q: Thanks for sharing all that.
Moving on, who are the biggest players in the venture lending industry, and how much activity is there?
A: The total market size in the U.S. is in the low billions USD each year. Venture capital activity is typically in the tens of billions USD, so venture lending is around 5-10% of traditional equity funding.
The players are split into “venture banks” and “venture debt funds.”
Venture banks are normal commercial banks, and so they accept deposits, issue loans, maintain checking accounts, etc., and they also fund startups.
They might charge fairly low rates, such as Prime + 1-2%, because they’re doing it to win the startup’s checking account.
It has become incredibly difficult for banks to attract new deposits, so providing funding at attractive terms is a great way to get these new accounts.
The biggest venture bank, by far, is Silicon Valley Bank, which has around 65% of the venture debt market.
Square 1 Bank has around 15% of the market, and then Bridge Bank and Comerica have smaller percentages.
On the other end of the spectrum are venture debt funds. These are not commercial banks – they raise money from Limited Partners and then issue higher-interest-rate loans.
They’re more like credit-focused private equity firms, and they take on more of a strategic role at startups, sometimes also taking Board seats.
Most venture debt funds do subordinated debt deals instead of the senior secured loans that venture banks use.
Typical rates might be in the 12% to 20% range (i.e., Prime + 8-16%), and these firms often fund riskier companies that are far away from generating positive cash flow.
However, they can fund larger loans and do so with less restrictive covenants.
I’m not sure there is a clear market leader in this area, but Trinity Capital, NXT Capital, and Lighthouse would be in the top 10; you can find full lists on Wikipedia and other sources.
Finally, there are also publicly traded specialty finance companies, such as Horizon Technology Finance and Hercules Technology Growth Capital, that operate in this market.
There are some differences because these specialty finance companies are public, but their goals are similar to those of venture debt funds.
Q: Thanks for sharing all that. So what do the numbers look like?
What do you see with default rates, returns, and loan sizes?
A: Default rates are generally under 5% because of the timing. Yes, most startups fail, but if a startup can get equity funding once, it can often get another round of funding as well.
Loan loss rates also tend to be quite low – ~1% of assets, the same range that normal commercial banks get – for the same reason.
Returns are quite low for venture banks, so it’s more like the typical interest spread for a commercial bank.
Returns can be much higher at venture funds, and sometimes they approach venture capital-level returns.
Warrants and equity kickers can theoretically boost returns, but in the current market (as of 2016), warrants have become less common and offer significantly lower percentages of equity (<1%).
The loans are usually senior secured loans, and financial covenants, if they exist, tend to be based on revenue.
The most common covenants are based on liquidity ratios (LQRs) and Trailing 3-Month (T3M), Trailing 6-Month (T6M), or Monthly Recurring Revenue (MRR) for SaaS (Software as a Service) companies.
The loans tend to have quarterly interest and amortization with 3-4 year maturities, but amortization is often deferred.
Tranching has become more common, and most lenders now split up funding by expected time-to-draw.
The loan size is about 1/3 or 1/2 of the most recent VC investment in the company. So a company that just raised $10 million in equity might raise $5 million in venture debt afterward.
For later-stage companies, covenants might be based on EBITDA, cash flow, and traditional leverage and coverage ratios.
Q: OK, so a couple of questions here.
First off, is there a guarantee that future VC funding will be used to repay the outstanding principal?
Is that written into the loan agreements?
A: No, it’s not an explicit guarantee.
However, since most venture loans have 3-4-year maturity periods, there’s a good chance that the next round of funding will happen before the loan matures.
Also, most companies that receive VC funding take at least a few years to fail, so if a loan amortizes over 3-4 years, the risk is much lower for lenders.
And since the debt is senior to the preferred equity that VCs typically use, the lenders get repaid first in the case of bankruptcy.
In the early stages, venture lenders are betting on the creditworthiness of the venture capital investors, not the company.
VCs are likely to repay the loans because they want to maintain the relationship and make more funding options available for their companies.
In the later stages, this point becomes less of an issue because the company has cash flow it can use for loan repayment – or it can more easily raise funding to do so.
Q: So let’s say a startup fails in between financing rounds.
How much value can you recover, and how do you do it?
A: In the early stages, you need VC funding to get anything back. So if the company has no cash and hasn’t been able to raise funding, the answer is: “Close to nothing.”
Even with senior secured loans, it’s very rare to recover anything close to 100%.
The only way to recover much is to sell the company’s intellectual property (IP).
For example, we might call large tech companies and see if anyone wants to do an “acqui-hire” and buy the company’s platform and hire its engineers. If someone does it, the acquisition proceeds might repay a portion of the debt.
This is why it’s so important to analyze the IP when funding companies – some people in VL have worked in product/strategy roles and evaluate companies’ IP, estimate its value, and assess the risk.
I don’t know the average recovery percentage, but we try to avoid this outcome by investing only in companies that are likely to raise another round of VC funding.
Q: How do traditional VC firms and venture lenders interact?
A: They interact very closely, more so than equity and debt investors in large, public companies.
First off, venture lenders always invest based on VCs’ investments.
Sometimes, venture capitalists even refer their portfolio companies to specific venture lenders when the companies need more funding.
After a company gets funding, VLs and VCs monitor it in very different ways.
VCs help the company grow, win new customers, and attract talent. They can use their Board seats to veto plans, but they’re more focused on the upside.
But venture lenders have an even better monitoring method: they can look at the startup’s bank account every single day.
They look at covenant compliance and the company’s financial statements as well, but cash is king.
Even if a startup violates a covenant, the venture lender won’t necessarily call the loan or penalize the company in the same way a traditional lender would.
Instead, the firm might alert the VCs, ask them to check on what’s happening at the company, and then determine how the company might come back into compliance.
The Work Itself: On the Job in Venture Lending
Q: Thanks for explaining all that.
So what is the job like? Various articles discuss the industry, but hardly anyone talks about how you evaluate companies and issue loans.
A: Venture lending is much more similar to a junior-level investment banking than it is to venture capital or growth equity.
There’s little-to-no sourcing, and we spend a lot of time on financial statement analysis and Excel models.
Just like in other debt-related roles, we write memos for the loan committee and risk managers based on the startup’s financials, market, and strategy.
We still conduct due diligence, monitor portfolio companies, and speak with the equity investors frequently, so in that sense, it’s more like a buy-side role.
Q: OK, but how do you evaluate companies if they have no revenue?
A: We look at their business plans and projections and compare them to the same documents from similar companies.
For example, we might look at a mobile gaming startup and compare its plan to one from a larger mobile gaming startup that raised debt in its early days.
It can’t be so early that the company has no pathway to revenue. These days, many companies do generate some revenue after that first VC investment.
So in those cases, we’ll make the comparison, build the company’s revenue model, and see what covenants, if any, make sense.
For SaaS companies, the covenants will almost always be related to monthly recurring revenue (MRR).
For life sciences companies, they’re based on clinical trial results and how long it takes to get to Phase I, Phase II, and Phase III.
For expansion-stage companies, we start looking at more traditional metrics like EBITDA, cash flow, leverage and coverage ratios, and so on.
So at that level, it’s not much different from credit analysis for normal companies, but we do have to factor in additional risk and operational scenarios.
Q: So going back to one of those example interview questions, how do you compete with larger venture banks for deals?
A: The biggest difference lies in the covenants.
You can’t offer lower interest rates because you need to charge a certain minimum rate for the math to work.
You also can’t compete by offering less dilutive warrants because dilution is already quite low and has been decreasing over time.
But you can offer less restrictive covenants, which startups care about a lot.
So if a larger bank offers funding with minimum-cash covenants and revenue milestones, we might leave out those covenants or make them less restrictive.
Compensation, Exit Opportunities, and More
Q: Thanks for that one.
Any ideas on the rough compensation range in this industry?
A: It’s lower than traditional IB/PE compensation.
As of 2016, Analysts and Senior Analysts at most venture banks earned $70K to $90K in base salary and a bonus of ~10-15% of that.
Note that these are rough estimates, and pay can vary a fair amount due to your experience level and the overall performance of your group.
Silicon Valley Bank pays more than this because they’re the industry gorilla and have been around longer than everyone, but it’s still a discount to IB pay.
As you move up, you might spend 3-4 years as an Associate and then 5-6 years in the mid-levels before becoming a Managing Director.
An Associate might earn between $100K and $115K in base salary. I don’t know the bonus structure, but I assume it’s a higher percentage of base salary than Analyst bonuses, though still a big discount to IB/PE compensation.
At the top levels, you can make $300K – $350K per year from your salary and bonus, and potentially even more from warrants in deals.
While this is much lower than IB compensation, you get a major lifestyle advantage: some of the top earners might work only 45-50 hours per week, and even at the mid-levels it’s more like 55-60 hours per week.
During “busy season,” it can go up to 70-80 hours per week for Analysts, but for the most part, it is 55-60 hours per week.
Q: How does the compensation differ at venture debt funds?
A: I’m not sure about that one.
Compensation is definitely higher, given the risk/return profile and the warrant structures in deals, but I don’t have the data.
Q: Fair enough.
So what do people do after working in venture lending?
A: The most common paths are:
- Move into Venture Capital – If you’ve worked in venture lending for only 2-3 years, this one is quite common. You are extremely unlikely to get into a top VC firm coming from VL, but it’s possible to get into venture capital at a mid-tier firm.
- Stay in Venture Lending, or Move to a Venture Debt Firm, Business Development Company (BDC), or Mezzanine Fund and Do the Same Work – Past 3-5 years, it gets tough to move into a completely different industry, so most people stick around.
- Become a CFO at a Startup – This one is more viable when you’re at the top, or close to it. Quite a few CFOs come from venture banks, especially for expansion and late-stage startups that need in-depth financial expertise.
Q: Awesome. Thanks for sharing everything!
A: My pleasure.
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