Managing partner and cofounder of Sanctum Capital Management, a debt and equity investment firm focused on high-growth tech companies.
A common misconception among fund allocators and private credit managers around the venture debt asset class is that it carries the same risk as venture equity but with capped upside from the debt. The reality—supported by decades of publicly available performance and research as well as my own experience with this asset class—is that venture debt in fact is far less risky than venture equity and has built-in upside features linked to equity returns that are rarely found in other types of debt.
In this article, I try to demystify these misconceptions in an effort to attract more capital into the asset class and hence provide more non-dilutive options for technology companies.
The primary confusion stems from the word “venture,” which is taken to imply a risk class but instead only refers to the fact that the large majority of borrowers have previously been funded by—and continued to be supported by—venture equity funds. While venture equity returns follow a power-law curve—heavily skewed by a small number of winners—venture debt returns are much more normal. In fact, given the de minimis loss rates demonstrated by funds in this asset class, practically all of the portfolio companies of a venture debt fund perform to underwriting. To avoid the confusion in nomenclature, a more precise way to understand a VD fund is to think of it as a private credit fund focused on mid- to late-stage technology companies.*
Several Avenues Simultaneously Employed for Risk Mitigation
Experienced fund managers in this asset class have been able to mitigate the risk of lending to technology companies in the following ways:
• Stage: They focus on mid- to late-stage companies that have achieved a minimum threshold of viability. This is often evidenced by high-quality, recurring revenues of at least $10 million to $20 million, institutional equity investment of at least $50 million, enterprise values of at least $150 million and a product or solution suite that is valuable to a large and growing customer base. These companies are real businesses that have secured dozens of paying customers tied to contracts, and technology platforms with a significant competitive moat. They have mitigated the following risk factors typically associated with young technology companies: (i) early-stage R&D and technology risk, (ii) market-fit risk and (iii) business model risk.
• Sector: Besides stage, another key risk mitigation strategy is to focus on technology sectors that provide mission-critical products and services with high switching costs. These include, but are not limited, to sub-sectors such as cloud infrastructure, software-as-a-service, enterprise software, healthcare IT and security. Equally important is to minimize exposure to sectors that are not well established or are speculative (cryptocurrencies), have volatile enterprise valuations with thin collateral (B2C hardware, certain e-commerce markets) or have binary pass/fail outcomes (semiconductors, pre-FDA medical devices).
• Security: Often structured as senior secured debt (i.e., top of the capital structure), venture debt is the first to get repaid in times of any exit event (M&A, sale, IPO, liquidation)—whether positive or negative. These loans are also typically not syndicated or clubbed, and hence one lender will often maintain control of any adverse process.
• Structure: Various protections are embedded in the loan structure itself, such as covenants, tranched funding and performance milestone metrics. In addition, monthly reporting and budget approvals further provide advance visibility in times of change.
While focused on downside protection, venture loans also include features that provide upside potential, which takes advantage of the high-growth nature of this borrower segment. These are usually structured as warrants or equity investment rights into future rounds.
The long-term result of these risk-mitigation features is an asset class that has historically demonstrated a low loss rate that typically ranges in the 1%-2% range on a cumulative basis. This is supported by public filings and results from various BDCs in the space.
In summary, while this asset class is referred to as venture debt, a more accurate and realistic moniker would be “private credit, focused on technology companies, with downside protection and equity-linked upside.” Funds in this asset class have reliably demonstrated consistent yields across cycles and still offer investors access to venture-like upside optionality that comes with high-growth technology companies.
*Note that in this article, I focus on private credit funds that focus on mid- to late-stage technology companies, and hence my observations may not apply to commercial banks that provide banking services or lend to technology companies, nor credit funds that lend to early-stage technology companies.