Financial risks and returns often move together, with investors demanding higher returns from assets that carry higher risks. And yet, while the yields on venture debt are often higher than the returns on other income-generating investments, as a category, venture debt still proved to be remarkably resilient during the Covid-19 economic downturn.
Of course, not everyone expected that outcome. That’s because the companies that often use venture debt typically have characteristics like negative cash flows or negligible asset bases that don’t align to most traditional lenders’ credit criteria. Plus, they aren’t exactly the attributes you’d expect for companies able to adeptly navigate a 25 percent contraction in global GDP.
And yet, that’s exactly what happened. In fact, according to PitchBook, venture debt exhibited lower volatility than any other form of private debt during 2020. Meanwhile, research from JP Morgan shows that private debt produced better returns than almost any other income asset class last year.
So why did venture debt fare so well? The answer is that many venture borrowers sell a product that is core to running their customers’ operations. Not only that, their business models and organizational cultures can quickly adapt to changing environmental (or economic) circumstances. And, as we’ll see, the best venture lenders also proactively work with their borrowers to achieve positive outcomes.
Why venture borrowers are a lot better than they sound
From a conventional credit analysis perspective, venture borrowers have a variety of negative characteristics such as the fact that they’re young, small, and burn cash. However, the reality is that these characteristics mask underlying dynamics that are a lot more compelling when analyzed through the appropriate lens.
First, many venture-backed companies are building products that are mission critical or core to operations for their users. For example, when companies were forced to flex and adapt to the realities of working remotely, the software that they were using turned out to be absolutely vital in terms of their ability to keep operating. Very often that software comes from fast-growing companies backed by venture lenders.
In fact, some of those companies actually experienced a tailwind from the realities of Covid. Companies that focused on mobile applications, for example, reported better-than-planned sales as they brought on new customers and increased their sales to existing clients.
But whether or not the typical venture debt user had a product that was perfectly suited to the business environment in 2020, many turned their youth and size into advantages in ways that weren’t possible for larger companies. That’s because a venture company can scale to well over $10 million with a comparatively small number of employees. And that lower headcount makes it much easier to get everyone facing in a new direction than it is for a traditional business with similar revenues to get its workforce — which is often much much larger — to reorient around a new world view.
But not every venture company sells mission-critical software, nor can every company instantly adapt to radically different circumstances. In fact, plenty of companies were caught offside by the realities of 2020. So how did that set of firms manage to work through those challenges?
Investing in growth rather than saving to survive
SaaS (Software-as-a-Service) companies often report negative earnings and cash flows in their early stages. Some of this is because they’re spending on research and development so that they have a product to bring to market. But even when sales are growing quickly, many companies report increasing losses.
The reason for this is that SaaS companies’ sales are fundamentally different from other revenue models. If a clothing manufacturer lands a new retail account, the sales aren’t necessarily a one-time event. If the retailer sells its initial order, it will probably order more, with the relationship accruing value over time. But each new order is uncertain, and each new order has to be manufactured, consuming working capital and margin.
While it’s a good business — and some companies execute it extremely well — the SaaS model is much more robust. That’s because in the SaaS model, an initial order is more like an annuity than a sale since it’s likely to repeat every year going forward. Plus, the incremental sales carry very high contribution margins, since nothing new is being manufactured to fill them.
That means that sales are more valuable to a SaaS company than they are to other kinds of businesses, and that software companies invest heavily in sales as a result. It’s this dynamic that often drives the negative earnings that early stage software companies report. Of course, the dynamic is well understood, and results in the very high valuations that the best software companies regularly command. 2020 was a striking example of just how well these business models perform in less certain environments.
As noted, a high percentage of SaaS companies’ operating costs relate to sales expenses. If sales aren’t happening — say because your customers are at home and not interested in placing new orders until they know what the world will look like post-pandemic — those expenses can be cut.
Cutting sales expenses in traditional businesses leads to lower sales. In fact, if your sales spend drops to zero, it’s reasonable to expect that your revenues will do so as well not long after. But when SaaS companies reduce their sales efforts, only the growth in sales is affected. Meanwhile, sales from the installed base continue. A company with $5 million in sales that’s growing at 50 percent per year could cut its sales expenses and see its growth halt completely. And yet, the $5 million it’s already generating will continue to recur.
And that revenue from current users is now unburdened by the spending required to attract new customers. This, in turn, allows many venture borrowers to toggle between growth and profitability as circumstances demand. When growth is unavailable, many venture borrowers can switch to survival mode, harvest cash from their installed base, and service their debt until the environment improves and they can resume growth.
Venture lenders versus traditional lenders
SaaS companies operate a particularly powerful business model, and are terrific venture borrowers as a result. But not every new company is that robust, nor can all of them seamlessly pivot as conditions demand.
This is why venture lending is a niche focus, and why it’s executed by specialists. A traditional lender probably can’t tell the difference between a firm that’s losing money because of its investments in growth and a firm that’s losing money because of inferior unit economics.
Specialists have other advantages besides being better at underwriting. For example, the best venture lenders understand that success demands adaptation, and that sometimes loans have to flex along with the businesses they’re supporting. Those lenders can lean on their experience to work with borrowers and craft solutions that accommodate their borrowers’ new circumstances while protecting their investors’ best interests. Expert, specialist lenders can discern which firms need support to get through a temporary soft patch, and which companies have reached the end of the road and are more appropriately capitalized by other sponsors.
Since those interests are in opposition with one another, resolving them isn’t straightforward. This means that experience and expertise are critical to ensure a favorable outcome. But it’s possible to achieve that balance, and protect investors’ capital, while affording borrowers room to adjust to their environment.
The case for venture debt
Venture debt performed well as an asset category during the economic upheaval of 2020. But that success wasn’t a fluke or a one-off. In fact, it shouldn’t have been surprising. Many of the characteristics that look as though they speak to high credit risk are actually much more supportive of debt than they appear to be at face value.
The best venture borrowers combine the potential for very rapid growth with tremendous resilience in the face of adversity, qualities that often make them excellent borrowers. And those business models are often operated by flexible, adaptive professionals who are used to having to pivot in the face of challenges.
But accurate analysis of those companies requires getting below the surface of their reported results, and that takes specialist focus and expertise. Successful venture lenders are capable of underwriting venture risks in ways that are foreign to their peers in traditional lending. Beyond that, though, venture lending doesn’t end at the underwriting stage. Managing a portfolio of operating companies requires just as much skill as originating and underwriting the loans in the first place. Being able to do so effectively is critical with respect to achieving great outcomes for investors while helping borrowers meet their goals.
Gordon Henderson is a Managing Director at Espresso Capital, a leading provider of innovative venture debt and growth financing solutions.