The venture debt landscape has undergone significant change over the past couple of years.
Banks are increasingly offering larger and larger venture debt commitments to emerging market companies, and at lower costs, says Daniel C. Pistone, senior vice president and manager in Bridge Bank’s Technology Banking Division.
“This lower priced debt is making it very difficult for non-bank venture debt firms to compete in the market due to risk/return requirements sought by these investors,” Pistone says.
“New venture debt fund formation has been challenging and at the same time, we’ve seen several venture debt firms close over the past two years.”
There are still a handful of active non-bank venture debt lenders, but due to this increased competitive pressure from banks, it’s important to ask: what should we expect to see for venture debt going forward?
Smart Business spoke with Pistone about the changing venture debt landscape.
What is venture debt?
Venture debt allows emerging technology companies to extend their financing runway with capital that does not carry the same dilution to ownership that comes with raising equity.
It is structured more liberally than traditional lending products in that it lacks the covenants and conditions characteristically in place to track a borrower’s financial health.
Instead, the underwriting for venture debt relies more on the analysis of intangible metrics like investor support, market potential and its unique proprietary position. In return for less strict borrowing requirements, venture debt comes at a higher price to businesses than traditional debt financing.
How has the venture debt landscape changed in recent years?
In recent years, there has been significant disruption in the venture debt community.
Whereas this lending product has historically been supplied primarily by specialized venture lending firms, more and more banks are moving into the space.
In addition to being able to offer lower rates due to lower cost of capital, banks can provide a one-stop shop for all banking needs versus just providing a single venture debt loan. As competition increases and banks compete more aggressively, more and more venture debt firms are being pushed out of the space causing further disruption in the industry.
Where is the industry today?
There continues to be price pressure in venture debt with banks offering consistently lower rates. We’ve likely reached the point where there is a need for caution due to the inherent risk in venture debt.
Common sense says that higher risk carries a premium return, but today that premium has diminished significantly. The argument against the need for concern is that the asset class has experienced limited losses and that lower yields are adjusting to create parity with risk involved.
But as banks continue to lower their rates, a delta is being created in what is appropriate for compensation vs. risk undertaken.
What is your outlook on the venture debt asset class?
If current trends continue, the venture debt community will not be compensated for the risk that they have undertaken.
While traditional debt structures provide early-warning signs through covenants, venture debt lacks those early indicators, making it harder to gauge when things might be heading south. Proper pricing of risk is critical and just because the banking community doesn’t have minimum return hurdles, they shouldn’t be underpricing risk.
What advice would you give to an entrepreneur seeking venture debt?
For an entrepreneur seeking venture debt it is logical to grab cheap capital when available. But it’s important to ensure that the venture debt provider is able to support you throughout the entire relationship.
There’s the saying, “If it seems too good to be true, it probably is.”
Being cautious and understanding when a market has become too frothy will hopefully help both lenders and borrowers make more informed choices in who they partner with. ●
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