Venture Debt Financing: Determinants of the Lending Decision

• Author: Timo Fischer,Gaétan Rassenfosse
• Date: 01 September 2016
• DOI: http://doi.org/10.1002/sej.1220
• Published date: 01 September 2016

VENTURE DEBT FINANCING: DETERMINANTS OF THE

LENDING DECISION

GAÉTAN DE RASSENFOSSE

1

* and TIMO FISCHER

2

1

College of Management of Technology, Institute for Technology and Public Policy,

Ecole polytechniquefédérale de Lausanne, Lausanne, Switzerland

2

Technische Universität München, Munich, Germany

Research summary: Venture debt lending is a form of start-up financing that lies at the

intersection of venture capital and traditional debt. We analyze the lending decision

criteria of 55 seniorU.S. venture debt lenders (VDLs)using a discrete choice experiment

in order to understand how VDLs overcomebarriers that traditionally hamper start-ups’

access to debt. We find, first, that theprovision of patents as collateral isas important as

the provisionof tangible assets to lenders.Second, VDLs showed a markedpreference for

start-ups that offered warrants. Third, venture capitalists’backing substitutes for a start-

up’s positive cash f lows.

Managerial summary: This article provides insights into the business model of venture

debt lenders.Venturedebt is an equity efficient way to raisemoney: it limits equity dilution

by prolonging runways and allowing entrepreneurs and investors to raise equity at the

next funding round at a higher valuation. The research suggests that venture debt plays

an important role in new venture financing, with about one venture debt dollar provided

for everyseven venture capital dollarinvested. It further suggeststhat backing by venture

capitalists (VCs) and the provision of patents as collateral significantly increase the

chance of obtaining venture debt. Therefore, it provides additional rationalesfor having

VCs onboard and for applying for patents. More generally, the research illustrates that

debt, in the form of venture debt, is available to start-ups with negative cash flows and

no tangible assets. Copyright © 2016 Strategic Management Society.

INTRODUCTION

Venture debt lenders(VDLs) are specialized financial

institutions that provide loans to start-ups. Loan

recipients usually operate in high-tech industries such

as biotechnology or information technology (IT).

They have negative cash flows and no tangible assets

to secure the loan.Venture debt financing is, thus,not

traditionalbank financing. This relativelynew form of

start-up financing lies at the intersection of venture

capital and tradit ional debt.

The U.S. venture debt industry is sizeable despite

its young age. A recent estimate by Ibrahim (2010)

puts it somewhere between $1 billion and $5 billion

per year. According to the estimates presented in this

article, the industry provided at least $3 billion in

loans to new ventures in 2010, which is about one

venture debt dollar for every seven venture capital

dollars invested. To be clear, venture debt loans do

not encompass supplier credits to start-ups secured

by suppliedgoods or convertible loans that come from

venture capitalists (VCs) or business angels. They

Keywords: discrete choice experiment; patent collateral; patent

signaling; venture capital; venture debt

*Correspondence to: Gaétan de Rassenfosse, College of

Managementof Technology, Institutefor Technology and Public

Policy, Ecole polytechnique fédérale de Lausanne, Odyssea

Station 5, CH-1015 Lausanne, Switzerland. E-mail: gaetan.

derassenfosse@epfl.ch

Strategic Entrepreneurship Journal

Strat. EntrepreneurshipJ.,10:235–256 (2016)

Published online14 June 2016 in Wiley Online Library (wileyonlinelibrary.com). DOI: 10.1002/sej

Copyright © 2016 Strategic Management Society

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also do not encompass loans to ventures that have

stable positive cash flows.

1

Despite its widespread use in practice, academic

studies have overlooked the venture debt phenomenon.

Scholarly research on the topic comprises only case

studies and field interviews. Some authors have studied

a particular lending transaction (Crawford, 2003;

Roberts, Sahlman, and Kind, 2008), and others have

looked more broadly at the business model of VDLs

using qualitative research methods (Mann, 1999;

Hardymon and Leamon, 2001; Hardymon, Lerner,

and Leamon, 2005; Ibrahim, 2010).

In this article, we empirically analyze the venture

lending decision criteria in order to understand how

VDLs overcome barriers that traditionally hamper

start-ups’access to debt. The analysis relies on a

discrete choice experiment conducted with 55 senior

venture lenders working for companies that cover at

least 60 percent of the U.S. venture debt market. The

findings are threefold.

First, we find that the provision of patents as

collateral is as important to lenders as the provision

of tangible assets; however, it does not substitute for

it. This result contributes to the literature on

intellectual property and start-up financing (Conti,

Thursby, and Thursby, 2013a; Conti, Thursby, and

Rothaermel, 2013b; Hsu and Ziedonis, 2013; Hoenig

and Henkel, 2015). Previous research has established

that patents facilitate access to equity, whereas we

show that patents also facilitate access to debt.

Second, VDLs showed a marked preference for

start-ups that offered warrants, which helpsovercome

the agency problems usually associated with loans

(Green, 1984; Brennan and Kraus, 1987). Whereas

previous research on venture debt described warrants

as a ‘nice bonus’(Ibrahim, 2010: 1183), our results

indicate that lenders actually highly value warrants

in the lending decision.

Third, we find that start-ups’VCs backing

substitutesfor positive cash flows only at earlystages,

not at later stages,of VC engagement. This result adds

another element to the list of benefits associated with

having VCs on board (e.g., Sapienza, Manigart, and

Vermeir, 1996; Stuart, Hoang, and Hybels, 1999;

Hellmann and Puri, 2002; Hsu, 2004). Besides acting

as certification agents to less informed investors and

providing strategic advice to start-ups, our findings

show that VC backing also increases the financing

capacity of start-ups by facilitating access to debt.

LITERATURE ON NEW VENTURE

FINANCING

Equity versus debt financing of new ventures

Start-ups receiveventure debt in the phase after initial

insider financing provided by the start-up team,

family, friends, and angel investors and before access

to public equity and debt market s. Firms in this phase

of the financing cycle have access to intermediated

financing in the form of equity provided by VCs and

debt provided by banks and specialized finance

companies. As pointed out by Berger and Udell

(1998), conventional wisdom holds that equity is the

primary funding for firms in that phase. However,

new ventures do rely on debt. Cassar (2004) reports

that 90 percent of new ventures in Australia in the late

1990s had some form of debt financing. In addition,

bank financing provided a sixth of the financing of

new firms. A combination of demand-side and

supply-side factors helps explain the debt-equity ratio

of new ventures.

The trade-off theory of capital structure captures

the demand-side factors. It holds that firms choose

their optimal debt-equity ratio by balancing the costs

and benefits of these financing modes (Kraus and

Litzenberger, 1973). Winton and Yerramilli (2008)

and de Bettignies and Brander (2007) model such

trade-offs in the specific context of new ventures.

On the plus side of venture capital, the entrepreneur

benefits from VC involvement in two main ways: it

acts as certification agent to outside stakeholders

(Stuart et al., 1999)and it brings managerial input that

increases the venture’s chances of success (Sapienza

et al., 1996; Hellmannand Puri, 2002). On the minus

side, the entrepreneur partially loses ownership and

control of his/her venture (Hsu, 2004; Ueda, 2004).

Supply-side factors also help us understand the

debt-equityratio. New ventures have peculiarities that

1

The case of Box.net represents a typical example of a venture

debt transaction. Founded in 2005, thecompany provides cloud

content management to business customers. Despite completing

a $6 millionSeries B round of funding in2008, the company still

needed additional funding to continue the development and

marketing of its platform. However, money was scarce, and the

management team wasreluctant to dilute the equity any further.

Box.netobtained a $3 million loan in the formof senior debt from

Hercules Technology Growth Capital, a specialty finance

company.The deal also involved preferredstock warrants,valued

at $48,000 at the end of 2008. This extra money allowed the

company to bridge a funding gap during a time of difficult

macroeconomic conditions, and Box.net eventually raised

another $7.1 million from its previous investors at the end of

2009. (Sources: press releases, SEC regulatory filings, and

company’s Web site.)

236 G. de Rassenfosse and T. Fischer

Copyright© 2016 Strategic ManagementSociety Strat. EntrepreneurshipJ.,10:235–256(2016)

DOI: 10.1002/sej