Why not bank loans to EU startups?

Guest post by Rafael González-Gallarza and Álex Pujol, partners at Garrigues Corporate Department

One way to boost the digital economy in the EU would be to help banks making loans to new businesses. To do this, the institutions themselves need to know about venture debt and other possible products, and the European and national authorities need to support a stable legal framework adapted to the business environment including the area of bank finance.

European banks are not in the habit of lending to young tech and innovative firms. Our startups get finance from other sources, generally from funding rounds among venture capitalists. The numbers and presence of these new companies in the EU markets are rising, according to data published by Invest Europe, the European private equity and venture capital association, and its reports still fail to show the presence of bank loans in the industry. European commercial banks are however in need of new profitable lines of business.

A different story in the United States

In the United States some banks do lend regularly to startups; Silicon Valley Bank, Comerica, PacWest, to name a few. Their ecosystem is indeed more densely populated, but there is no reason why things should be so different from Europe. There are even encouraging circumstances in the EU, considering that European banks have no regulatory barriers to investing in venture capital funds, as a way of getting close to the sector and all its opportunities, unlike in the U.S. where the Volcker Rule is an obstacle[1].

These U.S. banks take advantage of these transactions to offer other kinds of services, including private banking services, to founders and to executives. As the ecosystem and each company grows, the bank extends its business and introduces more conventional commercial banking products.

What is venture debt all about?

Venture debt is the term used for loans to tech companies in the seed phase, or more generally Series A rounds, in other words where the company has already commenced its first funding rounds among investors and made in between rounds. They are not structured against revenues or against assets; these startups are not even in the period of having revenues: they simply “burn money” on developing their applications or molecules and supplying themselves with funding in successive rounds among investors.

Venture debt consists of bridge loans tiding them over until the following round is concluded: they are facilities, including medium-term ones, which besides giving advance funding against capital contributions also partly replace them. Something they do very efficiently because their seniority over equity means they can offer more economic prices and therefore reduce dilution for founders and investors. Although these loans usually include a warrant that offers the bank to option to buy shares at an attractive price, the bank’s return includes fees and high interest, with an aggregate cost than is not dissuasive.

These loans may have collateral (typically over the intellectual property of the company) and senior and junior loans may coexist under an inter-creditor arrangement. All of this is offered in the standard way on these banks’ websites and the transaction costs are acceptable.

What about Europe?

Venture debt is not completely unknown in Europe and specialized funds are appearing but not commercial banks, which could be explained by unfamiliarity with the product, aversion to it, or a lack of size of the market, although the ecosystem of companies backed by venture capitalists is growing so this last reason cannot be the main one.

There are hungry venture capitalists aplenty and the idea behind and dynamics of rounds is not to drop the company so as not to lose invested funds and to reap what they sow, until a sale or initial public offering. Against this backdrop, lending is not inconceivable.

But for banks loans to these companies open the door to new customers and new business. The individual amounts are quite modest, very profitable, and may be worthwhile as the company grows and other financial solutions are provided to the company and its stakeholders, at a lower risk.

Regulatory capital requirements

The risk attached to these loans cannot be denied because a lot of firms fail and lose the trust of their venture capitalists, who will not step in and refinance the loan. The likelihood of default can be considerable, as can the exposure at default. The severity of the loss will depend on whether there are any realizable assets and there may be collateral which retains value.

The European regulation on capital requirements for credit institutions (CRR) which has just been amended is not much help but there is nothing in it that could be prohibitive.

Collateral

Here is where the soundness of the product is partly at stake. Venture debt, and even more importantly, the loans and more conventional solutions that follow it when the company brings in revenues and needs to be equipped with more fixed assets, are more appealing if they have collateral ensuring their senior ranking.

Here, there is room for improvement in the law: in most continental jurisdictions there is no floating security capturing all the company’s assets in the same way as the UK’s floating charge does. There are new types of intangibles in the digital economy that do not fall easily into our law’s categories of things and security interests: trade secrets is an example.

Banking legislation gives little flexibility: the Capital Requirements Regulation is very demanding when it comes to identifying assets able to be recognized as eligible collateral for credit risk mitigation (CRM)[2].

All of this can be revised by looking also at the U.S. example. It is a shame that the Commission does not seem to be persisting with its draft legislation on recovery of collateral[3]; Europe is a collection of jurisdictions whereas the United States has a Uniform Commercial Code governing movable property security.

Greater legal certainty

Generally, banks have the same needs as their potential customers: a stable and adapted legal framework. Banks will not lend either, even though there may be collateral and revenues, if the innovative company is always exposed to a change in case law or statutes, be it in employment law or regulatory, which will destabilize its business model. Once again, Europe has much to do here to push forward with its digital economy and breathe new life into its banks at the same time.


[1] The American NVCA is trying to get regulators to remove this obstacle (click here).

[2] The EBA’s recent draft guidelines on CRM for banks using advanced models is the latest document to be drawn up on CRM and reflects the requirements and restrictive approach in this area.

[3] See the legislative procedure for the proposal for a Directive on servicers and the recovery of collateral in which this last part seems to be cast aside or at least slowed down by the Council in this link.


Rafael González-Gallarza, Partner

He advises financial institutions, private equity firms, industry groups and public authorities on regulatory matters and on a range of corporate and financing transactions (mergers and acquisitions, private equity fundraising, structured finance, etc.). More…

Álex Pujol, Partner

Alex Pujol practices law with a focus on financial law in the broad sense. Accordingly, he has worked on myriad projects and transactions for clients in the financial services industry (credit institutions, investment services firms, collective investment undertakings, insurance companies, listed companies and private equity firms), advising on compliance and corporate governance matters, securities issues (corporate debt in particular), public offerings, tender offers, and compensation systems for directors, senior managers and employees of listed companies, as well as mergers and acquisitions and joint ventures carried out by the above entities. More…

Garrigues Corporate Department

Garrigues’ Corporate/Commercial Law Department is considered one of the most prestigious and widely acclaimed in the legal services industry. We have played a prominent role in the development of Iberian corporate/commercial law and we provide recurring corporate/commercial advice to companies of all nationalities. More…

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