Tech startups are not like most new businesses. They often make no money; some have no plans to sell anything. And their assets? Mostly ideas. Their execs? Kind of wacky.
Such companies definitely are not candidates to get bank loans. Commercial banks prefer lending to established businesses with predictable cash flow and hard assets that can be pledged as collateral. Bankers? Pretty stuffy.
But lately, commercial banks – including L.A.’s largest – have started lending to tech startups.
Called “venture debt,” these new loans aren’t secured by real estate or machinery or based on a borrower’s profits. Rather, they’re granted under the assumption the venture capital firms that back startups will invest again, paying off the bank.
Just over a year ago, downtown L.A.’s City National Bank started a tech lending practice, led by a team of bankers hired away from Dallas lender Comerica Bank’s Bay Area offices. Another downtown lender, Grandpoint Bank, launched a startup division in 2012, led by former Yahoo Inc. product manager Petra Griffith. In addition, Silicon Valley Bank in Santa Clara has recently ramped up its presence here, growing its Sherman Oaks office from eight employees just a few years ago to 23 today.
The loans give startups extra cash that helps bridge the gaps between rounds of venture capital investment. For entrepreneurs, a bank loan means giving up less equity to investors and keeping more for themselves. For banks, the relatively high-interest loans generate profits, and might help them connect to young companies that could become the next big thing.
With more lenders interested in venture debt, there’s more competition. Last year, when executives at Hollywood social media marketing startup TheAudience started looking for a loan, they talked to a dozen interested bankers.
“We had more or less every player at the table,” said Mike Drath, chief financial officer of TheAudience, which has celebrity clients such as comedian Russell Brand. “We just wanted to see what the interest level would be. It was quite a positive surprise.”
The firm decided on a loan from City National, which had already provided other bank services to TheAudience and to previous startups led by its founder, Oliver Luckett. For City National, that’s part of the plan: It wants to hold on to Luckett and other serial entrepreneurs by offering everything from basic business banking to venture loans to personal wealth management. It also hopes that by helping the startups of today, it can be the bank for the tech giants of tomorrow, said Rod Werner, managing director of City National’s tech and venture capital banking group.
“We want to be working with the next big entrepreneurs,” Werner said. “We want to bank those entrepreneurs and startups so that we have a relationship with them when they become the next Facebook or Google.”
Venture lending, or lending to venture-backed companies, has been around for decades, but it remains a niche business offered by only a handful of banks. There are also nonbank venture lenders, including Multiplier Capital in Bel-Air, which did its first deal in 2012.
It’s a specialized type of lending, largely because venture-backed startups aren’t usually profitable and often have little or no revenue, meaning they have no way to pay off debt on their own. Stephen Hughes, senior relationship manager at Silicon Valley Bank’s local office, said bankers who don’t specialize in venture lending might not grasp the concept.
“Why lend money to companies that are precash-flow positive, or even prerevenue? It is a bit of a head-scratcher,” Hughes said. “It’s a pretty focused discipline.”
Because the companies don’t make enough money to pay down debt, banks justify venture loans by assuming a startup that’s just raised millions from venture capitalists in the Series A round will be able to raise more money in the next round, called Series B, and use that cash to pay back the bank.
Say a startup raises $5 million from venture capital firms and plans to use that money to hire software developers to build a final version of its product. Executives might expect the money to last about 10 months. But if it’s going to take more like a full year to finish the job, the startup might seek a venture loan from a commercial bank to bridge the gap.
Once the product is built, the company can raise another round of funding from venture investors and pay back the loan.
“The purpose really is to give companies more runway,” Werner said. “It’s an extension of capital between funding rounds. Typically, A-round companies raise B rounds.”
To a startup’s co-founders, the big benefit to borrowing that final bit of cash is that they don’t have to give away any more equity in the company. Raising $6 million instead of $5 million in the Series A round would mean giving away 20 percent more equity.
That was the attraction for Luckett at TheAudience. He liked the idea of getting cash without having to give up more equity – and without having another part-owner involved in the business.
“City National Bank has not come in and told us how to do our business, which is what VCs and other equity investors do,” Luckett said.
Underwriting venture loans is a tricky business, one that doesn’t rely on the same measures used to judge most borrowers.
Banks look at a startup’s business plan, see how much money it’s spending and estimate the value of its contracts and intellectual property – including patents, trademarks and new technology. But more important is a bank’s estimation of a startup’s executives and investors, said Rick Shuttleworth, a senior credit officer in Silicon Valley Bank’s Irvine office.
He wants to know how successful a startup’s executives have been with other companies and how likely is it that the venture capital investors who participated in a company’s A round will invest more in a B round.
That analysis is part of Silicon Valley Bank’s risk rating system. Shuttleworth said bank examiners – regulators who make sure banks aren’t making overly risky bets with depositors’ money – want to see that the bank has clear criteria for approving and denying loans.
“They’ll take a big sample of loans and dig in,” he said. “They want to understand our risk rating system and see that it’s applied consistently, whether it’s a Boston deal or an Atlanta deal or a Silicon Valley deal.”
Still, venture loans are riskier than other business loans, and priced accordingly. After all, a company’s product might be a flop and a B round might never materialize. In that case, the bank could see a near-total loss. Though loans are backed by all of a borrower’s assets, those often don’t amount to much, Shuttleworth said.
Interest rates range from 5 percent to 14 percent, based on terms of a loan and on the type or size of company borrowing money. A typical small business in Los Angeles could likely get a commercial and industrial loan for between 4 percent and 6 percent, according to local bankers.
Besides charging a premium, banks manage the risk of venture lending in other ways. First, venture loans are usually small compared with the amount of money raised in a funding round. If a company raised $5 million from investors, a bank might offer $1 million. Banks monitor a company’s progress toward certain goals, doling out the loan in pieces. If a company falls too far behind, the distributions might stop, limiting the bank’s potential losses.
“The loan has to give the company real runway for another round – not runway to see if it works or not,” Werner said.
What’s more, banks typically get warrants that grant them the right to buy shares of the company in the future at a set price. That gives the bank some of the upside if a company strikes it rich.
But more than anything, banks manage their risk by lending money to companies backed by successful investors. Werner said he’s more likely to lend to startups with investors who have built solid companies.
“It’s about relationships and working with VC partners you’ve known for a long time,” he said. “We’re working with people I’ve worked with for 10-plus years.”
For City National, that was the attraction of hiring Werner and other Comerica bankers rather than trying to build a venture lending practice from scratch.
“If you got someone who’s never done it before, it would be harder,” he said. “The relationships are key.”
Ray Boone, managing partner of Multiplier Capital, cautioned that putting too much stock in the successes of big venture investors has gotten some venture lenders in trouble.
“There are people who think if the big, smart money does a deal, you can just follow them,” he said.
That’s not enough for his firm, which lends money only to venture-backed companies that have enough revenue to pay off debt.
But even with more lenders getting into the business, there remain few players in the venture lending business, and Hughes of Silicon Valley Bank said that provides some safety, too. The tech world is a small one, and entrepreneurs and investors are careful with their reputations. In Silicon Valley Bank’s case, Hughes said that means venture capital investors have stepped in to help cover losses rather than leave the bank holding the bag.
“In this tiny sandbox in which we play, everybody expects to have another go-round,” he said. “If we get out whole, the next time that investor is looking to have us work with their company, we know they’ve done a difficult thing in tough times to get us across.”
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