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Startups pitch banks as alternative to VCs
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Last year was difficult for startups — investors were not very interested in forking over their money. This year, it’s even harder. Venture capital funding for startup companies fell by almost half in the first six months.
So that has a lot of these embryonic companies turning to a source of funding called venture debt. At its most basic level, these are bank loans, and the demand for them is piling up.
Angela Lee is a professor of venture capital at Columbia Business School and founder of the startup investment network 37 Angels. She joined “Marketplace Morning Report” host Sabri Ben-Achour to talk about how venture debt has gained prominence in the startup funding field. The following is an edited transcript of their conversation.
Sabri Ben-Achour: Just as a baseline, how hard is it out there right now for startups trying to raise the money they need?
Angela Lee: Depends a little bit on what stage you’re talking about. What I would say is the later stage of a startup you are, the harder it is to raise. Because the closer you get to public markets, the harder it’s going to be.
Ben-Achour: Normally a startup would go to some investors and say, “Hi, can you put your money with us?” Then there is this alternative called venture debt. How is venture debt different? What is it?
Lee: The primary difference between venture debt and venture capital is that with venture capital, you are as a founder giving away a percentage of your company. Venture debt is you give me $5 million, and I’m paying you that back plus interest.
Ben-Achour: And demand for this version of financing is growing, right?
Lee: It absolutely is. It’s growing for a couple of reasons. One, there isn’t as much venture capital out there. So people need alternative forms of financing. The second reason is, as a startup, you want your valuation to keep going up. It’s very bad to say my company was worth $50 million last year, and this year, it’s only worth $30 million. One of the nice things about venture debt is there is no valuation put on your company. And so that makes venture debt particularly attractive right now.
Ben-Achour: Venture capital comes from investors. Where does venture debt come from?
Lee: So venture debt comes from banks, but not the banks that you’ve heard of — not the Citibanks and Wells Fargos of the world. It comes from folks who typically specifically do this type of lending, which is very different underwriting than, for example, a small business loan or personal loan.
Ben-Achour: If demand for this kind of debt is growing, how about supply? Are banks actually lending out more of this kind of debt?
Lee: Supply is down for three reasons. Silicon Valley Bank, which is one of the biggest venture debt suppliers, is gone. The second is that interest rates are up, which means that there needs to be a spread between what the venture debt banks are borrowing at and what they then [lend] the money out at. And that spread has to be maintained with interest rates up. And the third reason is adverse selection [or an excess of bad risks]. Because venture capital is depressed, there is a fear with a lot of venture debt lenders that only the companies that are really struggling are going to go after venture debt. And so you have all this adverse selection as well.
Ben-Achour: So who, in the end, is getting this kind of debt?
Lee: Venture capital tends to just focus on revenue growth [being] really important. Venture debt lenders are going to be much more focused on revenue quality. So what does “revenue quality” mean? It means that your revenue is predictable. It means that your revenue’s not supercyclical. It means that your revenue is growing steadily month over month. It also means that you are really managing your cash well. Venture debt, you have to pay them back every month or whatever your terms are. And so you have to have really good cash management.
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