Can you predict which start ups will transform industries, and which will fade? The answers to venture debt are not found in historical data, but rather in a forward-looking analysis. This article is part of a series on venture loans that explains how venture lenders use fundamental analyses to identify exceptional companies, and effectively mitigate risk. ( At the bottom of this column, you will find links to parts 1-9 in the series).
Future Focus
Venture debt is distinguished from traditional lending by its dual objectives. All lenders have the same primary goal: to ensure that principal and interest are fully repaid, while prioritizing the reduction of downside risk.
Venture lenders have a unique and important second goal: to invest in companies that are poised for significant growth. This growth can lead a significant increase in the value of the equity warrants that were received with the loan. This provides lenders with a significant potential upside.
Start-ups are often at a pivotal stage of their development and lack a track record, consistent cashflows, and profitability. Venture lenders tend to focus on future performance indicators rather than historical financial performance, which can be limited in start-ups.
The traditional credit assessment techniques are often inadequate, and fundamental analysis should include a deeper and broader evaluation of the growth potential and sustainability of a business.
Finding inflection points
Venture lending is about finding companies at a turning point, those that are approaching a state where they can be profitable and scale up. These companies are the sweet spot for investors because they can generate returns that far exceed the risk taken. After a thorough evaluation of the opportunities, lenders look for the following factors:
- Viable business plan with exit strategy. Lenders are looking for a business plan that clearly outlines the borrower’s viability, including a path to profitability and positive cashflow. Lenders prefer businesses with realistic plans to repay debt through organic growth, rather than relying on equity financing or being acquired.
- Growing revenue. Lenders are attracted to business models that generate recurring revenue with high growth. Sticky revenue generated by subscriptions or long-term agreements provides predictability and stability, which makes it easier for lenders assess the company’s debt obligations. Revenue is typically measured using key metrics, such as monthly recurring revenues, annual recurring revenues and last quarter’s annualized. Businesses with low capital expenditures and high margins are more attractive because they offer greater operational efficiency. A diversified revenue base and low customer concentration will also increase resilience to market fluctuations. This will reduce risk and ensure more consistent revenue.
- Strong product and market fit. The lender must determine whether the product solves an important problem for customers and justifies its existence. It is important to assess the product’s fit in the market, as positive feedback and strong customer adoption confirm that there is a genuine demand for it and that it has potential to grow market share. Another important factor is the competitive positioning of the borrower within their industry. Idealy, the borrower should have a proprietary, market-leading product that is hard to duplicate, creating a competitive advantage and barriers to entry for rivals. Lenders like to see that the company has a strong product pipeline, which ensures constant innovation and helps maintain its competitive edge.
- Loyal customers. The strength of the customer base is critical to a company’s financial stability and growth prospects. Lenders can gain insight into market penetration by evaluating customer demographics and purchasing behaviors, as well as loyalty metrics. In order to determine how well a company is able to attract, retain and satisfy its customers, key indicators are often used. These include customer acquisition costs, retention and turnover rates, customer lifetime values, net promoter scores and overall satisfaction.
- Operating efficiency. Operating efficiency is a measure of how efficiently a company can turn resources into revenue, cashflow, and profits. Operational efficiency is usually measured by unit economics for start-ups. This measures the profitability of every unit or transaction. Key metrics like average revenue per user (the amount of revenue generated by customers to cover acquisition costs), average gross margin, and breakeven points show how effectively resources are used. These metrics are crucial for lenders when evaluating the start-up’s ability to increase revenue without excessive costs, indicating its capacity for scalable growth.
- Viable capital structure and interest coverage. Lenders evaluate the debt structure of a company and its cashflow, evaluating metrics such as leverage ratios, revenue, and available cash. Interest coverage ratios can also be used to evaluate the company’s ability to cover interest payments.
- Sufficient runway. The concept of runway, which is the time period a company has to operate within its current financial resources without requiring additional capital, is important when assessing default risk. Lenders are looking for companies that can be capital-efficient and reduce spending when necessary while maintaining core business activities.
- Equity investment potential. Venture lenders must consider how venture equity investors view the company when evaluating its fundamentals. It is important for the company’s long-term growth and financial health to ensure that it can attract future equity investment if needed. This includes understanding investor appetite, market sentiment and the company’s capacity to present a compelling story.
Lenders can protect their investments by assessing the fundamental aspects of a borrower, while also securing a unique position to benefit from the exceptional growth trajectory of successful start ups.
Next month, our focus will be on the crucial role of leadership teams when it comes to determining a startup’s success. This will further enhance our understanding of venture debt.
Zack Ellison, the founder and managing director of Applied Real Intelligence and CIO for the ARI Senior Secured Growth Credit Fund is a member of the ARI Senior Secured Growth Credit Fund. Send any comments or questions to Zellison@arivc.com.
Previous columns of the series
Part I: Venture debt can be a lucrative investment for institutional investors
Part 2. Defining venture debt deal structures
Part 3. How venture debt can be structured to maximize equity returns
Part 4. How venture debt can be managed
Part 5. Advanced Risk Reduction Techniques in Venture Debt
Part 6. Exit and diligence tactics for venture debt
Part 7. Operational due diligence:
Part 8, Debunking five myths about venture debt
Part 9. Be a PEST when you analyze markets and industries