Yep, more later-stage companies are taking on venture debt

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Venture debt has been much in the news lately. Earlier this month, for example, we learned that ModCloth, an online company that sells vintage womens apparel, is being acquired by for less than investors poured into the company largely because ModCloth was tripped up by unsecured bank debt.More recently,we learned that after failing to land an investor or buyer, themusic streaming service SoundCloud decided to raise a $70 million debt round.

Are desperate times beginning to call for desperate measures? That might be an overstatement. At the same time, theventure debt firm Western Technology Investmenthas seen plenty of cycles and amassed plenty of dataover its 37 years in the business, and CEO Maurice Werdegarsays the firm just finished its busiest quarter ever.

We talked with him late last week in a chat thats been edited for length.

TC: It seems like venture debt is popping up in more deals. True or not true?

MW: Thelong trend is definitely that venture debt continues to play a moderately increasing role. The role its intendedto play is to complement a companysequity strategy to help extend [funding] from one round to the next, adding time and giving companies and their teamsthe optionality of having more data and reaching certain inflection points beforeheading into that next round.

TC: And youve traditionally focused on early-stage companies as a result. You provided debt to as part of itsmassive Series A round, for example. But it seems like later-stage companies are using more debt, too.

MW: Weve been very busy in late-stage rounds, too. I think people raise a little too little capital; they underestimatehow long it will take to raise their next round, so debt has become an interesting supplement to that.

TC: Are you seeing an uptick in the number of older companies knocking on your door?

MW: We cant get all the deals coming to us [there are so many]. Of course, theres always the adverse selection question that goes hand-in-hand with that demand: Are you getting the call becausethings arent going well or are these companies that are trying to be more thoughtful and strategic and proactive about their fundraising?

TC: Can you name names or sectors?

MW: Its just a giant pool of companies. If you think of the 30 most important companies over the last 15 years, we visited with more than 20 percent of them. Its a core part of the way that companies think about optionality.

TC: What do you make of this SoundCloud deal?

MW: The lenders in that [deal] arecounting on SoundClouds enterprise value being enough to cover its debt [as collateral].That wouldnt be a bet that Id necessarily be as comfortable with. Things can go wrong and collateral can be worth less than you think. When things fail, they fail badly. Companiesjust go out of business.They can definitely go to zero in this industry. Ive never met withSoundCloud and Im not saying anything about thecompany specifically, butthe idea of being the last-resort stop is dangerous.

TC:Yourindustry is known for taking money back when it gets nervous. Do you think founders fully understand how covenants work?

MW: We dont take covenants, actually. Other approaches [from other debt lenders] are to take more risk but to be able to get their cash back if they are nervous. So they monitor companies performance and if theyre nervous, they can either force VCs to put in more money or get their money back. Its a little likethe insurance policy that doesnt work when youre in anaccident.

[Silicon Valley Bank]s debt is very inexpensive, for example, but it comes with covenants. Were on the more expensive side, but its more like equity.Were pretty open about the fact that wevelost money more than 100 times, and by the way, we always see the trouble coming.

TC: Is more trouble coming now, broadly speaking?

MW: Everyone needs to grow into their valuations, and thats not easy to do if you raised in 2015, which was the high-water mark in a lot of rounds. So Id say instead that a lot of insiders are looking at debt as complementary, to make each roundlast longer. You can only do so many inside rounds before insiders get tired.

TC: So it does sound like youre seeing more older startups.

MW: Were having the most active quarter in our 37 year history period.Is there an uptick in older companies? Yes, but they feel like healthy companies that are nearing profitability [and theyre coming to us for a variety of reasons]. Their investors might be tired. They might not like the valuation theyd get if they were to head out right now. They might want to wait on a strategic [investor or acquirer] to get a better price. They might be wanting to make an acquisition and to use venture debt for that.

They might also be looking to refinance other venture debt. In some cases, lenders wont renegotiate, so companies are looking for other ways to [stretch out their funding]. Its not unlike refinancing your home to get a lower payment.

TC: How can founders be sure theyre striking the best deal when it comes to venture debt?

MW: Different lenders take different approaches, some with hidden covenants and clauses, but Id say its their law firms job to advise them. Theyve seen every lender 50 times so should be able to advise on what these different deals mean.

TC: How big is this market right now?

MW: There are around18 venture debt players; its avery robust market. We represent about 10 percent of the venture market, if you were to market size it. So if you read that startups raised $20 billion last year, then that probably includes about $2 billion of venture debt.

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