PRIVATE EQUITY & VENTURE CAPITAL

LECTURE 3

Theodosios Dimopoulos
HEC Lausanne,
Swiss Finance Institute
 Alternative Startup Financing I

1. Venture Debt

2. Crowdfunding

Readings: material posted on moodle

Introduction

 In the previous lectures we saw some major sources of startup financing:

 Seed capital
 Venture capital
 Mezzanine funds
 Today we will take a look at two alternative sources of finance
 Venture debt
 Crowdfunding
1. Venture Lending
Venture debt example

 In April 2020, Airbnb raised $1billon in a combination of debt and equity from Silver Lake and Sixth
Street Partners
 It was actually a downround (from a valuation of $31billon in 2017 to $26 billion)
 Interest rate was 11.5%
 Motivation: Obtain a cash source to weather the Covid-19 pandemic
 At the time travelers were cancelling their bookings and venture funds were skeptical about deploying
money
 A week after the first round, Airbnb raised a further billion from Fidelity, T.Rowe Price, Blackrock and
others for 9% interest.
 Airbnb raised $2 billion in covertible senior notes and 5 year maturity in 2021.
Venture debt example

 Obtaining debt financing was one of the two pillars that helped Airbnb throughout the pandemic
 The other was gaining market shares as travel opened up again, since travellers switched from crowded
hotels to airbnb-supported appartements.
 On October 2020, the company launched an IPO with a target to raise $3 billion fresh equity
 On first day of trade, shares skyrocketed from $ 68 per share to $146, corresponding to market cap of
86$ billion,
 That was higher than the market cap of established hotel chains such as Marriott ($42 billion) and
Hilton ($29 billion).
 In late 2021 Airbnb equity was worth about $110 billion. Now it is worth around 81$ billion
Major market developments

Source: Pitchbook
Sources of market growth

 Overtime the venture debt industry has seen considerable growth

 In terms of deal volume it is dominated to a significant extent by large deals
 In 2020, 37 loans , worth $17 billion made up 60.5% of the venture debt total
Growth by stage
Late stage loans

 Companies at late stage have an established revenue record

 Some of these companies attach their patents as collateral
 Players in the late stage loan market: Banks, Business Development Companies, Venture funds
 Sources of growth: Longer time to IPO, inflows to private equity
Early stage loans

 Growth is driven mainly by the right-tail

 7 deals in 2018-2020 are over $500M. Seven of them are in credit fintech
 Essentially they create another version of «shadow banking»
 The time to reaching positive earnings is less compared to traditional venture sectors, like biotech
Angel/seed loans

 At this stage, debt usually comes in the form of convertible notes

 Usually supported by the investor-company relationship (e.g. if another equity round is coming soon)
 Warrants and claims on the company’s intellectual property help reduce downside risk
Tech venture debt

 Fintech for credit services has been a major contributor here accounting for 75% of the segment in 2020
 Software as a service (SaaS) has also been a growth driver, by creating steadier revenue streams that
bode well with lenders’ credit score models
 Finally emergency financing was a major motivation for 2020, as startups drew down credit lines
Healthcare venture debt

 Healthcare &biotech are on paper not good candidates for debt: Long time-lines to product
development, regulator scrutiny, early years with little revenue and negative earnings
 The rapid development of healthcare venture is actually a very recent phenomenon
Healthcare venture debt

 Typical strategy to overcome credit constraints:

 Time the debt raising a few months before IPO
 Example 1: Harmony Biosciences
 Founded 2017
 Raised $200 debt from OrbiMed Advisors
 Pledged to repay loan from IPO proceeds in 2021
 The company launched an IPO on August 2020 (currently worth $2.68 billion)
Typical venture debt form

 Venture debt comes in two forms:

 Revolving line of credit:
 Borrow and repay repeatedly within a time interval, up to a maximal credit limit
 Term loan:
 It consists of a borrowing amount and an amortization schedule.
 Often borrowing takes place in tranches over time.
 May include mandatory drawdown.
Typical clauses in venture debt

 Collateral: Tangible assets+ intellectual property (IP)

 Friendly version: Negative pledge of IP, i.e. refraining from pledging IP to anyone else
 Upfront costs
 Warrants: Options to purchase new equity in the firm
 Covenants on financial ratios and activities
 Tripping Covenants: trigger full and immediate repayment
 Material Adverse change (MAC): Triggered if company has materially changed for the worse (e.g. lab results falsified)
 Investor Support: Triggered if the lender unilateraly assesses that the investors will not be supporting the company in the
future
Does Venture Lending make sense?
Some industry ``insights’’

 The typical justification for Venture lending that is given in industry documents is:
 «It allows founders to raise capital for their startup without giving up the startup’s upside potential»
 This insight obtains from the fact that raising capital through VC requires selling some «equity-like»
claim (btw: seldom ever straight equity) that allows the VC pay to rise significantly with the value of the
startup
 Since a lot of the value of the startup comes in its «upside potential», the argument goes, the startup is
better off raising debt

 Q: Do you agree with the above reasoning?

Some industry ``insights’’

 Turns out the above reasoning is flawed

 The reason is the Modigliani Miller theorem
 If the M&M assumptions hold, the value of the startup is independent of its capital structure
 Specifically, if debt allows founders to keep the startup’s «upside potential», it means it needs to
compensate the creditors sufficiently well in the «downside», if they are to break even on their
investment
 The fact that the distribution of value in a startup is skewed («a lot of the value in the upside») says
nothing
 Indeed the validity of the Modigliani Miller theorem does not depend on the distribution of firm value.
Some industry ``insights’’

 Another justification given in industry documents is:

 «venture lending allows founders to keep the control of the firm, as opposed to raising venture equity»
 This is certainly a better argument
 Still insufficient though to justify the existence of the venture lending industry
 Indeed in bankruptcy founders do lose the control of their firm
 And since startups are cash-strapped, with volatilie cash flows, with unknown date when revenue even
begins, startup borrowing may pose an equally large threat to founder control

 Q: So why do startups borrow?

The venture lending puzzle: Tradeoff theory

 According to tradeoff theory, firms balance the tax benefits of debt against the bankruptcy costs
 For a startup:
 Tax benefits are little, since they have little taxable income if any
 Their expected bankruptcy costs are high, due to
 Volatile cash flows that give rise to high distress probabilities
 High intangibility of capital that gives rise to little debt recovery in the event of default

 For these reasons debt does not seem a natural instrument of financing
The venture lending puzzle: Free cash flow

 According to the free cash flow theory of debt, debt is superior to equity whenever entrepreneurs tend
to waste the cash flows of the company in redundant expenses (e.g. empire building)
 Obviously startups are hardly an empire
 In addition they are rather cash strapped, so their opportunity for wasteful spending is limited.

 There does not seem to be a large free cash flow problem to justify the bankruptcy costs of debt
The venture lending puzzle: Debt overhang

 The debt overhang theory posits that financing through debt is not a good idea, whenever a company
with high investment opportunities but high probability of bankruptcy needs to decide between
investing and distributing dividends
 In essence debt «taxes» the returns to investment for shareholders, who are better off cashing out.

 Startups have both high probability of bankruptcy and high investment opportunities
 Debt overhang theory would therefore advise startups against borrowing
The venture lending puzzle: Risk shifting

 The risk shifting theory argues that debt financing reduces firm value whenever founders can increase
the riskiness of the startup’s value at the expense of reducing the expected value
 Essentially, founders get the opportunity to gamble by making risky investment choices (e.g. investing
in exotic technologies with large but very unlikely payoff).
 If creditors see through the founder’s potential to gamble ex-post, they will ask for a high credit spread
ex-ante
 Debt financing then reduces firm value
The venture lending puzzle: Asymmetric information

 Asymmetric information theory argues that debt financing is beneficial for a firm if investors know less
about the prospects of the firm compared to the founders
 This seems to be a promising ground for explaining venture lending
 Asymmetric information means that a highly promising startup may find it hard to convince investors
about its prospects and be «forced» to sell undervalued securities
 Under certain conditions, the security that minimizes this mispricing for good quality startups is debt
 This is not the complete story though
 First, we need to see what those «certain conditions are»
 Second, remember that raising vc equity vs. borrowing, allows the startup to lever the experience, help, and
knowledge of the vc.
 Is minimizing asymmetric costs worth giving up a relationship with a good vc?
Why?

 At this point we might wonder

 Do I really want to understand the reason for the existence of venture lending industry?
 Sounds a bit academic, and I am heading instead to industry. Why sould I care?
 Suppose you are working for a venture lending company.
 You would like to know which startup is a likely client
 The paper of Tykvova (2017) helps us understand exactly this point

 Our objective: Come up with a checklist of likely venture lending targets

What happens when only VC equity is possible?
When happens when only Venture lending (VL) is possible?
When happens when startups can choose between VC and VL?
Empirical anaylsis

 Data: Venture Source, Thomson ONE, webpages, other

 About 50,000 funding rounds between 2005-2013 for 12,629 VC backed companies
 Main regression (Table 7)
 Logit of dummy=1 if the startup gets venture lending on a bunch of firm, VC, and other characteristics
 Main empirical predictions: Likelihood of going for VL is less if likelihood of exit through IPO or M&A
is high, if VCs have a good reputation, or there is geographic proximity to good VCs, or the startup is
too young
The checklist

 If you are trying to find VL targets look for startups that

 Are not too young
 Not «stars» about to do an IPO
 In sectors/times that are not too «hot» for their industry

 That are not supported by a super-good VC

 Preferably located outside the main geographic area of activity of VCs
 That have more tangible capital than their peers
 At the same time, there is no need to go for lousy startups
 Aim for the «middle»

 Key message: Do understand the segment of the market you are playing in. For entrepreneurs, debt is
not as desirable as an IPO.
2. Crowdfunding
What is crowdfunding?

 Crowdfunding is a recent idea

 It aims at bringing capital providers ( «contributors») and users of capital (the «project initiators»)
together through online platforms with the aim of financing the user’s activity
 In some sense this looks like intermediated financing, albeit in a digital form
 However in traditional intermediation (e.g. bank), the intermediary has “skin-in-the-game”, that means
directly benefits from good investment decisions
 Instead in crowdfunding, the platform gets a fee in exchange for the service, and lets participants decide
if and how much to invest.
 The platform may help the investor by applying a model to assess the credibility of the capital user, but
it is not directly responsible for the investment
Types of crowdfunding

 Donation based:
 The purpose here is to support a charity cause. The contributors are not getting a return
 The key is here different than “finance projects”. Purpose, personal stories, emotion are oftentimes employed
 Example: Get help on medical bills
 Reward based
 Contributors here do expect a reward for their capital
 However it is non-monetary. E.g. be among the first to get a copy of a videogame, an app, a gadget
 Often such campaigns have an “all-or-nothing” clause
 Entrepreneurs use this kind of crowdfunding if they want to create early interest in their product
 Example: CoinTickr on Kickstarter
Types of crowdfunding

 Lending based:
 Individual investors crowd to lend a firm or a project of a firm in exchange for interest
 Peer-to-Peer (P2P): Matchmaker platforms between borrowers and lenders
 Active: Lenders get access to borrower info and choose whom to lend
 Passive: Lenders do not see borrower info, but declare their risk tolerance and the platform assigns them to an appropriate
pool of borrowers
 Sometimes lending may have humanitarian aspects. Example: Kiva
 Potential problem: Lack of platform incentives to monitor (moral hazard)
 Partial solution: Insure the contributors by part of fees in the event of default
 Example: Ripio Credit Network https://ripiocredit.network/how-it-works
Types of crowdfunding

 Peer-to-Business (P2B): Borrowers are firms

 Appeals to investors who are looking for high return
 Problem: Oftentimes the borrower firms have been already rejected from banks

 Equity-based:
 Contributors acquire equity stakes in companies
 The motivation here is mixed: Sometimes it is return-motivated, sometimes it is about funding a particular idea
for which the contributor is personally interested in
 Example: EarlyShares https://www.crunchbase.com/organization/earlyshares
Crowdfunding volume per capita

Source: Crowdfunding Monitor, Switzerland 2021

Swiss crowdfunding

Source:
Crowdfunding
Monitor,
Switzerland 2022
Entry and Exit in the Swiss market

Source:
Crowdfunding
Monitor,
Switzerland 2022
Fundraising in Swiss crowdfunding

Source: Crowdfunding Monitor, Switzerland 2022

Swiss Reward-based crowdfunding

Source: Crowdfunding Monitor, Switzerland 2022

Swiss lending based crowdfunding

Source: Crowdfunding Monitor, Switzerland 2022

Swiss equity+real estate crowdfunding

Source: Crowdfunding Monitor, Switzerland 2022

The French Market

Source: CrowdfundingHub 2022

France-crowdfunding by type

Source: CrowdfundingHub 2021

France- lending market performance

Source: CrowdfundingHub 2021

France-ESG Crowdfunding

 76,000 projects (440 m. EUR) were financed in 2021 in France with a social or environmental approach
 This represents 23% of volume and 46% of projects
 Usually connected to green projects
 Main Green crowdfunding platforms: Enerfip, Lendopolis, Lendosphere
 This is merely a few instances of a much larger push of crowdfunding towards green energy transition
on a global scale: See https://citizenergy.eu/
The German market (up to 2020)

The equity market:

The lending market: The segment exists, but data is scant

Source: CrowdfundingHub 2021

The UK market (up to 2020)

 Equity based: 332 mil.pounds raised in 433 campaigns

 Majority earned through Crowdcube and Seedrs
 Lending based: total funding worth 5.1 bil. euros, of which 3.2 billion in euros
 During first wave of covid a lot of P2P contributors withdrew
 Market is coming back
Crowdfunding in Italy (up to 2020)

 Massive increase in total funding from 65 mil. Euros in 2015 to 772 million in 2020
 Reason: Crowdfunding idea spreading+ improvements in regulation
 Equity based: Increase 95% from 2019 to 122.5 million euros
 Lending based: Increase 75% from 2019 to 179 million euros
 Donation+reward based: 101 million euros compared to 74 million in 2019
Latest market developments in EU

 EU initiative for crowdfunding geothermal projects

 Latest on EU regulation of crowdfunding