How Can An Entrepreneur Benefit From Venture Debt?

You might consider venture lending as an alternative source to venture capital or angel funding for several reasons.

1. No dilution.

In contrast to venture capital, you do not give up large amounts of equity at a low valuation.  This means your stake in the company will not be diluted.  However, you will have to give the lender warrants.  Warrants give the lender the right to purchase a specific amount of company stock at a set price.  Venture debt shops typically get less than a 1% stake in the company.  You will be hard pressed to find that low level of dilution from any other financing source.

2. Additional "runway."

Venture debt allows you to use your fixed assets to extract more time and value from your equity.  This means breathing room for the entrepreneur and more time to meet goals and milestones to satisfy the venture capitalists.  In this way, venture debt can be appropriate for firms seeking a bridge between funding rounds from venture capitalists.  The result is a greater chance of receiving another round of financing and at a better valuation.

3.  The relationship is arms length.

During the term of the loan, the lender, unlike a venture capitalist, does not get involved in the corporate governance activities of the company.  That means the debt holder will not ask for a seat on the board of directors.  In this sense, the venture lender is like any other commercial lender.  Yet, the lender may seek to provide advice on business strategy and operations. Overall, the venture lender will intervene less in the company's operations and management than the venture capitalist.

What Risks Does Venture Debt Present?

Although venture debt can provide needed capital for startups, you should be aware of potential pitfalls.

1. Drains cash.

Like any other loan, you have to pay back the principal and make interest payments.  You have to be certain that you have sufficient cash and ongoing revenues to make those payments.  Rich Ginn of Costella Kirsch explains that his firm likes to see that a company is close to break even.  If a venture debt lender does not impose that criterion in its lending, maybe you should think twice about taking their money.

2. Risky to take on debt to extend runway.

What can go wrong often does go wrong.  No matter how good things look today, debt becomes a problem when your plans don't come to fruition.  Many venture lenders expect the company to meet milestones.  If you fail to meet the milestones, you will have to negotiate with the lender.  You can expect greater scrutiny.

If you have to raise another round of money, debt amortization may become a burden.  If you have not paid off the loan before the next round, investors will have to put in money to help you pay off your debt.  That may discourage investors, who dislike seeing their money going immediately to another investor.  The next round's valuation will likely be lower.

Conclusion

Because venture loans are usually in the $1 to $3 million range, they provide an often needed infusion of capital into a venture backed company.  While this can benefit many companies, you should understand the issues that accompany venture debt.

Douglas Y. Park

Twitter: @DougYPark

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Source: Capital Advisors Group

With venture capital difficult to obtain, more startups are looking at venture debt to finance either growth or equipment purchases.  Venture debt involves a specialized financial institution extending a loan to a startup.  Traditional commercial lenders are hesitant to give loans to startups because they usually do not have tangible assets.  Unlike a venture capitalist, the venture lender does does not receive equity in exchange for capital.

What The Entrepreneur Needs To Know About Venture Debt

1. It's a loan.

Venture debt is a loan made to a startup.  That means the main features of a loan -- principal, interest rate, repayment terms -- are present.  The loan either provides operating capital or equipment financing.  Operating capital is used to grow the company.  Examples are research and development, marketing, and acquisitions.  Equipment financing is used to borrow against equipment that the startup buys, such as manufacturing equipment.

An important feature is that the lender does not receive any equity in the startup.  Like any other loan, the relationship ends when the company repays the loan.

2. It's more complicated than a loan.

• Interest rate. The interest rate will often be a function of the company's prospects and the reputation of its venture capitalists.  Another point entrepreneurs should understand: the cost of capital is not just the interest rate, but rather a multiple of the interest rate.
• Term. The loan is usually structured as a two to four year term loan.  The loan may sometimes include interest free payments or a final balloon payment that allows the company to avoid paying cash at the beginning of the term.
• Warrants. Venture debt loans generally include warrants.  The warrants give the lender the right to purchase a set amount of the company's common stock at a predetermined price.  This price is often at a discount ranging from 5 to 15 percent.
• Material Adverse Change Clause. Make sure you understand the material adverse change (MAC) clause and the circumstances that qualify as a MAC.  For startups,  something as common as the founder leaving the company or the company experiencing a change in its financial statements can trigger the MAC clause.  This can lead to the lender calling on the principal of the loan and closing down the company.  In 2009, Hercules Technology Growth Capital foreclosed on Kadoink's loan and sold the company's intellectual property assets because of a change in its financial statements.

3. Who qualifies?

One venture capitalist, Mark Peter Davis, notes that a startup generally must (1) be cash flow positive or (2) have a venture capitalist who will guarantee the loan to qualify for venture debt.  Anurag Chandra of Lighthouse Capital argues that venture-backed startups who are cash flow negative are prime candidates for venture lending.  Having highly regarded venture capitalists as backers and a promising future increase the company's attractiveness.

4. Venture debt lenders are not as involved as venture capitalists.

Venture lenders do not ask for a seat on the board of directors.  Nor do they get involved in the operations or management of the company.

5. Choose a reputable venture debt provider.

Because venture debt is a highly specialized type of lending, pick a provider who understands your industry and has an established track record.  Reputable players include Silicon Valley Bank, Costella Kirsch, Western Technology Investment, Hercules Technology Growth Capital, and Velocity Financial Group.  Silicon Valley Bank is an established venture debt lender with over 25 years of experience.  Costella Kirsch has also been around for about 25 years.  Western Technology Investment recently closed an oversubscribed $294 million venture debt cleantech fund.  Western Technology has provided debt funding to Facebook, Google, and Palantir, among others.  Hercules Technology Growth Capital recently lent $15 million to Reply.com, a company focusing on the online targeted marketing space. Velocity Financial Group has recently backed companies including Sportsvision and Alphion.

Conclusion

Venture debt is often overlooked as a potential source of funding.  Certainly, this type of financing is not for every startup.  In the next post, I will examine  the pros and cons of this type of financing.

As always, I welcome your comments.

Douglas Y. Park

Twitter: @DougYPark

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These deals raise the question: Why is the secondary market for private company stock getting strong now?

Reasons Why The Secondary Market For Private Company Stock Is Surging

The secondary market for private company stock has became a viable trading platform.  Several factors in combination have produced the conditions for this market to flourish:

1. The weak market for IPOs since at least 2007
2. A low number of mergers and acquisitions during 2009 of any year this decade
3. More companies hesitating to go public because of corporate governance concerns
4. More companies want to stay private longer to maintain control over their strategic direction

Benefits To Venture Capitalists

These factors have created a liquidity problem for earlier stage investors such as venture capitalists.  Venture capitalists have typically had their money in the companies for many years.  However, VCs need to be able to exit their investments in order to provide a return to the limited partners.  When VCs sell their stakes in the secondary market, they are able to give capital back to the limited partners.  During this difficult fundraising environment, VCs want to do all they can to return capital to the limited partners sooner rather than later.  Weak VC returns during this decade add a sense of urgency to this imperative.

Benefits To Private Companies

Most companies who stock is traded on the secondary market are late stage venture capital backed companies.  With the infusion of capital that accompany these transactions, the companies are able to stay private longer.

Further, purchases on the secondary market give companies a way to let their employees cash out on their other illiquid shares.  In 2009, Facebook did a variation on this theme by buying back employee common stock.  Employees are happy because they do not have to wait for an IPO or acquisition to benefit from their equity stake.

Discussion

Venture capitalist Fred Wilson summarizes the argument for a strong secondary market for venture backed companies.

Entrepreneurs won’t start companies and investors won’t invest in them if there is no path to liquidity on the company stock.  A secondary market for private company stock can fill the gap that the lack of an I.P.O. market has created.

While this market for private company stock provides benefits to the company and to VCs, these transactions involve securities law and business strategy issues. I will continue to discuss these legal and business issues surrounding the secondary market.  Whether you are on the buy side or the sell side, consult your business and legal advisor before engaging in such transactions.

If you have experience with these transactions, please share your story by leaving a comment.

Douglas Y. Park

Twitter: @DougYPark

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Common versus Preferred: The Liquidation Preference

Common stock gives the holder an equity ownership position in the company, voting rights, and sometimes dividend rights.  Preferred stock also gives the the holder an equity ownership stake, with additional rights that common stock does not possess as discussed below.

One big difference between common and preferred is that preferred stock enjoys a liquidation preference.  The preferred has the right to receive a payment prior to distributions to the common stockholders when a liquidation or sale of the company occurs.  This payment is usually a multiple (e.g., 2X) of the stock's issuing price.  To put the founders on the same footing as the investors in the case of liquidating distributions, founders usually prefer to issue common stock to angel investors.

There's another benefit to issuing common stock.  Issuing common stock rather than preferred stock produces a simpler capital structure with only one class of stock outstanding.  One benefit is that the company can continue to make the S corporation election because it has only one class of outstanding stock.

Despite these benefits, founders are not always in a position to issue only common stock.  Angels from an organized syndicate, such as Band of Angels or Kereitsu Forum, are more likely to push hard for preferred.  The attractiveness of the company plays a big role in how the negotiations will proceed.  The type of stock issued is a point of negotiation.

How The Choice Of Issued Stock Choice Affects Your Company's Future

In addition to the liquidation preference, preferred stock holders have other rights.  Here are four of the most important ones.

1. Preferred stock often contains a conversion option.  This means that the preferred holder can convert their preferred to common according to a given ratio.  The most common ratio at the time of issuance is one to one, though the ratio will change with additional rounds of financing.
2. Preferred stock usually contains an antidilution provision that is triggered if the company issues shares below the conversion price.  An antidilution provision discourages the company from reducing the share price in future financing rounds.  How the conversion price is calculated depends on the type of antidilution protection.  Full ratchet protection (favorable to preferred stock holders)  and weighted average protection (favorable to the company) are the most common types of antidilution protection.
3. Preferred stock sometimes has dividend rights.  The dividend can guarantee a certain annual return on the original purchase price.  In a liquidation event, dividends may have to be paid out to the preferred before the common gets paid anything.
4. Preferred stock may contain blocking rights.  Blocking rights allow the preferred to stop a sale of the company, an equity financing, or increase in the number of stock options.  Further, in some cases blocking rights events to corporate governance issues like the appointment of senior executives.

Conclusion

This brief discussion should underscore that preferred stock holders can substantially influence your company's operation.  Keep in mind that if you give angel investors certain rights in one financing round, that will establish the baseline for negotiating rights with angel investors or venture capitalists in the next round.  You cannot expect to give fewer rights than you have to a prior investor.

You cannot expect to issue only common stock for more than one or two rounds.  Many angels, and certainly VCs, will expect and demand preferred.  The important thing is to understand the effects of issuing common or preferred.

Douglas Y. Park

Twitter: @DougYPark

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Weak IPO Market

A strong IPO market is critical to venture capital success.  IPOs are the surest way for VCs to realize huge returns on investment.

During the late 1990s, VCs gave their limited partners returns in excess of 35% every year.  The reason?  A large number of IPOs.  Here are the number of VC-backed IPOs since 1995:

• 1995:   205
• 1996:   272
• 1997:   138
• 1998:   68
• 1999:   250
• 2000:   202
• 2001:   22
• 2002:   20
• 2003:   23
• 2004:   67
• 2005:   43
• 2006:   56
• 2007:   76
• 2008:   7
• 2009:   8

As of the end of March 2010, there had been eight VC-backed IPOs. So there are signs that the IPO market is picking up.  However, this slight uptick in VC-backed IPOs does not necessarily mean a return to the heydays of the late 1990s.  The 1990s were most likely an anomaly.

On average, exit by mergers and acquisitions provides lower returns than an IPO liquidity event.  Thus, the increase in M&A exits will result in lower VC returns compared to IPO exits.

Venture capital cannot survive without high return liquidity returns. The lower the returns VC provide, the less incentive limited partners have to give VCs their money.  Subtract out the abnormally robust IPO market of the first half of 1999, and you can see why ten year VC returns have shifted dramatically downward.

Venture Capitalists Are Making Fewer Early Stage Investments

The weak exit market means that VCs will view early stage startups as riskier investments.  That is exactly what is happening.  VCs are putting less money into early stage startups, investing in fewer startups, and giving more company to later stage companies with track record.  From 2002 to 2009, VCs invested most of their money into follow-on and later stage deals. That is what the data shows, whether by dollar amount or number of deals.

As a result of more money going to later stage deals, VCs will give their limited partners lower returns. More VCs, like NEA Associates, are doing private equity type deals.  Private equity deals tend to involve larger capital commitments, with shorter time horizons and lower returns than early stage investments.  The upside is that private equity are closer to exit.  The downside is that private equity deals are less likely to promote the innovation and entrepreneurial creativity that VCs have traditionally backed.

Fewer Venture Capitalists Have Operational Experience

The third factor that is hurting VC returns is fewer VCs have operational experience to help their portfolio companies execute their strategy.  The flip side of that is more VCs are acting like investment bankers, or have finance backgrounds.

Consider these comments from entrepreneurs responding to the 2009 "A Seat at the Table" survey on venture capital, conducted by Dow Jones VentureSource and the National Venture Capital Association.

“I’ve been an entrepreneur as well as a VC. The biggest travesty that VC firms can visit on a portfolio company is putting an inexperienced representative onto its board. Too many VCs have no real operating experience (sorry, having been a I-banker or recruiter does not count as experience).”

“This study is timely because I see a lot of dysfunctional stuff foisted on CEO’s by vc’s who have had no operational experience and who have no idea what it is to run a smaller company.”

“Venture capitalists with previous CEO experience are a vastly different breed than financially trained VCs.  The former tend to be less volatile when critical situations in startups arise and offer more value add to the enterprise.”

While most of the survey's respondents were happy with their investors, the most common complaint was VCs who lacked operational experience.  The reasoning is simple: Startups have to be able to implement.  By itself, financial experience does not contribute to implementation.

Conclusion

Venture capitalists enjoyed unprecedented success during the late 1990s.  Those days may never return as the number of VC-backed IPOs settles to a lower number and the nature of VC investments changes.  These changes raise an important question: How will changes in the VC industry affect innovation and technology entrepreneurs?

Douglas Y. Park

Twitter: @DougYPark

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