In venture debt, the quality of your deals defines the strength of your portfolio. Last month, we explored foundational principles for effective deal sourcing. Now, we’ll take it a step further with advanced strategies designed to help you stand out, avoid common pitfalls and secure high-potential deals that others might miss.
Avoid adverse selection
Adverse selection refers to a situation where the party initiating a transaction knows more than the counterparty, often resulting in poor outcomes for the uninformed side. When I was a corporate bond trader, I experienced this firsthand. For instance, large investment managers, like PIMCO or BlackRock, would send out a bid list to roughly 250 brokers dealers. If I bought a bond with the winning bid (that is, the highest price), that meant I paid more than 249 others. Ouch. “Winning” likely meant I overpaid. That’s adverse selection: you’re the buyer because others have turned it down.
In venture lending, the risk of adverse selection is lower but still present, especially when dealing with unsolicited inbound deals. If someone I don’t know is calling me to pitch a deal, it’s a near certainty that dozens of others have already turned it down. Adverse selection can also rear its ugly head when powerful VC firms pressure lenders into funding weak deals under the auspice of maintaining relationships, even when the terms are suboptimal for the lender.
The key as a lender is to remain both disciplined and proactive. Actively pursue deals where the company fundamentals align with your investment thesis, rather than being swayed by external influences or hoping a good deal falls onto your lap.
Don’t chase the hot deal
Chasing hot deals might work for equity VCs, but for lenders, it often backfires. Venture equity investors rely on the power law: they expect most deals to fail, so they need to be in on the few that succeed dramatically or they’ll miss their return targets. For lenders, this approach leads to overpaying or accepting weaker terms that don’t offer adequate downside protection.
The best results for lenders come from investing in solid, lesser-known companies where they can secure mid-teens interest coupons, strong downside protection and significant equity upside. For instance, helping a $20 million revenue company grow into a $100 million business is far less risky than betting on a no-revenue start-up becoming the next unicorn.
Another advantage of working with less-publicized companies is that founders are often more humble, practical and easier to work with. I’ve found that these types of founders often make for the best long-term partners.
Get to ‘no’ quickly
Finding deals isn’t difficult, but finding the right deals efficiently is key. Venture debt deals are labor-intensive, requiring extensive due diligence and structuring, so getting to “no” quickly is essential. This allows you to focus on the deals that are truly worth the effort.
When done right, venture debt deals often earn a premium without taking on the risks of larger, more commoditized loans. The reward lies in knowing when to walk away from deals that aren’t a fit early in the process. In fact, if you follow the principles discussed in this series, the risk-adjusted returns in venture debt can far outpace nearly all private credit strategies.
Build rapport with founders and boards
In venture-backed companies, board members play a pivotal role and often hold significant influence. They can be the final decisionmakers, particularly when large equity investors are involved. As a lender, demonstrating how your deal benefits all stakeholders by de-risking the company through extended runway, enhanced credibility and broader visibility, can be the deciding factor in closing a deal on advantageous terms.
Don’t be overly dependent on sponsors
A company with strong sponsors is valuable, but over reliance on equity investors can lead to problematic deals. When sponsors abandon a struggling company, lenders can end up “holding the bag.” We’re seeing signs of this now, as many companies funded by VCs in 2021 and 2022 are underperforming, with their lenders left exposed to excessive risk.
The best approach is to underwrite the company itself based on industry and market dynamics, the company’s fundamentals and leadership team, its operational strength and where the investment fits in your portfolio.
There are plenty of compelling opportunities among non-venture-backed companies – many of which are bootstrapped, family-owned or supported by private investors. These businesses may not fit the typical VC profile, but they are often stable and profitable, making them ideal for debt financing.
Start early, be patient and follow up
Quality deal sourcing takes time. Start building relationships with potential borrowers long before the need for funding arises. This proactive approach allows you to deeply understand the business, de-risk the deal for both parties and ensure smoother transactions. Trust-based relationships lead to better terms, more transparency and fewer surprises.
Consistent follow-up is key to maintaining these relationships over time. Check in regularly with founders to stay updated on their progress and evolving needs. By staying engaged, you not only position yourself as a reliable partner but also gain valuable insights into the company’s trajectory, which helps you act quickly when the timing is right. There are founders I’ve known for years, well before they had their first dollar of revenue, and when the time came, those relationships turned into successful investments.
Steer clear of intermediaries
Whenever possible, go direct. Intermediaries, whether they are brokers or advisers, add layers of complexity and cost. More importantly, they often create misaligned incentives, as their goals may not align with yours. Charlie Munger and I agree: “Incentives determine outcomes.” When you work directly with founders, you ensure that incentives are properly aligned, leading to better outcomes for both parties.
Successful deal sourcing in venture debt requires more than just looking in the right places. It demands discipline, focusing on less crowded opportunities and building long-term relationships with founders and boards. By applying these strategies, you will find better deals and create lasting value for both your firm and the companies you support.
Next month, we’ll explore the critical role of company valuation in venture debt. For lenders, accurate valuation is essential for assessing risk, setting loan terms and optimizing equity upside. Thoughtful and accurate valuation is foundational for structuring high-return, low-risk deals.
Zack Ellison is the founder and managing partner of Applied Real Intelligence and CIO of the ARI Senior Secured Growth Credit Fund. Send comments or questions to zellison@arivc.com and visit ARI’s website at arivc.com.
In venture debt, the quality of your deals defines the strength of your portfolio. Last month, we explored foundational principles for effective deal sourcing. Now, we’ll take it a step further with advanced strategies designed to help you stand out, avoid common pitfalls and secure high-potential deals that others might miss.
Avoid adverse selection
Adverse selection refers to a situation where the party initiating a transaction knows more than the counterparty, often resulting in poor outcomes for the uninformed side. When I was a corporate bond trader, I experienced this firsthand. For instance, large investment managers, like PIMCO or BlackRock, would send out a bid list to roughly 250 brokers dealers. If I bought a bond with the winning bid (that is, the highest price), that meant I paid more than 249 others. Ouch. “Winning” likely meant I overpaid. That’s adverse selection: you’re the buyer because others have turned it down.
In venture lending, the risk of adverse selection is lower but still present, especially when dealing with unsolicited inbound deals. If someone I don’t know is calling me to pitch a deal, it’s a near certainty that dozens of others have already turned it down. Adverse selection can also rear its ugly head when powerful VC firms pressure lenders into funding weak deals under the auspice of maintaining relationships, even when the terms are suboptimal for the lender.
The key as a lender is to remain both disciplined and proactive. Actively pursue deals where the company fundamentals align with your investment thesis, rather than being swayed by external influences or hoping a good deal falls onto your lap.
Don’t chase the hot deal
Chasing hot deals might work for equity VCs, but for lenders, it often backfires. Venture equity investors rely on the power law: they expect most deals to fail, so they need to be in on the few that succeed dramatically or they’ll miss their return targets. For lenders, this approach leads to overpaying or accepting weaker terms that don’t offer adequate downside protection.
The best results for lenders come from investing in solid, lesser-known companies where they can secure mid-teens interest coupons, strong downside protection and significant equity upside. For instance, helping a $20 million revenue company grow into a $100 million business is far less risky than betting on a no-revenue start-up becoming the next unicorn.
Another advantage of working with less-publicized companies is that founders are often more humble, practical and easier to work with. I’ve found that these types of founders often make for the best long-term partners.
Get to ‘no’ quickly
Finding deals isn’t difficult, but finding the right deals efficiently is key. Venture debt deals are labor-intensive, requiring extensive due diligence and structuring, so getting to “no” quickly is essential. This allows you to focus on the deals that are truly worth the effort.
When done right, venture debt deals often earn a premium without taking on the risks of larger, more commoditized loans. The reward lies in knowing when to walk away from deals that aren’t a fit early in the process. In fact, if you follow the principles discussed in this series, the risk-adjusted returns in venture debt can far outpace nearly all private credit strategies.
Build rapport with founders and boards
In venture-backed companies, board members play a pivotal role and often hold significant influence. They can be the final decisionmakers, particularly when large equity investors are involved. As a lender, demonstrating how your deal benefits all stakeholders by de-risking the company through extended runway, enhanced credibility and broader visibility, can be the deciding factor in closing a deal on advantageous terms.
Don’t be overly dependent on sponsors
A company with strong sponsors is valuable, but over reliance on equity investors can lead to problematic deals. When sponsors abandon a struggling company, lenders can end up “holding the bag.” We’re seeing signs of this now, as many companies funded by VCs in 2021 and 2022 are underperforming, with their lenders left exposed to excessive risk.
The best approach is to underwrite the company itself based on industry and market dynamics, the company’s fundamentals and leadership team, its operational strength and where the investment fits in your portfolio.
There are plenty of compelling opportunities among non-venture-backed companies – many of which are bootstrapped, family-owned or supported by private investors. These businesses may not fit the typical VC profile, but they are often stable and profitable, making them ideal for debt financing.
Start early, be patient and follow up
Quality deal sourcing takes time. Start building relationships with potential borrowers long before the need for funding arises. This proactive approach allows you to deeply understand the business, de-risk the deal for both parties and ensure smoother transactions. Trust-based relationships lead to better terms, more transparency and fewer surprises.
Consistent follow-up is key to maintaining these relationships over time. Check in regularly with founders to stay updated on their progress and evolving needs. By staying engaged, you not only position yourself as a reliable partner but also gain valuable insights into the company’s trajectory, which helps you act quickly when the timing is right. There are founders I’ve known for years, well before they had their first dollar of revenue, and when the time came, those relationships turned into successful investments.
Steer clear of intermediaries
Whenever possible, go direct. Intermediaries, whether they are brokers or advisers, add layers of complexity and cost. More importantly, they often create misaligned incentives, as their goals may not align with yours. Charlie Munger and I agree: “Incentives determine outcomes.” When you work directly with founders, you ensure that incentives are properly aligned, leading to better outcomes for both parties.
Successful deal sourcing in venture debt requires more than just looking in the right places. It demands discipline, focusing on less crowded opportunities and building long-term relationships with founders and boards. By applying these strategies, you will find better deals and create lasting value for both your firm and the companies you support.
Next month, we’ll explore the critical role of company valuation in venture debt. For lenders, accurate valuation is essential for assessing risk, setting loan terms and optimizing equity upside. Thoughtful and accurate valuation is foundational for structuring high-return, low-risk deals.
Zack Ellison is the founder and managing partner of Applied Real Intelligence and CIO of the ARI Senior Secured Growth Credit Fund. Send comments or questions to zellison@arivc.com and visit ARI’s website at arivc.com.
