The Venture Debt Value Proposition in 2023

A conversation with David Spreng, founder of Runway Growth Capital

David Spreng

Chairman, Founder, CEO, and CIO

Runway Growth Capital

For insight into the 2023 venture debt market, DealFlow caught up with David Spreng, Founder, Chairman, CEO and CIO of Runway Growth Capital. David is a seasoned and respected Silicon Valley-based investment executive, with 30 years of experience as a venture capitalist and growth debt lender. As a VC, he has been active in the formation and development of nearly 50 technology companies with 18 IPOs and 14 trade-sales. He was ranked four times by Forbes magazine on their annual Midas List as one of the top 50 venture capitalists; in 2006 he was ranked the #8 VC. He transitioned into venture debt and founded Runway in 2015. David is one of the featured speakers at The Venture Debt Conference coming up March 31 in New York City.

DealFlow: What is the biggest pain point for your firm and your clients right now?

David Spreng: So I think the biggest pain point within our portfolio and for our clients and really across the entire ecosystem is just access to capital. Everybody’s worried about how they are going to access capital in the future. And, you know, even companies that have a runway of 36 months or 24 months, they’re being advised by their boards and their investors to extend that runway. So, people are very, very worried about where they’re going to get money. There’s also a lot of concern about the economy and how to plan for growth in a very uncertain environment. And so we’re having a lot of folks come to us and ask advice on how do you plan with this kind of uncertainty? What we always do is plan very conservatively, meaning, for planning purposes we expect there to be a recession, and if there’s not, great, we’ll have plan B and C ready to go so that we can continue to invest in growth.

So for most companies what they’re doing is coming up with a very conservative plan, but being prepared, if the opportunity presents itself, to accelerate investment in growth, and then making sure there is access to the required capital. One of the big concerns that people have is, ‘do my VCs really have the dry powder that they say they do?’ That’s something I wouldn’t take for granted as the CEO or CFO or management team of a venture backed company. Making sure that you have diversified sources of capital and ideally, understanding what their dry powder is and how committed they are to you as a company.

DealFlow: To be clear, which do you think is a bigger concern for your clients right now? Is it access to capital, or is it the cost of that capital that they’re able to access?

Spreng: So the best companies are, of course, thoughtful about the cost of capital, but as you continue down the spectrum, survival is more important than the cost of capital. As a result, we arere seeing all kinds of new sources of funding entering the market. these new players are often described under the big umbrella as structured capital, whether it be structured debt or structured equity, which is really designed to take advantage of troubled situations. For many folks, of course, the cost of capital becomes irrelevant if the option is extinction. So, the companies that we deal with, which are the largest and latest stage and hopefully least risky companies within this broad universe of pre-profit companies, they tend to have a lot of choices, and they’re still thoughtful about cost of capital. That’s where venture debt has a very strong value proposition today. Because, relative to equity, which is as expensive as it’s ever been, debt is a good deal these days.

The Runway Growth Capital website lists three primary sectors – tech, life sciences and consumer. Do you go outside that wheelhouse?

Spreng: We target recession resistant industry sectors. Each of the three pillars is broadly defined. For example, the technology sector would include all types of subsectors such as clean tech, FinTech, InsureTech, PropTech, etc. Life sciences is also quite broad and includes all areas of healthcare. So that would be pharma, biotech, medical devices, diagnostics, tools, healthcare information systems, and healthcare services. Our target markets are designed to be pillars that are focused on recession-resistant industries and sectors. Within those sectors, we look for the largest, latest stage, most predictable, therefore least risky companies that we can find. Now, keep in mind they’re all still pre profit,  but because they’re so late stage, they have, generally speaking, a very clear path to profitability. So, yes, those three pillars are not exclusive, but they are going to capture most of the stuff we’re interested in, and they would be characterized as recession resistant industry sectors.

DealFlow: Why can venture debt be preferable to receiving equity capital? Why should I essentially take out a loan if I can raise money in exchange for a share of the business? Is it mainly to avoid dilution and loss of full corporate control?

Spreng: Dilution and governance are the two primary reasons. And, especially for later stage companies that have already raised hundreds of millions of dollars of equity, and the founders have gone from owning 100% to owning maybe less than 10%, and now need $50 million more to get to the end zone, to get to profitability or to get to an exit, why would they take equity and, and further dilute themselves? Now, I understand if one has the option to raise equity capital at a really high valuation, that can be an important signal to the marketplace, whether it be in advance of an IPO or in advance of an M&A process. So there is some benefit in that. It also can be a big boost for employee morale to do a super late stage, high value round like that.

But for most late-stage companies, from a cost of capital and a governance point of view, debt is just a no-brainer. That’s the bottom line. And there’s also a misperception problem that venture debt has in the world, that it’s somehow like rescue finance or should be used when you can’t raise equity. When the truth is the exact opposite. We always like to say the companies that raise debt are those that can raise equity but choose not to because they want to avoid the dilution. Raising debt also sends an important signal about confidence. To use debt, you need to be confident in your business. And I think it’s an important statement to the world: we are confident enough to use debt, we know where this business is going and we’ve already given away enough to equity investors..

The misperceptions about when and when not to use debt is a big issue. We, as an industry, need to get out there and tell that story a little bit more effectively. But you know, you hit the nail on the head in terms of the main value proposition. The main reason that people come to us is avoiding dilution. And avoiding governance issues like new board seats and all of that. 

The other thing that’s really very prevalent in today’s market, even for the very best companies, is the desire to avoid a down round for sure, but even on top of that, just simply avoiding the hassle of negotiating an equity deal because the terms are so aggressive. Some of the investors in the market today, especially if it’s a new investor, think the whole world is desperate and will acquiesce to these very aggressive terms that some of the less high quality companies are getting.

The other thing that’s driving the demand for this type of capital is that a lot of companies, management teams and boards believe that this is a temporary situation. That this decline in multiples will reverse itself, and in a year or sometime from now, it’s going to bounce back and that will be a better time to sell the company or go public or whatever. So just simply buying time is another big element, and debt is a perfect fit for that.

DealFlow: In terms of your clientele, the vast majority appear to be quality companies with strong fundamentals. That said, most of your portfolio appears to be involved with senior secured debt. Is there any thought to maybe taking on riskier bets or is that comfortable where you are right now?

Spreng: Well, we’re really happy in this environment where we are today. Not only are we senior secured, but we’re almost exclusively first lien so that we are the very top of the stack. That’s important to us for two reasons. One is being a good partner to our borrowers and the other is being a good steward or a custodian for our investors’ capital. That means minimizing losses. We feel that we’re in a better position to accomplish both of those goals if we have ball control as it relates to the debt, meaning if we are subordinated to a bank or we’re sitting behind another lender and there’s an intercreditor agreement that says we just have to sit around and watch, well, that doesn’t allow us help the company. Because we are unregulated and have a patient, steady handed, partnership approach, we are often in a position to be more flexible than other lenders. Being senior, first lien allows us to exercise that flexibility to the benefit of the borrower. 

Our reputation is for being a good partner and helping borrowers work through problems when they exist. If we’re not in a position to control the situation, that can be frustrating for both parties. So we’re very much believers in ball control so that we can be a better partner for the borrower and a better protector of our investors’ capital and avoid losses. That’s the reason that we have this senior secured first lien preference. But to answer your question specifically, I do think that we would be very good at playing and participating in other parts of the cap stack, whether that be junior debt, or even preferred equity. That’s not in the cards for us right now, but it, it probably will be down the road.

DealFlow: If the Fed doesn’t stop tinkering with interest rates, are you anticipating a less than shimmering year?

Spreng: I think 2023 is going to be another boom year for the venture debt industry, compared to the cost of equity and the paucity of exit options, whether it be IPOs or M&A. The other issue with the cost of equity is also the fact that VCs are becoming very stingy with their capital because they, like the companies themselves, are worried about where they’re going to get their next round. There’s something like 3,000 venture firms in the US, and let’s just ballpark and say that 100 of them could raise their next fund in any environment. Well, that leaves 2,900 venture firms that are standing around worrying about where they’re going to get their next fund.

So let’s say they’ve got $200 million or $300 million of dry powder left in their current fund. Well, they thought that only had to last a year. Now it might have to last five years. So  they are going to reprioritize their dry powder allocations and some of them will get fed and others will be left to find food for themselves. That’s what is happening behind the scenes today. And that what’s on the minds of our borrowers. They’re wondering, ‘where are we going to get the capital we need to continue to grow? Yes, our VC told us they had dry powder for us, but they might not really.’ The venture capital guys might also say ‘We love you. We love what you’re doing. We’re gonna stay on the board, but don’t expect any more money from us.’

So I think that phenomenon and fewer good exit opportunities will result in a good year for venture debt. On the other side, there won’t be as many prepayments. In the last couple years we’ve had a very high velocity of money with lots of prepayments resulting from companies going public,  being acquired, or merging with SPACs. In addition, the high level of liquidity in the market made refinancing from one lender to another a common occurrence. Those things on the exit side, the prepayment side, are all going to slow down. Bottom line, we predict less velocity in the industry, but still a very good year for new loan origination.

DealFlow: Any other insights that would be beneficial to our audience? 

Spreng: For potential borrowers, I think the most important message is that debt is a really important alternative that you need to consider. We feel it’s a better fit for late stage borrowers than early stage borrowers. But it’s possible at pretty much every stage. What I would really emphasize is, how do you select your lender? Most of the consultants that we know and the investment bankers that deal in this space and the VCs – they’ve all been around for years – all agree. Yes, of course the interest rate is important and the terms and the conditions are important, but what’s really important is which lender is going to be the best partner when there’s a bump in the road? Because there will be a bump in the road.

We all know that even for late stage companies, there is going to be change. And the most important, criteria for which borrowers select a lender is who won’t panic if there’s a small problem. Unfortunately, it’s an industry that can be prone to panicking. Many VCs who have been on dozens and dozens of boards, like I have, and had dozens and dozens of venture debt loans and bank loans, you’ve probably had a bad experience somewhere along the way. It might be something like a risk officer in North Carolina decides, oh, it’s time to be risk averse and let’s get out of this space. Then you get a call from your relationship person who says, ‘I’m so sorry, I have nothing to do with this, but you know, we’re gonna call our loan at the worst possible time.’

Having a lender partner who is not going to panic, who is going to be in business for the long term, and who you view as a partner and they view you as a partner, I think those are the most important elements of this business. It’s the reason that I started Runway – to create a firm that was more relationship-based and less transactional. I encourage all borrowers to look at venture debt providers as a partner and an important part of your capitalization. Somebody that you look forward to working with for a while.

DealFlow: For as long as you’ve been doing this, David, you’ve probably weeded out a lot of the lenders who might have a, a propensity for – how shall we say? – flaking out on you. Is that a fair assessment?

Spreng: (laughs) Well, uh, there are a number of firms that no longer exist. Some of the lenders that are more prone to — let’s just say sudden changes in strategy, sometimes it’s not in their control. For example, if you’re a bank and you’re regulated and a regulator takes a different view of what you’re doing, then you’re out of that business. But it’s still a relatively small pool. Like I was saying, there’s 3,000 VCs out there, at least, and there’s probably only 30 firms that really do what we do on a consistent basis. It takes a lifetime to build a reputation and only a couple minutes to destroy it. I will say that there are firms that have done things that might be viewed as panicky or capricious, and they’re still around. I guess it’s a testament to the business itself that it has a very strong value proposition.