On the podcast: The venture debt playbook

As the markets have turned south, venture debt seems to have become all the rage. But how many startups are actually raising it?

This week, Armentum managing partner John Markell joins the podcast to unpack the world of venture debt. Markell shares his thoughts on how venture lenders go about underwriting young companies, why investors are souring on the consumer market, how venture debt differs from structured equity, and which types of startups should—or really shouldn’t—raise debt.

In this episode of Sapphire Ventures‘ series “GameChangers,” Sapphire partner and Head of Revenue Excellence Karan Singh speaks with Forter’s Chief Revenue Officer Marcus Holm about unlocking seller productivity and repeatability through value realization methodologies.

Listen to all of Season 6, presented by Sapphire Ventures, and subscribe to get future episodes of “In Visible Capital” on Apple Podcasts, Spotify, Google Podcasts or wherever you listen. For inquiries, please contact us at podcast@pitchbook.com.


Marina Temkin: Hi, John. Welcome to the “In Visible Capital” podcast. Today, we’re going to be discussing venture debt. Could you please introduce yourself, your firm Armentum, and what role you play in the venture debt universe?

John Markell: Thanks, Marina. My name’s John Markell. I’m a managing partner at Armentum Partners. The role we play in the venture debt universe is we are advisers to technology and healthcare companies that are looking to raise venture debt as part of their capital-raising strategies. We help them raise the debt they want at terms that are optimized for their needs.

Marina: How long have you been around, and how has the venture debt landscape changed over those years?

John: We, as a firm, have been around for a little over, I want to say in earnest, about 11 years. Chris Carthy and I started the firm. Chris had started on the healthcare side. I started on the tech side. The market’s changed a lot, is the short answer. I guess part of this interview is to talk about how, but probably the most obvious thing to us is just awareness that venture debt is a funding tool for companies that they hadn’t previously thought.

Under the awareness category, I think companies now have a better understanding that it’s not just, “Oh my gosh, they’re going to take the keys to the company,” [and] that it’s actually quite a friendly funding tool.

Marina: I understand that there’s been a lot of new players that have entered the market over those years. Why are there new entrants into venture debt?

John: This is where I could take one of two tacks. One is because we’ve been doing our job, and we’re yelling from the rooftop the value of the asset class. That’s probably a tiny little part. But in reality, I believe it’s because venture debt as an asset class under the category of private credit is really attractive from a risk-reward perspective.

I think, even to this day, it’s not intuitive to a lot of the new entrants. I think because the word venture is associated with it, and because it’s so closely tied to venture capital, where they read article after article about how venture capital firms make their funds on one, two, three investments out of 20. There’s this, perhaps incorrect leap or assumption that venture debt must be almost as risky.

That’s simply not the case. I think the data has shown that it’s actually quite a safe asset class. Loss rates, certainly for, I’m going to say the most active 30 venture debt lenders, are below mid-market cash flow lending loss rates, and the returns are higher. Some of the larger credit funds look at this and go, “Gee, why aren’t we in this?”

Marina: I also understand that part of the reason there has been a lot more interest in the asset class, other than it turned out to be a rather safe, surprisingly safe, and surprisingly lucrative asset class, is that the sizes of the loans have increased tremendously over the years. Did that happen inline with the venture universe growing, or is there something else at play? Are startups more open to taking on more debt? Does that usually happen with the blessing of their venture capitalists?

John: There’s a lot to address there and unpack. I think one of the overarching drivers of loan sizes and just venture volumes increasing has happened because it’s piggybacked off of just private credit generally increasing. If you look at private credit today versus 10 years ago, it’s like 7x or 8x or even more. I don’t even know the data. It’s crazy. I just know that it’s straight up. That’s one factor. The other factor is the venture debt product or products have evolved to better suit the various borrowers of those products.

When we started in this business a little over a decade ago, I used to use the analogy that each lender’s widget was their term sheet. Like Apple sells this. This is what they sell, and they sell a phone. A lender sells a term sheet, and that term sheet, by and large, looks kind of the same for most deals. They tweak it on the edges, but years ago, the term sheet that you’d get from Pick a Lender, Hercules, TriplePoint, WTI, or whatever, it kind of looked the same for an ecommerce company as it did for an adtech company as it did for an enterprise software company.

As the market evolved, new entrants came in. Those loan products also evolved to fit the use case, the need, the risk. I think that was happening on the product side. On the, call it, ecosystem side, you had more and more venture capital firms, like the investors in these portfolio companies, getting a lot more comfortable with the venture lenders. They were realizing that, hey, these lenders aren’t just going to say, “Give me the keys to the company.” They really don’t have any interest in owning the company, and I think most venture debt lenders will identify themselves as relationship lenders.

It’s this approach that I think the venture debt firms have taken with those investors to say, “Hey, we have a problem. What can we do to fix it?” As opposed to consulting the loan and security agreement saying, “This is what we must do here, because it says we need to do this here.” There was a lot more, I’m going to call it, relationship furtherance between venture debt lender and venture capital investor broadly in the market, such that, “Okay, then maybe we can put a little bit more leverage on the company. Maybe we can put a little bit more leverage on the company.”

We still believe in many cases, companies are safely levered because of this phenomenon, if you want to call it a phenomenon. I think that’s a big part of why borrowers are borrowing more, or why they’re able to borrow more, because the product has evolved to fit the situation a little bit.

Marina: Broadly speaking, how do venture lenders make decisions about the creditworthiness of a startup, because all the startups, for the most part, are cash flow negative. In traditional lending, you’re either lending against assets of the company or cash flows of the company. For the most part, startups don’t have either of those.

John: Right. The way we simply view the lending world is, there are three types of loans, but like you mentioned, two of them you mentioned. There’s cash flow loans, which the underwriting is predicated on the lender’s view that the company will have enough cash flow to sustain and then ultimately repay the loan. Asset-based lending, where the underwriting is based on assuming that an orderly liquidation of the assets exceeds, the value that’s received from that, exceeds the value of the loan.

Then the third type is mostly where we spend our time and which is how venture debt define what’s called enterprise value lending. Enterprise value lending isn’t quite as neatly defined the way the other types of lending are. With enterprise value lending, lenders are generally looking for, not just an underwriting anchor to get comfortable with but perhaps a couple of things that together constitute an underwriting anchor. The best proxy is, “Well, what was the last valuation?”

The other thing is, does the IP have value, and not so much in the context of does it have value where we can offensively enforce any infringers, but rather, is this IP worth something to someone else if they were to acquire it?

IP is sort of a weird thing in that there’s no defined value for it. It’s worth as much as someone’s willing to pay for it. Those are just some examples of how lenders will get comfortable doing enterprise value lending. I should probably note, that type of analysis varies depending on the stage. When we’re talking to clients who haven’t done this before or have done it a few times, a venture debt loan being underwritten for a company that is, call it, Series E or pre-IPO, the underwriting is going to be very different than a Series A.

We always say it’s a two-pronged approach, where one prong is the lenders going through and trying to ascertain the inherent creditworthiness of the business itself. The other prong is, “Okay, who’s in the equity syndicate? What was their underwriting thesis? Is there more capital from this equity syndicate?”

In other words, they’re assessing future financing risk from the parties already involved in the business, and they ascribe value to that. A Series A company, they’re going to ascribe a lot of value to that latter prong. A Series E type of company, they’re going to ascribe much less value to that latter prong and more value to the inherent creditworthiness in business, so it shifts over time.

Marina: From what I understand is that historically, venture debt, and correct me if I’m wrong if this was more on the early-stage side, historically, it followed a venture equity round. But this year, there’s been a downturn in the public markets and venture capitalists retreated and they’re much more reluctant to fund startups, partially because of valuation having fallen. A lot of startups have turned to venture debt to extend their runway. But at…

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2022-11-14 22:00:00

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