Finance

Big banks are stealing a Silicon Valley business

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Wall Street banks are horning in on a tried-and-true Silicon Valley business.

And they're doing it at a crucial time.

Investors and executives say Silicon Valley fundraising for start-ups is stalling, right at a time when many need cash to support operations. Few are eager to do a down round — accept investor capital at a lower valuation — leaving them in need of a little leverage to get by. It means doing a deal for venture debt. Enter banks like Goldman Sachs, which are eager to underwrite debt for pre-IPO companies.

"As start-ups stay private longer, there's a broader need for venture debt to support operations," said one source who invests with big, pre-IPO companies. "It's on the rise, with companies that can get it."

Lately, there are a number of boldface-name start-ups that can: Uber, Airbnb and Spotify, and those are just the ones that raised $1 billion or more so far this year alone.

Various factors go into the growing trend toward venture debt: For Silicon Valley companies weighing an IPO, the extra cash lets them hold off on decision-making and focus on growth. The market hasn't exactly been friendly to companies looking to make public market debuts, and taking on VC money may be more difficult: At a time when venture capitalists have been raising more funds, their investing in start-ups began to decline earlier this year.

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Goldman Sachs has been involved in the venture debt deals of several top start-ups, including Uber and Spotify. The bank declined to comment.

Other banks in on the action include Morgan Stanley, Barclays and Citigroup. As is the case with corporate debt placements, big banks have the option of keeping the debt on their books as an investment, or selling it to related parties and clients (or both). Each of the banks declined to comment.

It's an industry that has typically been occupied by smaller, West Coast outfits, like Silicon Valley Bank or Western Technology Investment, which have put billions into start-ups, often doing venture debt deals as small as $5 million. But that's changing as start-ups offer bigger opportunities to Wall Street banks. Neither bank provided comment when contacted.

"They're in danger of losing some of their business," one banker said of smaller banks in the venture debt space, adding that because some companies' deals are not significant enough to attract Wall Street banks, there is likely room for competitors.

For today's hot, private start-ups, the venture debt market has mushroomed in size. Consider: In 2008, leading up to its IPO, Facebook's largest venture debt round was for only $100 million. The company did not comment when contacted.

At a time when artificially low interest rates have put pressure on investor margins, the venture debt can offer a tidy premium compared to the corporate debt of publicly listed companies. Three sources who spoke to CNBC said the cost of capital to borrowers is usually in the high single digits, or less than 10 percent, and can stretch up to the low teens. On top of that, the duration of debt deals is typically shorter than that of the ordinary corporate debt deal, or private equity transaction, sources said. Further, debtholders often have the opportunity of later converting their investment into equity.

It's expected more venture debt deals will be coming, especially if Silicon Valley's IPO activity remains muted. This year's IPO scene has been especially quiet, in part thanks to market volatility to begin the year.

"As a longer-term trend, more private companies are becoming more sophisticated at using all the tools typical of public companies with comparable market caps to these companies' private valuations," said an investor in start-ups, who was not authorized to speak publicly.