The search for yield continues. The prevailing low-interest rate environment has driven down banks’ profit margins on traditional assets, compounded by increased competition from disruptive lending entrants. As the effects of COVID-19 put pressure on traditional corporate and consumer lending, financial institutions are being forced back to the drawing board to identify new sources of return. 

At the same time, banks are investing in external innovation engagement models – from seeding startups through incubators and accelerators, to investing in high-growth companies. In 2019, corporate venture capital investment reached an all-time high, with ~$57.1 billion invested across 3,234 deals. Banks are increasingly active, participating in 43% of all financial services corporate venture capital deals.

However, there is a substantial and obvious gap. Despite globally maturing startup ecosystems and increased participation of commercial banks within these ecosystems, there has been a scarcity of direct lending from incumbents to venture-stage companies. This is not to say that there is no demand for debt from venture-backed companies – or that they are not receiving it. Over the past 10 years, a growing market of non-bank specialist lenders has emerged, providing an estimated $8-12 billion in bespoke debt products per year since 2014.

Given that lending is the cornerstone of commercial banking, why have banks shied away from debt financing for high-growth ventures? 

Venture debt is a growing market opportunity

Venture debt is a debt funding mechanism tailored to pre- or post-profit venture capital-backed companies, available earlier and in larger amounts than traditional bank loans. Debt is typically provided in a three- to four-year term loan; often interest-only for the first 6-12 months, followed by an amortisation period with few operational restrictions or covenants. This provides founders with relatively low-cost growth capital, without equity dilution, often used to bridge the business to the next round of funding at a higher valuation than could be achieved at the time of the loan.

According to a recent survey, the US venture debt market has almost doubled since 2016, growing from ~$5.5 billion to ~$10 billion in 2019. Other estimates are more aggressive – suggesting that venture debt makes up ~15% of all venture financing in the US market – which would put venture lending at $8-12 billion per year since 2014. Silicon Valley Bank, one of the major specialist lenders to startups, currently has around $10 billion in commercial loans outstanding, compared to less than $4 billion in total commercial loans outstanding in 2009.

Before deteriorating market conditions brought about by COVID-19, venture debt deal volumes, value and size were expected to rise in 2020, with lenders aggressively competing for the best startups. Some of the most successful major ventures – including Airbnb and Uber – have leveraged venture debt to propel their accelerated growth trajectories, instead of diluting equity through raising additional rounds of funding.

But what about the yield? Venture debt lenders typically expect returns of 12-25%, achieved through a combination of loan interest and capital upside. Industry analysis suggests that returns have been stable compared to mid-market lending, with a gross IRR of ~18% in the last 10 years. For the perceptively high risk taken by lenders, it is estimated that the venture lending industry realises just a ~2% loss of capital, compared to a ~17% loss rate of Small Business Administration loans granted between 2006 and 2015. 

However, banks are missing in action. To date, venture debt has typically been provided by specialist non-bank lenders and venture financing firms, who have close ties to the venture capital ecosystem. Commercial banks are notably absent. Why, as natural candidates to fill the debt financing gap, have commercial banks shied away from supplying loans to venture-stage companies?

A growing market – but where are the banks?

The lack of commercial bank participation seems to be driven by five main reasons – the size of transactions; perception of risk and credit assessment processes; perception of returns; sourcing quality deals; and regulatory constraints.

1. The size of transactions: Deal sizes typically associated with venture-stage companies are relatively small – especially if viewed through an investment banking lens. Given the time and effort required to assess each loan application, banks (particularly if unfamiliar with earlier-stage company business plans and financials) may not see the immediate ticket sizes as worth the upfront cost of screening deals.
2. Perception of risk and associated risk assessment processes: Banks perceive venture debt as requiring a higher risk tolerance than they are accustomed to, given the high failure rate of venture-stage companies (despite the market’s low capital loss rate). Traditional credit decision-making processes tend to overweight the individual likelihood that a principal loan amount will be repaid – rather than optimising for risk-adjusted returns across a portfolio of loans. These processes make use of predefined criteria, which typically discourage lending against untested future performance. Traditional due diligence processes, loan assessments and underwriting models are therefore not fit for purpose for venture-stage companies, and decision-makers within commercial banks often lack the paradigm, skills and experience necessary to assess the types of risks involved in venture debt decision-making.
3. Perceptions of returns and the distraction of equity: Given the nature of startup ventures and the ‘promised land’ of 10x equity returns, commercial banks have tended to engage with emerging companies through the lens of equity investment – viewing these assets as firmly within the realm of investees or vendors – and not potentially lucrative clients. This perception has blinded banks to profitable lending opportunities to venture-stage companies, who are willing to pay relatively large margins to avoid dilution of their equity interest.
4. Sourcing high-quality deals: Given their historical lack of integration with the venture capital community, banks may have struggled to source high quality venture deals. Unlike larger private and public companies, relevant information on prospective venture borrowers is difficult to find, and even where it exists, traditional credit assessors may not be able to effectively interpret it. Given the (mis)perceptions of relative risk and returns, banks have not been sufficiently incentivised to develop the specialised capabilities required to identify venture debt opportunities.
5. Regulatory constraints: Traditional banks face strict regulations governing lending to high-risk sectors. Although regulations vary by jurisdiction, banks are subject to scrutiny of their loan book, and must ensure compliance with defined risk tolerance levels. Supervisory bodies can inhibit a bank’s ability to write new loans if a particular loan class is perceived as risky or impaired. This means that if a bank accumulates a portfolio of loans in a specialist area, it must be confident that regulatory bodies will be able to effectively evaluate the loan book based on its inherent characteristics, rather than by comparison to conventional portfolios. The risk of mis-evaluation and a resultant write-down disincentives banks from building venture debt portfolios, particularly where the perception of risk is overstated.

Participating in venture debt

Selected commercial banks have started offering venture debt to complement their overall service offering – seeing the value in a new revenue stream and portfolio of smaller deals that may mature into large commercial clients. These early adopters have tended to adopt common techniques and operating structures to address the barriers identified above:

1. Outsourcing deal origination and due diligence: Rather than establishing specialised internal capabilities, participating commercial banks have tended to partner with established venture capital firms to source and qualify deals – benefitting from their expertise in startup scouting and due diligence. This reduces the cost of deal origination and credit assessment for banks, and provides direct access to market-leading insights on startup funding requirements across their development lifecycle.
2. Developing bespoke assessment and underwriting models, tailored to venture-stage companies: Successful commercial banks have adopted new end-to-end lending frameworks tailored to venture-stage companies – from credit assessment models to monitoring and compliance. Unlike traditional bank lending, venture debt lenders look for evidence that companies can repay loans from future equity and enterprise value – including market traction, customer retention, and milestone achievement. Underwriting criteria are closely correlated to the company’s life stage and capital strategy; calibrated to the applicant’s current and projected burn rate. Moreover, venture debt pioneers have leveraged equity round data, including funds raised and valuations, to inform credit assessments and loan structures. Typically, the loan size is set to 20-35% of the company’s most recent equity round, supplemented with an assessment of the venture’s growth rate, investor syndicate, consumer base, and potential capitalisation risks. According to Silicon Valley Bank, the venture debt-to-valuation ratio (a common metric for evaluating debt worthiness) has trended consistently at 6-8% of the company’s last post-money valuation – demonstrating the close link between venture debt decision making and the broader venture capital ecosystem.
3. Leveraging equity kickers to deliver financial upside: To mitigate risk whilst charging competitive rates, venture debt lenders typically take stock warrants in either common or preferred stock, covering ~5-20% of the value of the loan. The warrants are then typically exercised when the company is acquired or goes public, providing an opportunity for lenders to share in the upside of a borrower’s growth. Some lenders also seek to obtain rights to invest in the borrower’s subsequent equity round on the same terms, conditions and pricing offered to its investors in those rounds – reducing the cost of debt by securing future equity value.
4. Collateralisation of venture assets: Although venture debt is typically unsecured, lenders may increase security over the debt through cash collateralisation (for example through taking a deposit of cash to lend against) or through bespoke asset-based security. Given that many venture-stage companies do not have significant traditional collateral, specialist lenders often use intellectual property to secure the loans. Some lenders do not require collateral, and instead offer revenue-based structures, where monthly repayments are tied to the borrower’s inflows.
5. Offering adjacent financial services: To optimise the value of venture debt portfolios, leading commercial banks provide a holistic financial services offering to borrowers, including deposit-taking, providing business banking accounts, payroll services, international payments, and leasing (leveraging existing due diligence). Moreover, through bringing on borrowers as banking clients, banks can shift the growing company’s future revenues directly onto their balance sheets – providing an additional revenue stream, and reducing the risk in their loan portfolio through enabling the bank to monitor its investment by tracking deposits.
6. Setting up a specialist lending arm: Commercial banks who offer venture debt products tend to set up a separate operating structure or arm within the bank to offer both venture debt and equity propositions. For example, Wells Fargo launched specialist capital provider arm, Wells Fargo Strategic Capital, and Bank of America created a new team focused on capital raising and advice to privately owned companies, providing debt products and connecting startups with their high net worth clients to facilitate direct equity investment.

These common success factors show that, armed with the right operating model, commercial banks are not only well placed to enter the venture debt market – but to outcompete non-bank specialist lenders, given their ability to reduce risk (and therefore the cost of debt) through lending up and down the company lifecycle. In addition, banks may be able to pioneer new product constructs in the market, including securitised portfolio models, enabling securitisation and risk diversification of the portfolio, and opening participation opportunities to a wide range of investors.

There is no time like the present

As commercial banks continue their search for yield, venture debt presents a compelling opportunity to create additional revenue streams – delivering promising yields at relatively low default rates – as well as seeding a pipeline of potential assets for M&A advisory and direct capital participation. Moreover, falling valuations may significantly increase the short-term demand for debt, particularly for later-stage companies who are reluctant to participate in more expensive down-round equity financing.

Given current market conditions, banks have an unprecedented opportunity to capitalise on a growing industry, and complement their existing external innovation engagement models, unlocking commercial and strategic upside. A growing market, a right to play, and a way to win – banks, are you ready to venture for yield?

Elixirr have helped commercial banks and specialist lenders develop the strategies, business models and operating structures required to effectively capitalise on white-space market opportunities. To find out how we can support you in effectively capitalising on this growing opportunity, speak to us.