Meet The Expert Series: Matt Trotter of Stifel Bank on the state of the venture debt market, and how investors & startups should approach the credit markets today

0:00Welcome back to another episode of Venture Unlocked, the podcast that takes you behind the scenes of the business of venture capital. I'm your host, Samir Khaji. And on this special Meet the Expert episode, we're talking about the venture debt market with Matt Trotter, a managing director within Stiefel Bank's venture division. Given the dislocation of the regional banking market in early 2023, we discussed how venture investors and companies should think about the supply of venture debt today, the proper uses of the product, and what we should expect moving forward of venture debt in general.

0:30I hope you enjoy what I believe is a very insightful discussion on a topic that so many founders and investors are trying to decipher today. Samir Kaji is the CEO and co-founder of Allocate. Allocate and Venture Unlocked are independent of each other. Any statements or references made by Samir or his guests regarding third parties, investments, or securities are solely their views and opinions and are not intended as investment advice or an endorsement of such parties or securities by Samir, his guests, or Allocate. Allocate or its clients may maintain relationships with or investment positions in guests, third parties, or securities mentioned in this podcast.

1:06This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Matt, it's great seeing you. Thanks for being on the show. Thanks for having me, Shamir. You and I have known each other for a long time. Going back to our days as venture lenders at SVB, I started in the late 90s. I think you started a few years later, so much has changed in the venture market, in the lending markets. And an area that I know a lot of people are thinking about is not only have we seen the constraints of the equity markets, but with SVB and FRB and some of these other institutions going through this massive dislocation this year, a lot of startup companies are thinking about how do I now augment my equity with VentureDat.

1:50And maybe a good place to start, Matt, is giving a quick background on yourself, your background, and then just defining what is VentureDat. Nice to know you. My name is Matt Trotter. I'm with Stifel VentureBank. I've been in VentureBanking about 18 years. So as Samir mentioned, we actually started together. I was a junior associate on the same team that he was on. I've spanned during that period a number of different industries, a number of different types of companies, kind of all stages. I'm currently at Stiefel Venture Bank. So Stiefel's been around since about 1890s, has three main arms, an investment bank, a wealth manager practice, and then a commercial bank, which I sit in today.

2:29And we do kind of early stage lending as well as commercial banking for growth stage venture bank. And so if you think about venture debt, the history dates back to kind of the beginning of venture capital and venture capitalism when you had these kind of companies that were raising chunks of equity to go invest in growth and to build IP. And those companies might have had values in the tens of millions of dollars, even higher, but they couldn't even get a credit card because they weren't going to be profitable for a long time. And so venture debt was a tool that could be used by these companies to be able to buy servers and buy computer equipment and to augment the equity that they had raised in order to do just basic kind of banking things.

3:10And the banking system at that point really wasn't designed for these companies. How it's evolved today with kind of software eats the world, not as much need for kind of hardware for a vast majority of kind of companies out there. It's largely today venture debt is used for kind of runway extension. So it's a way to augment the highly dilutive equity with a less dilutive or minimally dilutive product that they can use to kind of add on to the equity that they have. They can use that to maybe achieve a milestone, to get a higher valuation. Sometimes it can be to time their raise better. So there's been certain periods of time where if you had to raise your round this month, if you think of like in 2008, if you had to raise at that moment and couldn't extend a little bit longer, your company went out of business.

3:59And so in some cases, it's kind of extending that on. And then in certain cases, we're seeing a little bit of a resurgence of hardware and deep tech stuff where there is actually equipment and things that kind of need to be bought. And then in terms of just the terms that come with it, you know, high level, it's largely kind of a non-formula loan. So it's not based on kind of any formula. It's right sized usually around kind of some percentage of the equity that you raise. You have usually a year plus to kind of choose whether you want to use it. And then you start paying it back over, you know, usually around three years or so with the raise, your next raise that you have.

4:38And then the cost, it's usually kind of an interest rate, a small fee and a warrant component, which is kind of the equity part. And then who is eligible? It's largely venture-backed companies. And you're usually putting it in place alongside an equity round. So it's usually a good hygiene to do relatively close to when you raise. If I can maybe play that back a little bit. So going back in the early days when companies had to buy servers, it was really equipment leasing was really what it was to finance those without using really expensive equity dollars. Over time, it's become more of a general purpose type of financing to augment an equity round.

5:23But when we think about the companies, many of these companies often have no revenue, no product. But ultimately, the banks, like in the past, Silicon Valley Bank, which we were both a part of, were comfortable lending against these companies after an equity round. even though the length of the venture debt was usually three or four years, and maybe the company with the equity rent only had two years of cash. How do lenders underwrite these early stage companies that have no revenues, no product, and providing this financing that actually extends out in terms of when it fully pays off way past when the company is going to be cashed out?

6:05It's quite unique of a product compared to kind of what most banks would offer. Now it's become more common where there's a number of banks that kind of offer this to venture-backed tech companies. But if you take someone who had kind of a normal underwriting background at a bank and said you're going to lend to cash flow negative companies with no assets, they would say, why are you doing that? from an underwriting perspective, you're kind of looking at three main things. You're looking at who the investors are and their capacity and history of continuing to support their company. So you're largely, most of these companies have 12 to 18 months of runway.

6:40You're underwriting a four-year loan. You're underwriting this company's ability to raise that next round of equity. So having an investor that has a dedicated fund hold reserves and that has shown them continuing to support companies is really important. Then you're also looking at kind of the management team, their history, their ability to fundraise, their ability to execute on plan. And then lastly, you're kind of looking at the market. Is it a market that you believe has a wide universe of investors that they can kind of garner interest to kind of raise more equity? Now, the other part that is key of kind of what all makes it all work is you do get warrants in these kind of early stage companies.

7:21And so if you look at like the track record of, of these banks that have kind of done this over a long enough period of time, the warrants are higher than the losses that you take, even though the losses for early stage venture debt are higher than a bank would normally be comfortable with. And so you do get, you know, these series A warrants in Airbnb and Fitbit and these other, you know, big companies that, you get in when they're very small, but when they ultimately exit, those end up paying for the losses that you have on the other deals, which kind of ties it all together. Right. It's essentially getting, as part of the compensation structure, stock options in the company itself.

8:03And at least historically, what I've seen is loss rates, depending on the year, maybe 2 % to 5 % at the early stage level, and then you have your warrants. Some of them are hit and it's that power loss. So the ones that do hit tend to do very well and kind of offset some of the losses. But one of the things you mentioned there, Matt, is the underwriting against the venture sponsor. So company raises a series A round. They raise 15 million. You layer on what at least over the last decade has been a decent amount of venture debt on top, maybe three to five million dollars. dollars. When that happens, it seems like from a company standpoint, you're getting cheap runway, at least historically cheap runway over the last decade before interest rates rose.

8:50And in talking to some VCs, some VCs wrote, once a company raises Series A, go get venture debt, no matter what. It's a cheap insurance policy. Now, there were other venture investors like Sequoia who have said, we actually don't think that many companies should just automatically default to getting venture debt. They should wait until maybe they have some demonstrable traction. There's other things that we can leverage like ARR or accounts receivable. When is it right for a company to take on venture debt? And maybe you can talk both on the pros and cons of making the decision and taking venture debt at the Series A.

9:29So I think from a macro perspective, there's one element that's happening is around the interest rates increases. So it's not inexpensive kind of free money. So a lot of these loans are based off Wall Street Journal Prime. With Wall Street Journal Prime at 8.5 % today, it's a high kind of single digit to maybe low double digit kind of interest rate that you might be paying for this. So it's not exactly low cost money. I will say that I don't actually think that part of it is that big of a deal because usually with venture debt, you're kind of only keeping it out for a short period. So like the interest rate, I often don't focus maybe as much unless you can't pay it back.

10:11So in certain, some of these, and we'll get into kind of the terms and the things you have to be worried about, but as long as you can pay back the loan when you have a successful raise, then it served its purpose. You pay interest for a short period. So what are the downsides of kind of taking venture debt? One is if you can't get out of it. So in certain cases, there is prepayment penalties and things like that, that you are signing up for then a pretty expensive chunk of capital for three or four years. So when you're taking it, your company will hopefully be stronger over that next period of time and will be able to leverage lower cost forms of debt financing during that period of time.

10:46You don't want to preclude yourself from that. You can make sure that you're checking to make sure what's it going to take for me to get out of this, make sure that you have as much optionality as possible. The other is, I think, kind of over leveraging companies, what ends up happening is if you take on too much debt and you're not performing well, and then you come back and you have to do that inside round or that not great round, and the investors are coming back to the table and they look and they say, we're going to give you$10 million,$5 million of that is going to go to pay debt payments.

11:17They're not very happy and it's not a great situation for them to kind of fund into. And so what I've found is right now where you have companies that can't go raise an outside round or don't want to go raise an outside round because of the valuation. They have a really large debt load and they have it formed and they're looking, you know, they want their investors to step up with just a small amount of money to keep going. It ends up having being kind of an issue because most of that money is going to go to debt paid. And in today's market, of course, we were in the ZERP period for the better part of a decade.

11:56Since 2022, everything has shifted. And the capital equity markets have changed pretty materially, right? So if you look at what's happened, Series B and on, the number of rounds has gone down significantly. And it has been the case that many of these companies have had to take some measures to stay viable, whether it's reducing headcounts, getting an inside round. Many of those companies are actually saddled with a lot of debt and are in these situations where they're talking to the inside investors for a small amount. but when the venture investor looks at the balance sheet and sees several million dollars of debt that needs to be repaid, the amount of equity needed to create an accretive effect is higher.

12:44What are you seeing on the ground right now with companies that are in these situations? I think those companies are having a hard time or it's almost like all the lenders and the equity investors are having to come together to kind of come up with a solution. If you have equity investors and lenders who are willing to work together and have a long history together, I'm seeing deals get done. So finding everyone is going to have to take some risk. Everyone is going to have to kind of double down or kind of stay involved with the company. The equity investors won't come in unless the lender will move and do some concessions.

13:23Everyone kind of has a little bit of pain and a deal gets done. In situations where there's not a great relationship or there's not a lot of trust built there, then I think companies will struggle to raise and ultimately go down the sale process or something like that because they're not able to bring in that equity or they're just saying pay off the debt and close shop. It is interesting from a macro perspective where we talked about a couple of different events of the equity markets were already streamed and there was already valuation concerns. And then there was the bank fiasco that happened that threw all that up upside down.

14:00Those were totally different, and they were kind of removed from each other. But it was interesting that the equity markets being strained make the actual demand for debt a lot higher. So when there's uncertainty in the market, or you also don't want to put a value in your company, venture debt is a way to get capital without having to put a valuation on your business. So before the SVB bank run and some of the other consequences of that, demand for debt was incredibly high. And then you have all the stress that got put on it of, you know, all the disruption and players going in and out of that market that made it kind of harder to get.

14:36So it has been a situation where I've seen the demand for debt or venture debt is really high. And in a lot of cases, companies are very interested to, you know, put it on the books as an option because the options are limited in certain cases. But those are also the situations that are probably the toughest for banks to kind of lend into. And one thing I mentioned is you're largely underwriting to what is the next round, you know, the company's ability to raise the next round of equity. When you have a company that seems to have a huge valuation overhang, it's very hard to confidently predict that they're going to be able to raise that next round given where their valuation sits today.

15:14Those are also the hardest kind of deals to do. Whereas in a fresh Series A that was done a month ago, it's totally different than a Series D company that's sitting on a several billion dollar valuation that seems quite overvalued. Yeah. So the net new deals maybe price in, you know, what's happening in the equity market. So you have valuations that have kind of reverted to pre 2021, maybe AI is the one exception, which, you know, appears to still be, fairly red hot in terms of valuations, amount of capital going to some of these companies. But when you think about demand and supply, so you mentioned demand for venture debt during the dislocation macro from a macro perspective, you know, went higher because you needed capital to run these companies, but less equity was available to you.

16:02But at the same time, you did have a supply disruption when, you know, Silicon Valley Bank and other banks that were lending, went under. And of course, there's been offshoots, there's been new banks, Stiefel now doing early stage venture debt. But I would also surmise that some of the supply decreases, underwriting standards have changed because the risk of a company getting a Series B or a Series C round is materially different than it was any time probably from 2013 to 2021. So what is available to companies and how are banks and maybe even venture debt funds, if you can speak to that, how are they underwriting companies differently today?

16:48And how drastic of a supply issue is it for companies that are demanding venture debt? you know everyone has FOMO so like you know everyone you know and so when the capital was just flowing you'd have to you'd want to have a hard standard of say oh is this pre-revenue company really worth you know a billion dollars and and then you'd see five companies get funded in that same vein like the next week and you'd be like well I guess so you know it's very hard to have a critical eye on metrics and what is appropriate valuations and where do you need to be to raise the next round. I'd say there's now it's a lot clearer or there's a lot, you can be a lot more disciplined around this is, this company is overvalued.

17:30And frankly, it leads to much more direct conversations with investors saying, let's be real. This company probably cannot raise an outside round unless they're willing to take a giant haircut. A, are they willing to do that? Or B, are you willing to step up? What does that look like? And it actually is a better environment to be able to have, you know, these kind of, I'd say, direct conversations or direct kind of underwriting conversations around, you know, how are you going to raise that next round? And so it's largely those kind of later stage companies that have not performed. I think, you know, it's the, I look at it, we talk about it as like three categories, just the companies that have, you know, either our brand new funding or later stage companies that have performed well, they're going to have access to capital.

18:16We can do that. There's the companies that are performing okay, have really great growth plans or cutting burn and are trying to kind of extend the runway. And if they hit those plans, they will be able to raise. In a lot of those cases, we're doing debt tied to those metrics. So it's like, sure, we'll step in, but we got to tie it to tranching and you got to hit those milestones to access the funds. And then there's the companies that we just don't think are going to be able to raise. And those are, to be honest, a quick no, you know, that those are kind of the situation where we don't think debt's really appropriate.

18:52And so we kind of put them in those kind of three buckets. And I don't know if it's helpful to talk about kind of debt funds and banks, how they look at the world differently. And maybe just to maybe define that a little bit. So everyone knows bank lending, right? So banks, you know, taking deposits, using those deposits often to make loans to, in this case, startup of companies, venture debt funds essentially are taking third-party capital and deploying it through a fund structure. This is a question that comes up a lot from a lot of the companies and founders we work with is, I have venture debt funds here providing me, what they're saying is much more flexible capital, larger amounts, but it's significantly more expensive because the hurdle rate's different.

19:38And one of the things people are trying to navigate through, especially in this environment, is how do I look at these two products and juxtapose the differences between bank venture debt and venture debt fund venture debt? And what are the pros and cons of each avenue? So maybe you can speak to that. And there's a lot of myths about this. So I kind of talk about what I believe is true or not. So first, I do think you need to think about kind of the cost of capital, the strategy, and then like the incentives. So if you think about a venture bank that is providing venture debt, so a commercial bank providing venture debt, one, they're using deposits to fund these loans.

20:21So that means the cost of capital is going to be very low, but they are more heavily regulated. So it's not like they can just have, you know, a huge$30 million loss and that's going to be totally fine. But they do report to regulators and have to kind of track their performance of a portfolio. They have guidance what they want to do. They also, the thing that's key, and this is the part that's kind of changing too, is a lot of the reason that venture banks are doing venture debt is not necessarily to make money off the venture debt, but it's to acquire new clients that are going to be great customers over time.

20:56So not only are you going to get them kind of over as a client now, but the ones that end up being breakout companies, banking is very sticky. And so they end up being clients for you for a decade. And the lifetime value of that type of company, just for all the great banking services that they're going to want to do and deposits and all these things, it wouldn't be uncommon for us to win a series egg business with a$3 million loan. And then that company goes and raises a$50 million series B that ends up on your ballot sheet. And that's a great earner for us. And so the one part about the commercial bank deal is the requirement for banking, requirement deposits.

21:35This is an interesting sticking point, sticking point with kind of where the world has ended up kind of with this focus now on having segregated banking relationships and sensitivities around that, which we can maybe circle back on. But I think largely, you know, commercial banks are looking to do venture debt as a client acquisition engine. So that means that they're trying to take granular bets with their venture debt and not trying to do any one deal to be huge, but to kind of grow that portfolio kind of that. On the venture debt fund side, they're going to make money off that transaction. So that's kind of it.

22:09Or at least several transactions from a loan, but they're not making money off deposits and all the other things. Also, their cost of capital is LPs that have a certain return level that they want for the risk of taking. They need to be priced higher, but they also, the pro of that is they have the flexibility to not live within a box. They can go bigger sizes. They can do different structures that might make sense because again, it's usually smaller teams, not as much regulation and they're kind of, they're more beholden to the LP agreement as opposed to regular, which kind of makes the approaches be a little bit different in kind of how they're working with.

22:48One of the myths is that banks aren't going to let you use, or venture banks aren't going to let you use the money for runway extension and venture debt funds are. In my experience, I don't believe that's true. And I actually believe a venture bank, they may come with a smaller proposal, but their intent is that you're going to use it for runway extension. They are not going to at that moment, and I can't speak for all banks, but most of the banks that we all know that have a history of doing this, that are committed to it. They understand that there's no financial confidence in these deals and you can use them for pure runway extension and are going to allow you to do.

23:25So maybe let's just walk through what that actually means. So a company hypothetically raises a$10 million Series A. They get a$3 million venture debt, a line of credit or line. They draw down on the line 12 months later. and let's say in month 24, the company is down to$3 million in cash and they owe$2.9 million in the debt financing because some is amortized down, maybe it's$2.7. At that time, what happens? What does that conversation dynamic look like between venture investor, who's the equity player, who you're relying on to fund the company further, the bank who has now debt that equals cash and now the company that's sitting in the middle navigating between raising you around a capital and also working with the bank to ensure that the bank is in a comfortable place.

24:23So I can only speak for kind of my experience, everybody, every bank, you know, in situation kind of is different. But I think largely what ends up happening from a bank perspective at that period of time is the banker will just want more visibility or more constant conversation in terms of what is plan a plan b c and the large goal is to not be so i think at that point most of like the the lender understands that there's nothing more to do there's no getting your money like calling your money back at that point like you're kind of you committed to stick with it and you're going to be there and you're it's really used for runaway extension but you'd like them to kind of be investors as well as the company to give you updates on the progress that they're doing towards that so that internally you're able to kind of message that the worst thing you want credibility from a lender perspective internally is that you you're you have a situation where you're like everything's great and everything's fine and they're going to raise money and then all of a sudden the plug gets pulled then you kind of lose a lot of credibility both internally but also with the regular why are why were you not kind of monitoring.

25:31But it is important to kind of understand. I think sometimes when things get tight, founders are naturally thinking, well, this is the worst case scenario and my lenders can pull my money. And the lender then starts asking more questions and they're like, wow, this is feeding exactly into what I was worrying about. And I usually, when I sit with companies on the side, I kind of, I'm very explicit. I'm like, we're with you. Like you were using it for runway extension and we're going to support you through that. What I need for you is I need transparency. I need a lot of updates when I want to ask just so that I'm kind of tracking internally.

26:03But just so you know, there's no conversation happening behind the scenes where we're thinking about, man, how can we pull our money? And I think the thing that's nice about it is Venture is a pretty small industry and it's very connected. I mean, just frankly, look at the SVB Banker. Word spread's quick and people take action fast. And if you were known for pulling cash and putting companies out of business, if that was part of your playbook, in my opinion, you would be out of business very quickly because that would get around to folks really, really fast. And you have to be a good partner in this space because there's nowhere really to hide.

26:43Everyone is connected. So when you're navigating through these times, of course, transparency is important on both sides. And you addressed a little bit of what I was thinking of. And I hear this a lot of banks at the end of the day, when cash hits the loan amount, you're going to get a call every single week. Your board will, it gets really nerve wracking, creates a lot of stress. Whereas a venture debt fund, because of lack of regulatory structure and the fact that they're charging more, they can take on more risk and fly closer to the sun. In your mind, are there, from a founder's perspective, are there scenarios where venture debt from a venture debt fund actually makes more sense than taking it on from a bank.