Darian Ibrahim has posted a new paper describing the market and function for venture debt. One key insight is that venture lenders rely on the reputation of the VC investors in making the loan — they are relying on the VC coming back to fund the next stage as the source of repayment of the loan. It seems odd that, in an environment where information is costly and highly uncertain, the parties would introduce another party to the transaction. But the cost of equity capital is so high, it must be cheaper to get venture debt than to sell additional equity to VCs.
It’s also a system that might work better when returns are good (and so VC funding the next stage is fairly routine). Now that VCs are pulling back a bit, the “implicit contract” to fund the next stage is presumably less reliable, and VC lenders may have to look to more traditional exits (cash flow from the borrower!) before making the loans. I would predict the venture debt market to dry up pretty quickly in the current environment.
Very interesting, and another great contribution to the VC literature from Darian.
Venture debt, or loans to rapid-growth start-ups, is a puzzle. How are start-ups with no track records, positive cash flows, tangible collateral, or personal guarantees from entrepreneurs able to attract billions of dollars in loans each year? And why do start-ups take on debt rather than rely exclusively on equity investments from angel investors and venture capitalists (VCs), as well-known capital structure theories from corporate finance would seem to predict in this context? Using hand-collected interview data and theoretical contributions from finance, economics, and law, this Article solves the puzzle of venture debt by revealing that a start-up’s VC backing and intellectual property substitute for traditional loan repayment criteria and make venture debt attractive to a specialized set of lenders. On the firm side, venture debt helps entrepreneurs, angels, and VCs avoid dilution, improves VC internal rate of return, assists VCs in monitoring entrepreneurs, and follows from capital structure theories after the first round of VC funding.