Which form of venture debt should your startup go for?

Given the surplus of liquidity in the markets, entrepreneurs have access to more funding options than ever before. Venture banks, venture debt funds and venture capitalists are each jockeying to prove how their money is greener.

Nonetheless, each has constraints that dictate their behavior. While a venture capitalist may swing for the fences in each investment they make to get outsized returns, one home run can make up for nine strikeouts. Contrarily, most banks are playing Billy Beane’s Moneyball — they try to get the entire lineup on-base while making as few outs as possible in the process.

Think of capital availability as a spectrum, from low risk and low return (venture banks) to high risk and high return (venture capital), with venture debt funds sitting somewhere in the middle.

It helps to understand how venture banks make a profit: Essentially, they take deposits from one customer and lend them to another. Most banks currently collect a 4% interest rate from loans while paying less than a 1% interest rate to depositors, generating a margin of approximately 3%.

If we assume that a bank must also cover 2% of overhead for costs like employee payroll and rent, then it must collect at least $0.99 of every $1.00 loaned to generate a profit.

Despite the unscrupulous behavior of a few bad actors (see the Great Recession), the banking industry has a profoundly positive impact on economic productivity overall. More economic productivity means more taxes, so federal and state governments have a vested interest in greasing the skids and have instituted agencies like the Federal Deposit Insurance Corporation (FDIC) to help protect depositors and monitor banks.

The FDIC ensures that each bank under its regulatory oversight has a sound lending policy in place and operates within those parameters. That said, there is an exception to every rule, and borrower activity that may be deemed “too risky” by rigid underwriting guidelines may, in fact, be normal (or even desirable) in certain circumstances. For instance, increasing sales and marketing or research and development spend to leverage or develop a sustainable competitive advantage that will bear fruit in the future — even if that means foregoing profit and increasing burn in the short term).

Therein lies the rub: In the process of protecting depositors, rigid credit guidelines, thin margins and low risk tolerances can create challenges for borrowers operating in dynamic and sometimes volatile markets, often leading to undesirable outcomes.

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