Venture debt lenders poised for resurgence

Coming off a successful retirement of a $1 million venture debt funding deal with a Los Angeles-based maker of cancer drugs for pets, California Capital Partners called a partners meeting on a recent Thursday to discuss strategy in light of a contracting domestic economy.

In October, CalCap launched its venture debt fund—California Capital Investors—with $195 million in commitments, which includes $65 million from limited partners and $130 million in matching funds from the Small Business Administration. The firm’s $1 million investment in PetMedicus Laboratories was from a side-car fund formed in 2006 to demonstrate to LPs how the fund’s venture debt instruments would be structured.

The LPs were likely impressed with the PetMedicus deal, since the debt was retired ahead of schedule last month, according to CalCap Managing Director John Nelson.

“Ultimately the deals we make will be about $5 million each,” Nelson says. “We were putting our toe in the water with PetMedicus.”

Venture debt, which typically achieves similar returns for limited partners compared to venture funds, are structured on fixed interest rates and are usually retired much sooner than the time it takes for a venture-backed company to exit. Nelson notes that the venture community’s company line is to have an exit in three to five years.

“But actual statistics put it closer to seven years, and after 10 years, 20% of the venture deals still haven’t reached an exit,” Nelson says.

However, Nelson says that debt can be structured as narrow as six months, but deals are typically cast between 18 and 42 months. For example, PetMedicus retired the two-tranche, 20-month debt placement in just 11 months.

“Limited partners are seeing the same or better returns with venture debt, but get out faster with somewhat less risk,” Nelson says.

Indeed, venture debt is becoming an increasingly attractive funding alternative.

Other notable venture debt lenders include TriplePoint Capital, which was launched In February 2006 by former Comdisco CEO Jim Labe. Within the first year of launching with a $310 million venture lending and leasing fund, TriplePoint had a lucrative exit when Google bought YouTube, which had raised venture debt from TriplePoint. The Menlo Park, Calif.-based firm walked away with shares of Google stock worth $6.5 million.

Also, Horizon Technology Finance Management, a Farmington, Conn.-based venture debt provider, says it has provided debt financing for more than 750 companies during the last 15 years, representing more than $2 billion in commitments. Horizon recently secured $200 million in new investment capital from WestLB and Compass Group Investments.

Of course, most venture investors would argue that venture debt doesn’t afford the huge upside potential—the lucrative and sometimes high-profile exits—that early stage VC investments have the potential of doing, notes William “Boots” Del Biaggio, founder and general partner with Sand Hill Capital in Menlo Park, Calif.

Del Biaggio admits that debt can also be a downside to startups that might be struggling with cash flow during an economic contraction. And many startups might not want to add more debt to their balance sheets.

But for limited partners, venture debt is always safer, Del Biaggio says. “We are definitely more on the debt side than equity side right now,” says Del Biaggio, who co-founded the firm in 1996 as a venture debt fund. The firm also raised a $55 million venture fund in 2005 called Sand Hill Sakura Fund.

Another upside to venture debt is the flexibility it affords partners and CEOs. For example, a company might have raised Series A and B rounds of venture financing, but it needs cash to ramp up infrastructure and doesn’t want to dilute its equity further. The startup could opt for a debt placement that typically goes hand-in-hand with generating revenue or have a clearly marked path to revenue.

However, while liquidity becomes elusive to venture capital deals, Federal Reserve actions can eat away at venture debt returns. Last week, the Federal Reserve slashed a key interest rate by three-quarters of a point, capping its most aggressive two months of action to halt a spreading credit crisis. CalCap—which charges a premium of prime plus from 2% to 4%—and most venture debt firms tie their interest to the prime rate.

As CalCap partners headed into their recent Thursday partners’ meeting, how closely the firm structures deals based on the fallout from Fed interest rate changes was likely on the agenda.

“We do pay attention to the Fed rate, but that may change if it keeps dropping,” Nelson says.