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The Top Five BAD Reasons to Take on Venture Debt

// Mike Berrier - Founder + SVP, Risk Management

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October 1, 2013
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At Square 1 Bank, we’re dedicated to the start-up marketplace. As lenders, we focus on working with institutional venture capital firms and the companies they fund.  Lots of those companies are still developing their product or service. Others have reached the point where they’re figuring out how to attack the market, and still others are working to maximize profitability. 

Lending to companies with venture capital backing is different from traditional banking in some ways, but in other ways it’s very similar. Over the years I’ve seen some great uses for what we lovingly refer to as “venture debt,” and some reasons to borrow that didn’t make as much sense.

Below are some of the BAD reasons to take on debt that have come across my desk. Some may seem obvious, but if you’re new to the world of venture lending,  some may seem quite surprising.

1. Debt is cheap equity.

This idea is simply not true. If you don’t believe me, you can contrast this to this

Banks are not venture capital firms. A few have affiliates that make investments, but regulators make us keep those activities discrete from banking. There’s good reason for that. Direct investing is supposed to be riskier than bank lending and taxpayers shouldn’t be on the hook for investment risk. Investors have greater upside, but greater risk. Banks have lesser upside and lesser risk, and it’s largely because of that lower risk profile that banks get the benefit of the U.S. government’s backing. As we all know, federal and state regulators are intensely interested in the performance of banks—and rightly so. They’re the taxpayers’ watchdogs, because when a bank fails because it’s made bad loans, it might lead to taxpayers having to cover the deposits. Think TARP (which I’m happy to say Square 1 didn’t take). 

The calculus of bank performance is actually the opposite of venture fund performance. Since a VC fund has unlimited upside and downside, a venture fund can still return capital to its LPs if only a small number of its companies succeed—as long as the successes are big enough—but success at a bank is measured by how small a percentage of its portfolio doesn’t succeed. Banks don’t have the unlimited upside of equity investors to offset write-offs. Interest income from even the most wildly successful borrower doesn’t offset a large bad credit for a bank. 

Another reason banks get so excited about getting all their loans repaid is that most of the money banks lend doesn’t belong to them. It belongs to their depositors. Pause and think about that for a second. You put your hard-earned money on deposit with a bank and you have every right to expect it back when you want it. You enter into a trust relationship with the bank to keep your deposits safe. Would you want your banker lending your deposits to someone who considers it a sunk cost? Of course not.

2. I don’t want to involve my investors.

This is a bad reason to pursue debt because any bank worth its salt will involve the borrower’s investors in its decision-making process if it’s lending to a venture-backed company. The bank will have conversations with investors covering things as mundane as a common expectation that the debt will be repaid (see item #1 above), as well as key issues like how the investor measures the company’s progress, the investment’s exit strategy, under what circumstances the investor will provide additional capital to the company, and how much they’ve set aside for that purpose. The answers to these tough questions should inform the bank’s credit decision and may lead to redirection of the dialog with the borrower. 

An investor’s willingness to support their company’s decision to take on debt will be partly based on borrowing experiences they’ve had in the past, but also on how they view the value of their investment in the company. The way capital stacks up, senior debt has to get repaid before investors get a penny. That means the investor has to believe that the market value of the company is greater than the sum of the carrying value of their investment in the company, plus the debt. Sometimes that’s the case, and sometimes, unfortunately, it’s not. And if the management team holds common shares, they need to think that through too, since the lender, and then the preferred equity holders, all have to be repaid before the common stockholders begin sharing in the return. 

3. The more leverage, the better the return on equity.

The operative word here is more. Leverage in the form of bank debt can serve a valuable purpose under the right circumstances. It can provide a low-cost, low-dilution method for getting a borrower from one point to another, sometimes increasing a company’s value by the time another equity round is needed, and sometimes dramatically increasing it. But too much debt, or debt structured the wrong way, can stop an equity round in its tracks or can make a company unattractive to an acquirer. This concept is lost on some borrowers—and on some banks, for that matter. I’ve seen other banks get so worked up over a chance to lend to a company that they offer more debt than the company requested. There are times when it’s to a company’s benefit to borrow more, but I have seen new investors resist coming into an equity syndicate because the company’s debt burden is too great (see the discussion about the capital stack, above). 

Responsible lenders want to enhance the company’s value, not take it over by exceeding the position of equity holders.

4. No personal guarantee? No personal responsibility!

Personal guarantees from the management team are almost never required by banks providing venture debt, but that doesn’t mean there’s no fallout if a management team doesn’t take care of business. One of the basics of lending is character. Even the safest loan can be impossible to collect if the people who borrowed the money don’t intend to repay it. Most troubled situations don’t involve anything as egregious as fraud. More often, people just make poor choices. This can be true of actions as seemingly innocuous as incomplete disclosure, or spin. But the best thing borrowers and lenders can do for one another is to be as candid and forthcoming as possible, as soon as possible, if things aren’t going according to plan. 

Ben Franklin said, “It takes many good deeds to build a good reputation, and only one bad one to lose it.” This works both ways, and believe me, at Square 1, we understand that. We’ve been so acutely aware of it that being square is one of our core values, and we hold one another accountable for it. We understand that burned bridges can be impossible to rebuild.

5. If I just had another six months of runway, I might be able to raise equity.

I can’t tell you how often I’ve seen this reasoning over the years, but when raising needed equity is questionable, using bank debt to get to a decision point is a bad idea. The argument I hear most often revolves around what makes bank debt worthwhile, and how repayment risk has to be extreme to make that case. Look, we have and will continue to provide thoughtful bridge exposure to the right companies, with the right investors, in the right situations. But (and you knew there was a but coming along) what we won’t do is bridge to an indefinite event without a fall-back position. See Item #1, above. I tell people that as long as it’s a question of “when” funding will occur and not “if” funding will occur, we will consider going into a bridge situation. 

All this gets back to the premise of venture banking as distinct from venture capital. Put another way, if bridge financing is needed to get your company to a point where it can determine whether or not it can survive, please don’t consider bank debt.

I hope this article gave you a glimpse into the thought process of at least one of the risk managers at Square 1 Bank. If it’s raised any questions, or if you’re interested in learning more about how debt can be of value to your company or your venture firm’s portfolio companies, I hope you’ll give us a call.

 

The views, opinions, beliefs, conclusions, and other information expressed in this material is not given, verified, or endorsed by Square 1 Financial, Inc. or any of its affiliates. Instead, this material is solely the work of the author, and represents his views, opinions, beliefs, conclusions, and other information he wishes to present, in all cases without any manner of endorsement from or verification by Square 1 Financial, Inc. or any of its affiliates. 

This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that the author believes to be reliable, but which has not been independently verified by the author, Square 1 Bank, or any Square 1 affiliate, and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal, or other advice, nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to this material should be construed as a solicitation, offer, or recommendation to acquire or dispose of any investment, or to engage in any other transaction. 

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Square 1 Bank is a member of FDIC and Federal Reserve System. Square 1 Bank and the Square 1 logo are among the trademarks registered to Square 1 Financial, Inc. Square 1 Asset Management, a registered investment advisor, is a non-bank affiliate of Square 1 Bank. Products offered by Square 1 Asset Management are not FDIC insured, are not deposits or other obligations of Square 1 Bank, and may lose value. 

 


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