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.

via SSRN-Debt as Venture Capital by Darian Ibrahim.

Interesting abstract – I’ll have to read the paper to figure out why the hostage strategy can’t be replicated by contract outside the nonprofit form.

In a well-functioning stock market, issuing firms publicly disclose all relevant information to investors and prices approximate the true value of those firms. This disclosure generates liquidity as investors large and small engage in trading. While it is tempting to take this “good equilibrium” for granted, the current banking crisis suggests a “bad equilibrium” in which disclosure is suspect so banks stop lending to each other and small investors flee the market.

In this paper, we argue that a good equilibrium was in place when the New York Stock Exchange (NYSE) operated as a non-profit organization. We argue that far from being an outdated and elitist holdover, the mutual form allowed underwriters, who dominated NYSE membership, to extract hostages from managers of firms listed on the NYSE. That is, managers were expected to invest personal funds in shares of other listed firms, including new issuers (“IPOs”).

Since the hostage arrangement was tied to the non-profit form of the NYSE, we predict a decline in information quality after the NYSE became a for-profit firm in March 2006. By comparing the bid-ask spread before and after demutualization, we show that information quality did indeed decline. This finding holds after controlling for market-level variation measured by the bid-ask spread of the NASDAQ National Market. We believe our results can help shed light on the current banking crisis, which originated in areas of the financial system that lack a hostage structure.

via SSRN-Using Hostages to Improve the Quality of Financial Disclosure by Jennifer Kuan, Stephen Diamond.

After many years with Typepad, I’m finding wordpress a breeze.  But it still takes a long time to update links … it could be weeks before I update all of these links …

Hey – I’m currently re-working the site.  Check back soon.