The Leveraging of Silicon Valley: Venture Debt in the Innovation Economy

Abstract

Venture debt is now observed in 28-40% of venture financings. We model and document how this early-stage leveraging can affect firm outcomes. In our model, a venture capitalist maximizes firm value through financing. An equity-holding entrepreneur chooses how much risk to take, trading off the financial benefit against his preference for continuation. By extending the runway, utilizing venture debt can reduce dilution, thereby aligning the entrepreneur's incentives with the firm's. The resultant risk-taking increases firm value, but the leverage puts the startup at greater risk of failure. Empirically, we show that early-stage ventures take on venture debt when it is optimal to delay financing: such firms face higher potential dilution and exhibit lower pre-money valuations. Consistent with this notion, such firms take eighty-two fewer days between financing events. This strategy induces higher failure rates: $125,000 more venture debt predicts 6% higher closures. However, conditional on survival, venture debt-backed firms have 7-10% higher acquisition rates. Our study highlights the role of leverage in the risking-up of early-stage startup firms. Aggregation of these tradeoffs is important for understanding venture debt’s role in the real economy.

Keywords: Corporate Finance, Entrepreneurship, Venture Capital

JEL Classification: G24, G30, G32