New evidence on venture loans

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1 New evidence on venture loans Juanita González-Uribe LSE William Mann UCLA November 21, 2017 Abstract We show that venture debt, a growing segment of venture capital, confers flexibility in the timing of equity raising. In the Preqin database, we show that venture debt constitutes 15% of total venture capital since 2010, most of it coming between the Series A and D rounds. Using novel contract-level data on venture loans, we further show that debt is repaid quickly out of subsequent equity rounds; that default is rare, while prepayment risk is large; and that intellectual property collateral and warrant coverage are prevalent features. We present a model in which venture debt avoids dilution and extends the runway. For valuable comments, we thank Ulf Axelson, Josh Lerner, Adair Morse, Ramana Nanda, Jeffrey Glassman of Ervin, Cohen, and Jessup, and seminar participants in the Entrepreneurial Management Unit at Harvard Business School. All errors are our own.

2 Introduction The choice between debt and equity capital has preoccupied financial economists for decades. A vast theoretical literature demonstrates potential benefits of debt financing, yet these benefits are often difficult to disentangle empirically. Most notably, for publicly-listed corporations, empirical studies often cannot reject the view that the benefits of debt are entirely about tax savings. Other frictions that make leverage attractive, such as information asymmetries or agency problems, are theoretically compelling but less salient. Consequently, it has remained an open question which of the many proposed benefits of debt are empirically important in explaining observed financing decisions. In this paper, we document and study benefits of debt in an underexplored setting, the market for venture debt. This setting is interesting for at least two reasons. First, conventional wisdom downplays the role of debt contracts in innovative industries. Our study is part of a recent literature reappraising this view. Second, companies at this stage are generally unprofitable, so they do not use debt for tax benefits. We show instead that debt is used to wait out perceived equity undervaluations. This theory of venture debt nests two popular narratives: First, that venture debt avoids dilution of the firm s equity owners; and second, that it extends the runway between rounds of equity financing. Flexibility in capital structure choice can be both privately and socially valuable, in that granting more expected rents to the founder increases the rate of socially-valuable entrepreneurship. The departure point for our analysis is the recent growth of venture debt in the United States. We show that debt constitutes 15% of total venture capital investments recorded in the Preqin database since 2009, with a volume of over $8 billion per year in 2015 and For the 3,400 companies in Preqin that have accessed venture debt, venture debt accounts for 23% of the total financing they have raised at the mean (13% at the median). Most of these loans come between the Series A and D rounds of equity financing, when borrowers are still growing and not yet profitable. Nevertheless, they appear willing to employ debt, contrasting conventional wisdom about the capital structure of venture-backed companies. 1

3 We further show in the Preqin data that venture debt arrives at a point in the company s development when the amount of its external financing, and the number of investors from which it raises capital, are both increasing. However, the venture loans themselves are not part of these trends: Their proceeds are small relative to the preceding and subsequent rounds of equity, and over 90% of the time they are originated by only one lender, not cosyndicated. When a subsequent round of equity financing is recorded in Preqin, it usually happens within eighteen months, and its proceeds greatly exceed the amount of the loan. These findings suggest that venture debt plays an auxiliary role in the company s transition between rounds of equity venture capital, an intuition on which we expand below. While striking, these figures leave unanswered many questions about the contracts underlying venture loans. Indeed, data availability has been a general challenge in research on venture debt. Prior studies are generally constrained to survey evidence, or to indirect indicators like the creation of security interests in intellectual property (see discussion below). To address this issue, we introduce a novel, hand-collected dataset of venture loans made by three of the largest lenders in the venture debt market. These lenders are organized as closed-end investment companies that must report their activities to the SEC, and so we are able to gather extensive details on every loan they have made going back to We use this data to shed light on the contractual design of venture loans. We first confirm that venture loans constitute loans in the conventional sense. They are not convertible to equity, and only come with a small degree of warrant coverage, distinguishing them from the traditional convertible note. Interest charges are applied regularly (typically monthly), at yields exceeding those of junk corporate bonds, with the expectation that the loan will ultimately be repaid through future rounds of equity financing. Lenders use security interests or negative pledge covenants to obtain collateral protection, with the borrower s intellectual property serving as the primary collateral. Venture loans thus seem to resemble the traditional concept of a debt contract, as modeled in the large literature on the choice between debt and equity. 2

4 What is the appeal of accessing debt for companies at this stage of the life-cycle? We begin our investigation of this question by ruling out factors one at a time: Tax benefits of debt are irrelevant to unprofitable companies with uncertain growth prospects. The main attraction of a convertible note equity participation without the immediate need to perform a valuation is also unimportant since the loans we study are not convertible. Debt is also not explained by lower coordination and negotiation costs with the venture lender than with the existing venture capital investor, because the decision to structure a round as debt appears to be a cooperative one between these two parties and the borrowing company any costs of dealing with the existing VC would be borne regardless of the debt/equity decision. Moreover, the benefits of venture debt appear to be transitory. This is because venture loans in our sample are repaid quickly: Over 40% of a lender s loan book is repaid on average each year, with the majority of this activity coming from prepayments ahead of schedule. The average loan is thus repaid well within the three to five years of initial maturity stated in the loan contracts. These patterns are consistent with the stylized facts from Preqin as described above, and with anecdotal evidence in our study and elsewhere; but our figures are, to our knowledge, the first quantitative evidence. We conclude from this empirical pattern that the value of venture debt must be closely linked to its timing. Based on these observations, we develop a model in which venture debt is used by a company in transition between equity rounds. We assume that the company must grow by introducing new members into the syndicate of equity investors, as is true in practice. We also assume that the inside venture capitalist has some ability to influence the pricing of future rounds. Because the VC will also participate in those rounds, new equity investors are naturally concerned with the VC s incentives to influence the price. As in Admati and Pfleiderer (1994), we show that these concerns disappear if the inside VC invests a fixed fraction in each round. This requirement has the practical implication that, if the inside VC owns a larger stake in the company at the time of the equity round, then fewer investors can be introduced into the syndicate, limiting the company s growth rate. 3

5 We next introduce an interim period prior to the equity round at which the company must raise capital in order to survive to that round. This can be justified by the common requirement in practice that companies achieve visible milestones before new investors will join, and that those milestones sometimes take a longer time than expected. The inside venture capitalist can arrange the interim financing, but structuring it as equity would exacerbate the problem described above: Because the insider now owns a greater share of the company s equity, either the company will be constrained to introduce fewer investors and grow more slowly, or its valuation in the equity round will suffer due to concerns about the VC s incentive to distort the equity price. Both of these effects harm firm value, and therefore cause the inside-equity interim financing to be dilutive. A debt contract allows the parties to avoid these concerns. Different from an equity contract, the face value of debt becomes an equal obligation of all future investors. This means the inside VC s incentive to misprice at the margin can be eliminated with a larger syndicate than if the interim financing were equity, allowing faster growth and less mispricing concern during future equity rounds. This benefit of outside debt compared to inside equity can be interpreted as avoiding dilution or extending the runway. Outside debt is preferable to inside debt for two related reasons: First, inside debt creates a conflict of interest between the VC s debt and equity claims, giving him the incentive to drive the company opportunistically into bankruptcy, which again harms the valuation that the company can achieve in the equity round. Second, due to these same conflicts of interest, legal challenges in bankruptcy can reduce the priority of the VC s debt claim to that of equity, Our narrative generates several empirically accurate features of the market for venture loans: First, it implies that the decision to originate a loan is a cooperative one (because the outside lender is brought in only to assuage concerns about conflicts of interest with inside debt), and therefore venture lenders are expected to work closely with the existing venture capitalist investor. Indeed, lenders in our contract-level data explicitly appeal to the importance of certification by a venture capitalist, and describe connections with reputable 4

6 venture capitalists as an important source of deal flow. The importance of VC certification for venture loans has also been documented in the interviews conducted by Ibrahim (2010), in the choice experiment of de Rassenfosse and Fischer (2016), and in the empirical analysis of Hochberg, Serrano, and Ziedonis (2017). Second, to overcome residual information frictions, collateral is a critical feature of venture loans. Indeed, we document that venture loans are always collateralized in our contractlevel data, and that the key collateral is the borrower s intellectual property, as emphasized in several recent studies. Borrowers almost always have either patents or trademarks (85% of borrowers have one or both), and have them both more frequently and in greater numbers than non-borrowers in the Preqin data. We further document a connection between collateral value and warrant coverage in venture loans: Borrowers with larger intellectual property portfolios grant larger warrant coverage, both in absolute amounts and as a fraction of loan amount. We argue that this aligns the incentives of the borrower with the lender by promoting continuation rather than foreclosure at the margin, which is important since intellectual property collateral typically represents the firm s core assets. We also show that the importance and prevalence of intellectual property collateral for venture loans is not captured in security agreements registered with the Patent Office. These registrations have formed the basis of some prior empirical work on venture debt, but only capture 37% of venture loans in Preqin. The filings we study suggest that, when a venture debt borrower has intellectual property, it essentially always serves as collateral for the loan. Lenders can effectively obtain a senior collateralized position in the borrower s assets through negative pledge covenants, without formally creating a security interest at all, let alone registering that interest with the Patent Office. This stands in contrast to the situation for mature, public borrowers with more complex liability structures. Finally, we investigate how lenders structure the interest payments on loans to address the prepayment risk posed by rapid repayments of the loans. Origination fees and prepayment fees, while common, do not appear to be large. On the other hand, end-of-term payments 5

7 provide a guaranteed return to lenders regardless of the realized maturity of the loan. These payments are only employed for 23% of loans, yet when used, they are quite large, ranging from an average of 5% of principal up to a maximum of 16%. We document industry heterogeneity in the usage of end-of-term payments: They are the norm for companies in the business services and consumer-goods areas, yet rarely used in the internet, energy, or semiconductor areas, suggesting that sudden, breakthrough success is less common in the latter industries. This heterogeneity is absent for the current-pay component of interest. The most comprehensive prior study of the venture loan market is by Ibrahim (2010), who conducts surveys of market participants to understand the economics of this market. He concludes, consistent with our findings, that venture loans are made early in the company s life-cycle, repaid by later equity rounds, and that their primary attraction is to delay those rounds in the expectation of higher valuation at that time. His interviewees describe venture loans as funding to subsequent rounds of equity (p.1184), and also attest to the growing importance of intellectual property collateral, and the cooperative nature of the decision between the manager, lender, and existing VC investor. In the finance literature, Hochberg et al. (2017) show empirically that venture lenders rely on the certification of venture capitalists. Their study uses the security agreement registrations mentioned above to proxy for the existence of a venture loan. Tykvová (2017) uses venture loan data from Dow Jones Venture Source from 1995 to 2013 to test a signalingbased model of security choice betwen venture equity and venture debt. de Rassenfosse and Fischer (2016) conduct a choice experiment using officers from several prominent venture lenders to assess the factors that affect their lending decisions. Our paper provides, to our knowledge, the first large-sample evidence that combines loan magnitudes with intellectual property statistics, and also provides the first contract-level data on venture loans. More broadly, a growing literature studies debt financing and collateral for low-tangibility, innovative firms. Mann (2017) uses the USPTO patent collateral data to study financing for publicly-listed patenting firms. Robb and Robinson (2012) show that debt financing is more 6

8 common for startups than has previously been realized. Related papers in this literature include Loumioti (2013), Lim, Macias, and Moeller (2017), and Hellmann, Lindsey, and Puri (2008). One distinction between the venture lending market and the settings of those papers is the rapid repayment of venture loans in practice. This pattern means that venture loans do not represent a long-term adjustment to capital structure or leverage ratios. Instead, the benefit of venture loans is connected their timing, as we highlight in our model. Finally, our justification for venture debt appeals to results from the literature on syndication of staged equity financing, e.g. Admati and Pfleiderer (1994), Lerner (1994), and Tian (2012). Our data on BDC lenders also represent a trend towards nontraditional financial intermediaries between households and early-stage firms, similar in spirit to Chernenko, Lerner, and Zeng (2017), who study investments in unicorns by mutual funds. The rest of the paper is organized as follows. Section 1.1 establishes several novel stylized facts about the market for venture loans using data in Preqin, and Section 1.2 builds on this analysis with our novel contract-level data, and also establishes the prevalence of prepayment and collateral. Section 2 lays out a model of venture debt usage based on the facts established in these two sections, then turns back to the empirical analysis to investigate further implications of that narrative. Section 3 concludes. 1 Venture loan market: Stylized facts 1.1 Data from Preqin The first source for our empirical analysis is the data provider Preqin. As discussed in Kaplan and Lerner (2017), Preqin s data are sourced primarily from public filings by pension funds. Secondary sources include Freedom of Information Act requests to public pension funds and voluntary reports from general partners (roughly 60% of the data) and limited partners. One limitation of Preqin is that it may miss some high-performing funds that do not have public pension fund investors or have reporting restrictions. 7

9 Figure 1 displays the aggregate volume of venture loans in the Preqin data by year. The venture lending market has been growing steadily in Preqin since the late 2000s and in recent years has averaged over $8 billion in new loans originated per year. Figure 2 shows that venture debt borrowers are also an increasing fraction of venture-backed companies in Preqin: To construct this figure, we construct separate subsamples of series A, B, C, and D equity rounds in Preqin from For each subsample, we calculate the fraction that are followed by a venture loan to the same company within the next three years. For example, the figure shows that 25% of Series B companies in later years obtain a venture loan within the next three years. This fraction is naturally higher for later rounds of financing, as it becomes more likely that the company survives in Preqin to the next round of financing. Figure 3 translates this fraction to dollar terms by examining the aggregate fraction of venture financing in Preqin that has come from debt in recent years. The figure plots total venture loans, divided by the sum of loans plus Angel, Seed, and Series A through K financing rounds in Preqin. This fraction has grown rapidly since the financial crisis and has hovered around 15% for the last few years in the sample. Figure 4 performs a similar analysis at the company level: For each venture loan borrower in Preqin, the figure plots that company s total borrowing through venture debt, divided by its total venture capital in any form. The mean (median) value of this ratio for Preqin venture loan borrowers is 20% (14%). These calculations from Preqin closely match the magnitudes obtained by other studies using different sources: The interviewees in Ibrahim (2010) estimated the size of the venture loan market to be between 10% and 20% of aggregate venture capital. Using the dollar magnitudes from Ibrahim (2010), de Rassenfosse and Fischer (2016) estimate an aggregate magnitude of one venture debt dollar provided for every seven venture capital dollars invested. Tykvová (2017) calculates that 28.7% of VC-backed companies in Dow Jones Venture Source access venture debt. Furthermore, we will show a similar rate of growth in the smaller contract-level dataset that we employ later, which has constant coverage of lenders over time. The growing aggregate importance of venture loans thus appears to be a 8

10 reliable observation across data sources and methodologies. The remaining figures focus on patterns within the lifetime of the company, developing our narrative about the use of venture loans. We therefore apply several filters to the data to ensure that loans in the data do not appear too far removed from rounds of equity financing, which may happen due to missing equity rounds in Preqin for a given company. First, when we observe an equity round labeled anything other than Angel, Seed, or Series A through D, we drop that and all subsequent observations for the same company. This ensures that we do not include equity investments unrelated to venture capital, such as PIPEs, nor unspecified rounds, and leaves us with 30,780 observations in Preqin, of which 2,382 are venture loans. Next, 382 of these loan observations immediately follow another loan, with no intervening equity round. We interpret these as rollovers or expansions of prior debt rounds, and retain only the first observation in each such spell. Finally, we drop 424 observations (of any type of financing round) that represent multiple financing events for the same company on the same date. This ensures that we can uniquely identify observations by company and date. The final sample is 29,974 observations, of which 1,822 are venture loans, 1,200 are angel financings, 8,424 are seed financings, and 9,104, 5,523, 2,799, and 1,102 are Series A, B, C, and D respectively. This filtered sample will be the basis of the next few figures, which focus on the timing of venture debt in between those rounds of venture equity. Figure 5 examines when venture debt is employed in the lifetime of the company. The figure plots, for each venture debt borrower in Preqin, the equity round recorded prior to the first venture loan date. The figure reveals that the bulk of loans are obtained between the Series A and C rounds. Venture debt is essentially never obtained prior to the seed round, and only somewhat often before the Series A round, but it is also relatively rare after Series D. This squares with intuition about the venture loan market, especially the view that the market supports rather than replaces equity capital usage. To motivate further the distinct role of venture debt at this point in the company s life cycle, Figures 6 through 11 compare venture loans with prior and subsequent rounds of equity 9

11 financing. Figure 6 compares the average syndicate size, and Figure 7 the average proceeds, by stage of equity financing. The figures document two facts that seem, at first, to be in tension with each other: On the one hand, venture loans are obtained at times when the company s external financing, and the number of investors, are increasing. From the Series A to Series D rounds, the average deal size increases by a factor of four, and the average syndicate from roughly two to four investors. On the other hand, the loans themselves do not continue that trend: The average amount of a venture loan is smaller than for any of the rounds following Series A, and loans are almost never originated by more than one lender. To make this point more carefully, Figure 8 modifies the analysis of Figure 7 in two ways. First, it restricts the equity rounds to those that are immediately followed by a venture loan. This makes little difference to the average proceeds by round compared to Figure 7, suggesting that future borrowers are not very different from non-borrowers at the date of the prior equity round, consistent with our view that accessing venture debt is an unexpected contingency. Second, the figure breaks out the average proceeds of a venture loan across the different stages that precede it. This analysis strengthens the prior conclusion that venture loans are smaller than the surrounding equity rounds. Most importantly, although the average venture loan in Figure 7 was bigger than the average series A proceeds, the loans that actually follow Series A financing are smaller. 1 Completing this intuition, we next examine the relationship between the venture loan and the next round of equity capital. Figure 9 plots the empirical density of the time between the venture loan and the next equity round. The next round arrives within three years of the loan the vast majority of the time, and virtually always arrives within five years. Loans typically have a three- to five-year maturity, as we will show with our contract-level data in the next section. For comparison, the figure also displays the distribution of this lag when the current round is an equity round. Across Series A through D rounds, the distribution of 1 Andy Weyer of Square Bank describes a consistent pattern: For early stage companies (i.e., prerevenue, Series A-B), lenders will typically commit 25%-50% of debt relative to the last round of equity (e.g., $1,000,000-$2,000,000 of debt for a Company that recently raised a $4,000,000 Series A). 10

12 time until the next round is similar, and is uniformly longer than for venture loans. As another benchmark for comparison, Figure 10 plots the density of the time since the prior financing round, again separating by round type. Here there is no great difference between venture loans as opposed to any other round. The interpretation is that venture loans arrive at roughly the time the next round of equity financing might have been expected, and thus plausibly in situations where the attainment of the milestone for the next round is unexpectedly delayed; but after being obtained, they are repaid as quickly as possible. Figure 11 further shows that the next equity round is more than sufficient to pay off the venture loan. with an average log growth of 1.68 (that is, the next round is over five times as large as the venture loan on average). In fact, Ibrahim (2010) notes that venture loans are typically made with the implicit expectation of being repaid by the next round of equity financing, and we will show in the next section that this expectation is explicit for the lenders in our sample of venture loan contracts. In sum, venture loans are not best understood as a substitute for equity capital, but rather as a temporary supporting mechanism. These facts motivate a timing-based view of venture loan usage that we will develop below. Figures 9 and 11 are subject to one important caveat: They are conditional on another round of equity financing actually being recorded in the Preqin data. A large fraction of venture loans in Preqin, 35%, are not followed by any subsequent equity financing round in the data. But these should not necessarily be interpreted as events of default, as they may also capture acquisitions and other positive exits that are not recorded by Preqin, righttruncation in the last three to five years of the data, and simply incomplete coverage. We will instead use repayment patterns in our contract-level data in the next section to get a sense of the frequency of defaults and delinquencies in this market The role of intellectual property A voluminous literature studies the role of intellectual property, especially patents, as both a cause and effect of external financing for venture-backed companies. In this section 11

13 we study the amount and type of intellectual property obtained by borrowing companies in the Preqin sample. We match all Preqin companies by name to two datasets: The first is the list of all patents granted to US companies through the end of The second is the list of all trademarks granted to the same companies. Trademarks have been less studied in the finance literature than patents, but they are a more common form of intellectual property among young companies, as we will show. 2 Table 1 restricts the sample to all Preqin companies that obtain a Series A financing at some point, and summarizes these firms intellectual-property portfolios, separating them based on whether or not they ever obtain a venture loan in the data. The table confirms that the existing literature has been correct to focus on intellectual property as an important determinant of external financing for venture-backed firms: While 67% of non-borrowing companies possess either a trademark or a patent, this figure is much higher at 81% for borrowers. This finding is consistent with a large literature focusing on intellectual-property protection as both certification and collateral for prospective lenders. We will return to this idea in our later analysis. The table also demonstrates that trademarks should not be overlooked as an asset class for young firms, despite the traditional focus on patents in the finance literature. Only 29% of non-borrowing firms, and 47% of borrowing firms, possess patents in the Preqin data. In contrast, these figures are much higher for trademarks, at 63% and 75% respectively. The usual focus on patents is based on their interest as an outcome variable: They are likely to reflect innovation, a process of critical importance for economic growth, and therefore the object of much study. However, when the firm s assets are on the right- rather than the left-hand side of the analysis, and understood as mechanisms by which the firm can certify its value to outsiders and offer them collateral protection, then our data suggest that trademarks are potentially as important as patents for this purpose. The lower half of Table 1 examines the intensive rather than the extensive margin, by 2 Appendix B.1 contains more information about trademarks and the public-use dataset. 12

14 restricting to the Series A companies that actually obtain (respectively) patents, trademarks, or either form of IP, and comparing the (log) number of them across borrowers and nonborrowers. The same intuition continues to hold: Converting the log numbers to levels, borrowers with patents have on average 5.6 of them, compared to 3.8 for non-borrowers; borrowers with trademarks have on average 4.8 of them, compared to 3.7 for non-borrowers; and borrowers with either form of IP have on average 7.2 patents or trademarks, compared with 4.8 for non-borrowers. 3 Some prior papers study the debt financing of innovation through USPTO documents that register the creation of security interests in patents. For example, Mann (2017) focuses on the enforceability of these security interests as a constraint on patent collateral value for Compustat companies. Hochberg et al. (2017) use the same documents to proxy for the more general usage of venture loans among venture-stage companies. For comparison with those papers, we next examine how much overlap exists between the Preqin venture loan data and the USPTO patent security agreement records. In Figure 12 we separate Preqin venture loans into four categories: Loans for which a patent security agreement is filed with the USPTO during the same year; loans for which the borrower has patents but does not file a security agreement; loans for which the borrower has no patents, but does have trademarks; and loans for which the borrower has neither patents nor trademarks. The figure records the share of each category, weighted by loan amount. As in Table 1, borrowers with no intellectual property are rare in the data, constituting only 15% of loans. On the other hand, patent security interest records do not complete the picture: Only 37% of our Preqin venture loans can be matched to USPTO patent security agreements that are filed in the same year. The majority of loans are to companies that have intellectual property (either patents or trademarks), but do not file formal security agreements with the USPTO recording a collateral claim by the venture lender. We stress that this finding does not imply that venture lenders do not obtain collateral 3 Table 7 in the Appendix restates all these results as regressions, and shows that they are robust to fixed effects for industry and for the final stage attaine by the sample company. 13

15 protection when making venture loans. The venture lender can obtain collateral protection simply by preventing borrowers from pledging their assets to any other party. While this might not be considered an effective strategy for a large borrower with complex liability structure, it seems to be sufficient for early-stage companies. 4 Indeed, using our contractlevel data in Section 1.2, we will demonstrate that venture lenders always regard themselves as having collateral protection, regardless of whether a formal security agreement is created or registered with the Patent Office. We will thus continue to focus on the importance of intellectual property collateral for debt financing of innovative firms, as in prior papers; but we will not interpret USPTO documentation as a necessary condition for collateral to be economically important in a given loan. These stylized facts shed considerable light on the economics of venture debt based only on the magnitudes and timing of the financing. However, to make further progress in understanding this market, one requires contract-level data that speak to the security design of venture loan contracts. In the next section we introduce a novel dataset that will allow us to offer such a contribution, containing both qualitative discussions and quantifiable statistics. 1.2 Data from business development corporations The contract-level data that we introduce come from a set of three venture lenders that are organized as business development companies. A business development company (BDC) is an investment fund that promotes small-business finance, and benefits from special regulatory treatment under laws passed by Congress in the 1980s. BDCs can sell shares to anyone, not just qualified investors, and distributions receive pass-through treatment with respect to corporate taxes. At the same time, BDCs can invest like a private equity fund, giving them access to illiquid and high-return investment 4 In fact, the role of a patent security agreement is not to perfect the security interest in the patents, which is accomplished through state filings. Instead it is to protect against unauthorized sales while the collateral claim is outstanding, which is more of a problem for larger companies when there is no venture capitalist performing the monitoring function. 14

16 opportunities in privately-held, growth-stage companies. 5 They can also employ up to 50% debt financing to augment their investable funds. The primary costs and obligations of organizing as a BDC are related to distributions and reporting. BDCs must distribute 90% or more of their investment income each year as dividends to their investors. Moreover, they must file financial statements with the SEC, whether or not they are traded on an exchange. This last feature is what allows our data collection exercise. Although the typical BDC does not focus on venture-stage companies, we have identified three that specialize in venture loans. All three rank in the top lenders in Preqin in Table 2, and all three are also in the list of thirteen lenders that Ibrahim (2010) describes as the core of venture lending. Two are also in the top ten lenders in Venture Source as reported by Tykvová (2017). 6 Their SEC filings make their business model clear: Hercules Technology Growth Capital: We are a specialty finance company focused on providing senior secured loans to venture capital-backed companies in technology-related markets, including technology, biotechnology, life science, and energy and renewables technology industries at all stages of development. Horizon Technology Finance Corporation: We make secured loans, which we refer to as Venture Loans, to companies backed by established venture capital and private equity firms in our Target Industries, which we refer to as Venture Lending. TriplePoint Venture Growth BDC Corp: Our investment objective is to maximize our total return to stockholders primarily in the form of current income and, to a lesser extent, capital appreciation by primarily lending to venture growth stage companies focused in technology, life sciences and other high growth industries backed by our Sponsor s select group of leading venture capital investors. Further discussion in the filings illuminates the nature of their investments. For example, Horizon Technology Finance provides the following characterization of venture debt: Venture Lending is typically characterized by (1) the making of a secured debt investment after a venture capital or equity investment in the portfolio company 5 This makes them part of a growing trend by which institutional investors bypass restrictions on their ability to invest in such companies. Chernenko et al. (2017) document a similar pattern with data on mutual funds investing in unicorns. 6 A fourth lender, BlueCrest Capital Finance Corporation, only filed for one year with the SEC. We exclude them from our analysis. 15

17 has been made, which investment provides a source of cash to fund the portfolio company s debt service obligations under the Venture Loan, (2) the senior priority of the Venture Loan which requires repayment of the Venture Loan prior to the equity investors realizing a return on their capital, (3) the relatively rapid amortization of the Venture Loan and (4) the lender s receipt of warrants or other success fees with the making of the Venture Loan. Ibrahim (2010) also documents several stylized facts distinguishing these non-bank lenders from bank lenders, such as the well-known Silicon Valley Bank: Unlike banks, venture lenders organized as funds typically lend in larger amounts, but do not obtain the borrower s deposits, which for banks is a valuable benefit of venture lending. Non-banks are also more likely than bank lenders to employ covenants, again because banks have access to deposit business that provides an alternative monitoring mechanism; but for both groups, covenant structures are generally much less restrictive than for bank loans to mature companies. Lenders instead rely on the monitoring and implicit guarantee of the venture capitalist. For each year that a BDC venture lender files with the SEC, it reports the entire list of portfolio companies to which it has made loans, along with a wealth of data about each loan: The remaining book value and maturity; the seniority of the loan; any accompanying warrant coverage; and the interest rate charged, including details such as whether the interest rate is fixed or floating, how much is current-pay versus end-of-term, etc. These filings constitute, to our knowledge, the first publicly-available contract-level data on venture loans, beyond the simple amount of the proceeds as recorded in Preqin. Just as important, the lenders provide in each filing a qualitative discussion of their business model, akin to the interviews conducted in Ibrahim (2010). In this section, we use the discussions, loan data, and financial statements from the lenders filings to fill in remaining missing pieces of the picture of venture lending. After having done so, we will lay out our model of venture lending, then turn back to the data for further empirical tests suggested by that narrative. 16

18 1.2.1 BDC venture loan data and comparison with Preqin The contract-level data include 787 loans to 534 distinct portfolio companies. Portfolio companies are about one-third healthcare; one-third software, telecommunications, and internet; and one-third other categories including clean technology and business services. High-profile technology and media borrowers in the sample include Box, Modcloth, Sling Media, SugarSync, and Thrillist. Figure 15 documents an upward trend in the combined volume of lending by the BDC lenders in our sample, to over $600 million per year in each of the last four years, similar to the trend for Preqin overall. Of the companies in the BDC data, 398 of them (75%) can be matched with Preqin data on equity financing rounds. For these companies, we can fill in the surrounding details of their equity financing rounds and compare with the Preqin data. Figure 16 shows the prior stage of recorded equity financing for borrowers in the BDC data that can be matched to Preqin, restricting the sample of loans to those for which the prior recorded stage is Seed, Angel, or Series A through F. Compared to Figure 5, the recorded stages are later in the company s life cycle, with the most common prior round being Series C. The amounts of the loans in the datasets provide further evidence that venture loans are made later for the BDC as opposed to the Preqin lenders: Figure 17 compares the (log) principal amount of venture loans in the two datasets, without restricting to the subset of borrowers that can be matched across the samples, and shows that BDC loans are larger than the average Preqin venture loan, as suggested by Ibrahim (2010). However, Figure 18 removes fixed effects for the prior recorded round of equity financing (equivalently, subtracts out the average loan size by stage), and reveals that there is little remaining difference in the distribution of average loan amounts across the two datasets. Finally, Table 3 compares the intellectual property portfolios of borrowers in the contractlevel data compared to the average Preqin borrower. The left column in the table corresponds to the Preqin borrowers that do not appear in the BDC sample, and thus almost matches the right column of Table 1. The right column corresponds to borrowers in the BDC sample, 17

19 including those that can be matched to Preqin. The two subsamples are equally likely to have patents, at about 47% of borrowing companies. Interestingly, BDC borrowers are significantly less likely to have trademarks, at 65% compared to 74%, and as a result 33% of BDC borrowers have neither category of intellectual property, compared to only 20% of non-bdc borrowers. However, conditional on having any form of intellectual property, the BDC borrowers have much more of it, as summarized in the last three rows of the table New facts in the BDC data The first and most simple fact to establish is that venture loans are indeed debt, not convertible securities or other types of hybrid contracts. While this fact has been implicitly assumed in prior studies of venture loans, it has not been possible to establish with certainty. However, it is made clear by the discussion in the BDC filings. As with any traditional loan, lenders highlight the importance of collateral, and especially intellectual property. Importantly, even when the loans are not explicitly secured, lenders obtain a negative pledge covenant preventing a collateral claim on the company s assets by any other party, so that the lender is effectively always the secured party. 8 Lenders do receive some measure of convertibility via warrant coverage, which is present in 73% of loans. However, these warrants are economically quite small: The carrying value of the warrants reported in the lender s financial statements (which they calculate following a Black-Scholes approach based on the company s concurrent valuation) is only 1.4% of the principal amount of the loan at the median, and 3% at the mean. (In dollar terms, the mean and median are $90,000 and $215,000.) The economic role of such a ubiquitous, yet small, amount of warrant coverage is not immediately obvious. 9 In later analysis, based 7 Table 8 in the Appendix restates all these results as regressions, and shows that they are robust to fixed effects for the borrower s industry. 8 Hercules s 10-K for 2013 has the following information: At December 31, 2013, approximately 62.8% of the Company s portfolio company loans were secured by a first priority security in all of the assets of the portfolio company (including their intellectual property), 37.1% of portfolio company loans were to portfolio companies that were prohibited from pledging or encumbering their intellectual property, and 0.1% of portfolio company loans had an equipment only lien. 9 Ibrahim (2010) downplays the importance of warrant coverage based on his interviews with venture 18

20 on our theoretical discussion, we will argue that warrant coverage mitigates opportunistic foreclosure against intellectual property collateral that also represents the firm s core assets. One of the most immediate puzzles with the use of debt by a young, unprofitable, growing company is how the company can expect to repay that debt within the set horizon dictated in a loan contract. Even more puzzling is the fact that venture loans typically include current-pay interest, not just end-of-term (EOT) or payment-in-kind (PIK). This means that cash interest payments are due regularly from the start of the loan, and thus increase the company s cash burn rate. Indeed, in our sample, nearly all loans have cash interest payable monthly (with some featuring additional EOT or PIK interest). Repaying this debt seems like a difficult and strange commitment for a venture-stage company to make. The resolution to this puzzle, as noted in Ibrahim (2010) and other prior work, is simply that the commitment is not made by the company per se. Instead, the lender s expectation is that the company will achieve an additional round of equity financing that will be enough to repay the loan prior to maturity. In the meantime, cash payments are made out of the initial proceeds of the loan. Indeed, the implicit guarantee from equity investors is a critical aspect of venture debt financing. The value of this guarantee was empirically documented in Hochberg et al. (2017), and it is clearly referenced in the quotations above, where lenders acknowledge that only venture-backed companies are targets of venture loans. Thus, venture lending is a complement to, not a replacement for, traditional equity-structured venture financing. Its main role is to facilitate the optimal timing of the next equity raise, which is expected to happen in any case. We will expand on this view in the remaining sections. Thanks to the implicit guarantee of a venture capitalist, venture loans achieve remarkably low default and delinquency rates, despite the high-risk nature of their borrowers. This could not be completely established in the Preqin data, as many borrowers disappear from the data without taking out another equity round after the venture loan. The BDC filings do not report default or delinquency patterns at the loan level either. But they do provide statistics lenders, calling it only a nice bonus. However, de Rassenfosse and Fischer (2016) dispute this conclusion, as they find that warrant coverage makes a large difference in the loan decision in their choice experiment. 19

21 at the level of the lender s portfolio, and these suggest that loss rates are quite small. Hercules Capital reported only five debt investments in non-accrual status at the end of 2016, worth $44 million at cost, on a total loan book of $1.4 billion. Even if completely written off, this would represent a loss rate of about 3%, close to recent default rates on junk corporate bonds, though likely with lower recovery rates. 10 The rapid repayment patterns suggested by the Preqin data are also borne out in our contract-level sample. Table 4 reproduces the total repayment rates reported by the three BDC venture lenders for the years in our sample. Prepayments match or exceed scheduled repayments in every year, implying that loans are repaid rapidly. Despite low loss rates and timely repayments, returns on venture loans are quite attractive possibly in part as compensation for large prepayment risk, rather than default risk. Figure 19 shows the distribution of current-pay interest rates in the sample of BDC venture loans, which is centered at around 10%. The effective yield is higher thanks to end-of-term payments, payment-in-kind interest, and various fees, so that lenders report higher yields on their loan portfolios, of around 13% per year. We discuss the structure of interest rates and fees in Section Model and empirical extensions 2.1 The role of venture debt Modigliani and Miller (1958) showed that, in a benchmark model, managers should not prefer to use debt over equity financing. The most prevalent departure from their benchmark, the deductibility of interest payments from pretax profits, is not operative for the unprofitable firms in our sample. Yet the venture lenders in our study perceive themselves as supplying an unmet demand for debt financing among venture-stage companies. In this section, we lay 10 Moody s reports default rates for speculative-grade companies as 4.5% in 2016, and forecasted this rate to fall to 3% by the end of See Moody s Investor Service, Annual Default Study, Corporate Default and Recovery Rates,

22 out a simple model to rationalize the source of this demand. Our model builds on an insight in Admati and Pfleiderer (1994): When an inside venture capitalist has influence over the pricing of a later round of equity issuance, he internalizes incentives both to overprice (as an existing shareholder) and to underprice (as an investor of new capital). These incentives can be balanced against each other by maintaining a stable ownership stake for the VC from one round to the next. In their model and in ours, these effects can be perfectly balanced if the VC keeps a constant stake, so that there is no mispricing incentive at all. 11 We add to this insight the possibility that the company must raise financing at an interim date prior to the equity financing date. The key security-design insight in our model is that when unexpected financing needs arise, it is optimal to use the financing source that has the least distortionary effect on the existing ownership structure of the company. When we take into account legal challenges facing the use of inside debt, we arrive at outside debt with maximal collateral value and rapid repayment as the optimal financing contract. Our model has three dates, t = 0, 1, 2, which we describe in reverse order: At time two, the value of the company will be realized as a payoff θ, which is distributed to all stakeholders according to financial contracts signed in the prior periods. The discount rate applied by all investors to this value is R. At time one, the company must obtain financing equal to I 1. It does so by raising equity capital from a syndicate of size N, which will include an inside venture capitalist (VC), who already owns a share α 0 of the company s equity. For simplicity, we assume that all members of the syndicate will contribute an equal share of funds, I 1 N, and they will also receive an equal share of the company s equity in exchange. The share of equity α 1 that each syndicate member demands at time 1 will be determined by their common valuation of the company, θ. This valuation is not necessarily equal to the true value θ. We assume that the VC observes θ, and has some influence over the value of 11 Lerner (1994) finds empirical evidence of the dynamics of ownership stakes predicted by the model in Admati and Pfleiderer (1994). 21

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