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«DEBT AS VENTURE CAPITAL Darian M. Ibrahim* Venture debt, or loans to rapid-growth start-ups, is a puzzle. How are start-ups with no track records, ...»

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IBRAHIM.DOCX (DO NOT DELETE) 7/8/2010 9:10 AM

DEBT AS VENTURE CAPITAL

Darian M. Ibrahim*

Venture debt, or loans to rapid-growth start-ups, is a puzzle.

How are start-ups with no track records, positive cash flows, tangible

collateral, or personal guarantees from entrepreneurs able to attract

billions of dollars in loans each year? And why do start-ups take on

debt rather than rely exclusively on equity investments from angel investors and venture capitalists (VCs), as well-known capital structure theories from corporate finance would seem to predict in this context?

Using hand-collected interview data and theoretical contributions from finance, economics, and law, this Article solves the puzzle of venture debt by revealing that a start-up’s VC backing and intellectual property substitute for traditional loan repayment criteria and make venture debt attractive to a specialized set of lenders. On the firm side, venture debt helps entrepreneurs, angels, and VCs avoid dilution, improves VC internal rate of return, assists VCs in monitoring entrepreneurs, and follows from capital structure theories after the first round of VC funding.

TABLE OF CONTENTS

I.  Introduction

II.  The Venture Debt Puzzle

A.  Conventional Wisdom

B.  Reality

C.  Tools for Solving the Puzzle

III.  Lenders’ Perspective

A.  Lenders’ Financial Motivations for Making Loans.................1182  * Assistant Professor, University of Wisconsin Law School. For helpful comments, I would like to thank Bobby Bartlett, Brian Broughman, Bill Carney, Vic Fleischer, Dave Hoffman, Ronald Mann, Larry Ribstein, Gordon Smith, Chuck Whitehead, and participants in faculty workshops at Wisconsin and Western New England, an INSITE Interdisciplinary Research Seminar at the Wisconsin-Madison School of Business, Gordon Smith’s Law and Entrepreneurship class at BYU, the 2009 Law and Society Conference, and the Fourth Annual Big Ten Aspiring Scholars Conference at Illinois. Thanks to several of my Wisconsin colleagues including Kathie Hendley, Stewart Macaulay, and Bill Whitford for useful discussions about interviewing methodology, and to Cheryl O’Connor in the Wisconsin Law Library for valuableresearch assistance. Most importantly, I thank all of the venture lenders who agreed to be interviewed for this project. My promises of anonymity prevent me from naming them here, but as I have told them privately, their participation was critical to the project’s success.

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–  –  –

B.  Overcoming Practical Hurdles: The Implicit Contract with VCs

1.  Venture Capital as a Substitute for Cash Flows...............1184 

2.  Intellectual Property as a Substitute for Tangible Collateral

C.  Are Start-ups Irrelevant?

1.  Selecting Start-ups

2.  Monitoring Start-ups

IV.  Equity Investors’ Perspective

A.  Equity Investors’ Financial Motivations for Taking Loans...1196 

1.  All Equity Investors (Entrepreneurs, Angels, and VCs)

2.  VC Specific

B.  Capital Structure Theories and Venture Debt

1.  Modigliani and Miller Irrelevance Theorem

2.  Tradeoff Theory

3.  Pecking Order Theory

4.  Free Cash Flow Theory

C.  Overcoming Potential Conflicts with Venture Lenders.........1206 

1.  Competition over Making Loans

2.  Priority in Intellectual Property

V.  Conclusion

I. INTRODUCTION

The conventional wisdom is that debt and start-ups don’t mix.1 Rapid-growth, high-tech start-ups without track records, positive cash flows, or tangible collateral appear to be a risk-averse banker’s worst nightmare due to the uncertainty of loan repayment. Therefore, while debt is an extremely important source of finance for virtually all other types of companies, from small, lifestyle businesses to Fortune 500 corporations, debt is not thought to be a significant source of finance for rapid-growth start-ups, especially those in their early stages of development. The conventional wisdom is that start-ups rely almost exclusively on equity funding from angel investors and venture capitalists (VCs), and therefore remain debt’s last frontier.

This Article will show that, like much conventional wisdom subjected to rigorous scrutiny, the conventional wisdom on debt and startups misses the mark. While it is the case that start-ups cannot typically obtain debt financing from traditional banks, major U.S. banking institutions, public firms, and private firms specialize in providing loans to the very start-ups that traditional banks turn away. These specialized venture lenders (VLs) provide “venture debt,” or loans to fund start-up

–  –  –

growth, to the tune of $1–5 billion per year.2 Venture debt does not mean debt from angel investors or VCs that is commonly converted to equity;3 nor does venture debt mean loans to start-ups that have developed to the point of attractiveness to traditional lenders. Instead, venture debt as defined here is loans to early stage, rapid-growth start-ups that have no traditional means of paying it back—including personal guarantees, which no rational start-up entrepreneur will sign because most start-ups fail.4 This Article is necessary to resolve the discrepancy between the conventional wisdom that start-ups cannot attract debt financing and the reality that a robust venture debt industry exists. It is also necessary to expand our knowledge of what types of finance are available to entrepreneurs. With traditional drivers of U.S. economic growth including Wall Street finance and the auto industry in crisis, start-ups have become increasingly important to our economic future and job creation.5 Without financing from sophisticated investors willing to accept the inherent risk of start-up failure, our entrepreneurial culture would be in serious jeopardy. Google, Facebook, and YouTube were each fledgling start-ups once—great ideas, but in desperate need of financing to launch. Although angels and VCs are the primary sources of entrepreneurial finance, VLs offer entrepreneurs another important source of capital to fund start-up development. The founders of Facebook and YouTube knew about venture debt; each company used it to propel their rocket growth.6 Still, venture debt remains largely unknown to the masses of entrepreneurs and almost completely unexplored by academics.7 With the real-world importance of venture debt as a starting point, this Article explains why venture debt works despite good reasons to think that it would not. Using hand-collected interview data8 and theoretical contributions from finance, economics, and law, this Article presents and solves the puzzles inherent in venture debt. Through its





2. See infra notes 51–53 and accompanying text on the size of the venture debt industry.

3. See Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874, 902 (2003) (“Empirical evidence suggests that [VCs] sometimes use convertible debt.”); Darian M. Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 VAND. L. REV. 1405, 1430 n.119 (2008) (arguing that angels sometimes use convertible debt to avoid having to price their investments).

4. See infra note 28 and accompanying text on personal guarantees in start-ups versus lifestyle businesses.

5. See Press Release, Nat’l Venture Capital Ass’n, Nat’l Venture Capital Ass’n Releases Recommendations to Restore Liquidity in the U.S. Venture Capital Industry (Apr. 29, 2009), http://www.

dcm.com/dnld/news/NVCARecommendations042909.pdf (“[I]n 2008 public companies that were once venture-backed accounted for more than 12 million U.S. jobs and $2.9 trillion in revenues, which equates to 21 percent of U.S. GDP.”).

6. See infra notes 36–37 and accompanying text.

7. See Pui-Wing Tam, Venture Funding Twist: Start-ups Increasingly Take On Debt to Keep Businesses Chugging Along, WALL ST. J., Feb. 14, 2007, at C1 (explaining that venture debt remains largely “out of the spotlight”).

8. See infra notes 61–62 and accompanying text for more on the interviewing portion of this project.

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1172 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2010

empirical and theoretical explanations for venture debt, this Article contributes to several important literatures including the commercial law literature, the corporate finance literature (on firm capital structures), the economic literature (on information asymmetries and agency costs), and the emerging literature on law and entrepreneurship.9 It also furthers my own efforts to expand the academic discussion of entrepreneurial finance beyond private venture capital and into its alternatives.10 The presence of a billion-dollar venture debt industry confirms the “thickness” of the market for entrepreneurial finance—a point of immense practical importance for the future of innovation. Finally, this Article offers another example of interviewing as a means of gathering empirical data, especially in instances where quantitative data might be unavailable or difficult to obtain.11 The Article is divided into three main Parts beyond the introduction. Part II lays out the basic puzzle of venture debt in more detail—the conventional wisdom about venture debt contrasted with the reality. It discusses the tools I will use to solve the puzzle, most notably my interviews with VLs, but also trade publications and a key article by Ronald Mann from 1999 that discusses lending to software start-ups.12 Parts III and IV look at venture debt from the lenders’ and equity investors’ perspectives, respectively, as set forth in more detail below.

In Part III, I explore venture debt through the lenders’ eyes. What financial motivations could possibly make it worthwhile for VLs to lend to risky start-ups? We will see that the answer depends on the type of lender. VLs organized as banks have a very different business model than VLs organized as non-banks, yet both have strong financial incentives to provide venture debt. With these financial incentives as motivation, the question becomes how to reduce the risk of lending to companies who do not possess any of the criteria that give other lenders confidence in loan repayment.

9. See Darian M. Ibrahim & D. Gordon Smith, Entrepreneurs on Horseback: Reflections on the Organization of Law, 50 ARIZ. L. REV. 71, 82 n.65 (2008) (citing examples of academic work that fits within the “law and entrepreneurship” genre).

10. See generally Darian M. Ibrahim, Financing the Next Silicon Valley, 87 WASH. U. L. REV. 717 (2010) (discussing angel investors and state-sponsored venture capital funds as alternatives to private venture capital); Ibrahim, supra note 3 (explaining the basics of angel investing and its differences from venture capital).

11. For excellent examples of data gathering through interviews from “law and entrepreneurship” work alone, see Ronald J. Mann, Secured Credit and Software Financing, 85 CORNELL L. REV.

134 (1999) (exploring software-related lending); Mark C. Suchman & Mia L. Cahill, The Hired Gun as Facilitator: Lawyers and the Suppression of Business Disputes in Silicon Valley, 21 LAW & SOC.

INQUIRY 679 (1996) (portraying Silicon Valley lawyers as networkers and business transaction facilitators); Brian J. Broughman & Jesse M. Fried, Do VCs Use Inside Financing to Dilute Founders? (Aug.

13, 2009) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?

abstract_id=1442524 (investigating whether VCs use their control rights to dilute entrepreneurs in inside rounds).

12. Mann, supra note 11.

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No. 4] DEBT AS VENTURE CAPITAL 1173

From the lenders’ perspective, the answer to the venture debt puzzle is surprisingly simple: venture capital. Before VCs have invested in a start-up, VLs will not lend. But once a VC has invested, VLs are soon to follow. A start-up will still have no cash flows, tangible collateral, or track records after early-stage VC investments, but the presence of venture capital—and to a lesser extent the start-up’s intellectual property (IP)—effectively substitute for traditional loan repayment criteria and make venture debt an attractive proposition to a specialized set of lenders. In short, similar to a bridge loan,13 venture debt is about “funding to subsequent rounds of equity”14 rather than relying on the underlying start-up’s ability to repay the loan through cash flows.

Moreover, because VCs are far more likely to follow-on their investments early in the start-up’s development, we discover the counterintuitive proposition that VLs actually prefer to lend to start-ups in their early stages as opposed to their later stages when cash flows and tangible collateral may emerge. Part III then asks whether reliance on venture capital for loan repayment makes start-ups themselves basically irrelevant to VLs. After uncovering reasons why start-up success still matters to lenders, the end of Part III examines ways in which VLs select and monitor their start-up borrowers in the face of severe information asymmetries and agency costs—problems familiar in the venture capital literature. Interestingly, VLs use very different selection and monitoring mechanisms than VCs, in part due to their different skill sets, in part due to their relationships with VCs, and in part due to legal considerations.

In Part IV, I switch gears and present the puzzle of venture debt, albeit less starkly, from the perspective of the start-up’s equity investors.

What financial motivations drive entrepreneurs, angels, and VCs to seek venture debt rather than continuing to fund the start-up through equity sales? We will see that venture debt extends the start-up’s “runway,” or time until the next equity round is needed, thereby allowing existing investors to extract a higher valuation from new investors and reduce their own dilution. VCs have two additional reasons to favor venture debt.



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