This provider of venture debt says it sees attractive opportunities, not just in Silicon Valley, but outside the region at a time of a rising tide in the business.
The explanation for the growing use of debt among startups isn’t hard to find. The stigma that used to be associated with venture debt appears to be fading.
“It is being viewed more as an astute move by venture capitalists and the CEOs of companies because they are focused on capital dilution and enhancing shareholder value,” said CEO Manuel Henriquez. “If you use it tactically the right way and don’t over-leverage yourself, it can be highly accretive to both the management team and the early investors.”
Henriquez argues that it is a mistake for startups to use expensive equity dollars to buy furniture, equipment and to provide working capital—dollars that could cost 35% or 40% on a cost of capital basis. Expensive equity dollars should be used to hire smart engineers and accelerate product development.
In this way, “we actually help leverage the return of the venture capitalists for their benefit and the early-stage investors for their benefit,” he said.
VCJ recently had the opportunity to catch up with Henriquez for an update on the debt business. An edited transcript of the interview follows:
Q: The demand for venture debt among startups appears to be on the rise. What is fueling this upswing?
A: They want to supplement their coffers with additional sources of growth capital that are not dilutive to earnings or existing shareholders. So the startups are asking more and more these days to use venture debt as a way of complementing equity dollars.
You’re seeing a lot of smart money [involved], whether it’s RingCentral, FireEye or Rocket Fuel. All these companies had some form of venture debt in their companies. You’re seeing more and more of that happening now than you did just a couple of years ago.
Q: How is the strong demand reflected in Hercules’ business?
A: In terms of Hercules, from the third-quarter numbers released so far, we’re at the $550 million level of commitments.
I started the year by indicating that we would probably do between $500 million to $600 million. That number is going to go up now. Probably we’re going to be in the $600 million to $700 million of new deals done this year alone. Very strong demand.
Q: You recently opened a New York office and added five new managing directors and one new principal. Half of the new hires are outside Silicon Valley. Is that where the growth is?
A: The answer is, kind of. What I mean by kind of is back in the heyday of 1997 to 1999, a lot of good software development and security was coming out of New York. That tapered off quite dramatically over the past decade. We’re now seeing a fairly significant resurgence in social media and software and security coming out of Manhattan.
The Virginia market suffered tremendously with the collapse of the dot-com era. It too is beginning to show some good security development on data encryption and electronic records. Software and communications seem to be now resurgent in Virginia. There are definitely more attractively priced opportunities for deals coming out of those markets.
Q: Are you seeing much change in the financial terms of debt deals?
A: The changes are subtle. I’ve been doing this since 1988 and prime has been as high as 8½ and prime has been as low as 3¼. Typically deals [today] are done as low as 9% and as high as 14%. It has been in that range forever.
Q: Are you seeing other changes?
A: The only difference in the industry. If I look back to what we did in the early ‘80s and the late ‘90s, is the warrant value, or the warrant contributions, on deals has probably been cut in half.
In the old days, I was doing deals that typically had, say, 12% or 14% warrant coverage, meaning that for every million dollars I would get $100,000 or $140,000 in equity value. Today with that same exact company, I am seeing more on the order of 5% or 9% on deals.
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