A brief history of venture debt

Steven Michau

Venture debt has been around since the 1970s, a time when a growing number of early stage companies needed computers, hardware, and other physical assets to grow their business. The challenge that these companies faced was that they often lacked the cash flows necessary to secure traditional debt financing. To get around this obstacle, a handful of lenders began offering equipment financing, which soon became known as venture leasing.

In the 1980s and early 1990s, Silicon Valley Bank and a few other banks and boutique leasing firms arrived on the scene and expanded on venture leasing using a simple model. They began providing loans to startups that, while still light on cash flows, were generally heavy on IT equipment, provided that they were backed by reputable venture capital firms. Typically, they would secure those loans against the specific equipment being financed, assuming that existing equity investors would act as a backstop by continuing to fund the companies in future equity rounds. Not only that, the lenders were also careful to structure their loans to complement whatever equity the borrowers had already taken. 

From venture leasing to venture debt

Fast forward to the dotcom boom in the mid to late 1990s, and venture leasing really began to take off. As more and more tech companies started reaching astronomical valuations, a growing number of lenders decided to enter the market with a clear value proposition for prospective borrowers. Not only were they prepared to provide the debt financing that traditional banks weren’t comfortable offering, they would also help borrowers avoid the dilution they would otherwise suffer if they were completely equity financed.

Unfortunately, the challenge that many of these early venture debt lenders faced was that they didn’t know how to properly structure or underwrite these types of loans. That meant that they had to figure out how best to assess risk as they went. As a result, venture debt was often a disorganized and volatile form of lending. Plus, venture debt lenders could be aggressive, often demanding warrants of 8 to 12 percent of the total facility amount, which made the product relatively expensive. For any borrower looking to work with these lenders, it was often like navigating the Wild West. Not surprisingly, when the dotcom bubble finally burst, many venture debt lenders went under. 

In the years that followed, the industry began to migrate to enterprise value loans, (i.e., loans that are secured by all of the borrower’s assets and not just their IT equipment), thus beginning the shift from venture leasing to venture debt. One of the big reasons for this shift was the emergence of application service providers, and later SaaS (software as a service) and cloud computing, which dramatically changed the cost equation for building and operating software, while also making their revenues and business models more predictable. 

Attracted by the opportunity to work with these higher-quality businesses, venture debt lenders began popping up around the United States and overseas.

Venture debt matures

It wasn’t until after the global financial crisis in 2008 that the modern venture debt market we know today began to emerge. An array of new market entrants created competition, which had the effect of raising the overall sophistication of the market. Over time, brokers also entered the market, which had a network effect and resulted in the further professionalization of the industry. 

As a result, venture debt lenders began acting more like traditional lenders by, for example, only offering terms that were market, and starting to care more about their reputation in the industry. Eventually, venture debt began to mirror asset-based and middle-market lending and became known for its clean and predictable underwriting process and for creating deals that truly benefit borrowers. Over time, the industry has also become far more specialized with sub-verticals (such as healthcare and technology) with dedicated teams, and different types of loans and credit policies to serve these sub-verticals.

Today, venture debt represents between 10 and 15 percent of the total venture market. The number of lenders has also increased significantly, which makes choosing the right debt lender increasingly important. Experienced lenders that have a longer track record of successfully underwriting and pricing transactions are the ones best positioned to structure mutually beneficial deals that deliver the business outcomes today’s borrowers seek.

Of course, the best venture debt lenders don’t just provide capital or help you avoid dilution. They’re also true partners who support borrowers by helping to facilitate additional financing, and making introductions to investment banks and strategic and financial buyers for potential M&A events. Increasingly, the best lenders are also using sophisticated analytics to help tech companies analyze their business and achieve better financial results.

Picking the right partner for the future

Over the course of many years, venture debt has become a proven and predictable source of capital for many healthcare and technology companies. Today, it’s a financing option that founders and CEOs should consider almost any time that they’re raising capital. 

It’s important to note that the number of firms offering venture debt solutions has grown considerably over the last 20 years. As such, borrowers need to take care to partner with those that truly understand their industry and have been operating in this space for a long time.  Finding a firm that takes the time to understand a business prior to lending, and that has the experience to draw upon during challenging times like these, will be crucial to the ultimate success of any venture debt financing relationship.