There are varying opinions and views on this topic, and I will not claim to have all the answers.  I have spent the last few years covering the competitive landscape of venture debt lenders on behalf of my firm, and I was making investment in the space.  In that time, I developed a strong view of how this unique investment product can be best used.

The way I see it, venture backed companies can be divided into three groups (kind of):

• The top third of high flyers that are just amazing companies – generating tons of value for everyone who was fortunate enough to get some ownership in through any means necessary.  These companies are the reason people continue to dump truckloads of money into the venture asset class, the hope that you might invest in the next WhatsApp and make $19B.
• The bottom third of companies that are bound to fail, or at the very best be rolled into another company with little fanfare.  These are the businesses that just never make it, for a multitude of reasons including poor capitalization, mismanagement, or just a lack of market acceptance.
• That leaves the elusive middle.  These are the companies that are just somewhere between raging success and relative failure.  They probably are a good business, (i.e. they do make money) but they just aren’t ever going to make a lot of money.  Which isn’t bad, but it doesn’t justify the large risks nor generate the outsized returns, which are required of the venture asset class.

In my opinion, the top third of companies have no need and no business wasting time taking on venture debt.  Revolving lines of credit, bank lines, equipment financing and all of the other great credit vehicles can be used, but there is no real value of venture debt over equity.  Equity can be raised at very non-disruptive valuations with minimal impact to management, and in sufficient quantities to support the rapid growth.

Venture debt gets to pick from the bottom third and the middle third.  The best venture debt investors can tell the difference between the two.  Good companies in the middle third that are generating money and value in the market can raise venture debt in order to capitalize growth at a level that is attractive to management, while helping to juice the growth rates and increasing value to equity investors.

Companies in the bottom third of the market are the ones that can be harmed substantially by raising debt, and can harm venture lenders returns.  They are unable to repay the loan, forcing the lender to try and sell the business at a likely inopportune time, degrading the value of the equity for all of the holders.  This is just bad for everyone involved.

It is not simple to tell the difference between the middle and bottom third.  Lots, actually, all management teams believe their business in not the in bottom third, and there is ALWAYS a reason it is ‘just about to turn the corner’.  Sometimes they do, sometimes they don’t.

Venture debt investors that are able to pick the companies in the middle third while avoiding the bottom third, make money.  The top third just don’t need money in the traditional venture debt model, and usually would price a deal so competitively that it isn’t always worth the work to generate the return – just put equity in and get the associated upside.

Notice, NONE of this is predicated on revenue, or growth, or patients, or magic beans.  It is primarily business analysis.  There are some governors that most lenders have in place to try and avoid issues (they may require $10mm in revenue, or a plan showing positive EBITDA in 12 months, or something), but typically those are focused on avoiding the bottom third.  Metrics drive value, and financials are indicators of strength.  The combo is the special sauce which represents success.