OCC issues policy guidance to national banks engaged in venture lending

On November 1, 2023, the Office of the Comptroller of the Currency (OCC) issued a bulletin to all banks under its regulations that are involved, or are considering involvement, in venture lending, or what the OCC refers to as “commercial loans to early-, expansion-, and late-stage companies.” The bulletin addresses the heightened risk that comes with lending to emerging growth companies, provides guidance on managing these risks, and includes discussions related to common venture lending risks such as approved risk management practices, guidance on risk-rating loans, evaluating repayment capacity, and capital adequacy.

It is unclear whether these standards will be adopted by the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), or state banking authorities to apply to all banks, or if they will continue to apply only to national banks and federal thrifts. However, even in the absence of direct application by regulators, it is advisable for state banks to consider similar factors and risks for their venture lending activities.

This alert summarizes the OCC bulletin and highlights key considerations for both lenders and venture-backed companies seeking or maintaining loans from OCC-regulated national banks and federal thrifts.

Background

The OCC classifies venture borrowers into two categories: (i) early- and expansion-stage companies or (ii) late-stage companies. In both segments, borrowers may lack sustainable cash flow to service debt, including payment of fees, interest, and principal, or they may not have sufficient assets to use as collateral for a conventional loan.

The OCC guidance describes early-stage and expansion-stage companies as those typically in the initial stages of business planning with limited revenues and high expenses. These borrowers have limited operating histories for banks to evaluate and underwrite. Generally, banks will consider the quality of their investors, the likelihood of subsequent capital raises, and the projected cash burn relative to cash on hand. The OCC guidance suggests that relying solely on these factors, without proper credit enhancements, poses severe default risk on a venture loan portfolio.

Late-stage companies are often characterized by significant rollout of new products or services to the market, potentially ramping up for significant scale or having already achieved it. Lending to this borrower category requires strong underwriting, as these companies may have negative, intermittent, or insufficient cash flow for debt service. Such cash flow issues result in significant dependance on secondary repayment sources (ie, private equity financing, public debt or equity, the sale of assets, and liquidity from earlier fundraising), which require significant diligence under the OCC’s guidance.   

Venture lending risks

The OCC identifies the primary risks associated with venture lending as unproven cash flows, untested business models, intense capital requirements, and limited refinancing options. Given the undeveloped nature of these emerging companies, the venture loan facility may exhibit defined weaknesses. It is important for banks to recognize and flag the potential risks associated with a borrower, including:

• Declining or insufficient liquid assets and working capital
  
  
• Negative or insufficient operating cash flow to service or repay debt
  
  
• Insufficient assets to pledge as collateral to mitigate credit risk or an inability to restrict and reserve balance-sheet cash collateral for loan repayment
  
  
• Reliance on future fundraising as the primary source of capital for repayment

Risk management

The board of directors and senior management at an OCC-regulated bank are advised to establish, document, and communicate the bank’s risk appetite as it relates to venture lending (by means of “a clear risk appetite statement and risk limits for venture lending”). It is suggested that banks monitor material or growing exposure in venture debt, as well as establish and maintain prudent credit underwriting practices that take into account the concentration of credit risk associated with their venture loan portfolio. The OCC expects banks to establish appropriate operations and managerial standards, such as maintaining loan documentation practices that support informed lending decisions, assess risk, and document a borrower’s ability to repay.

Additionally, the guidance directs banks to consider:

• Implementing business or lending plans appropriate for the bank’s size and complexity, including a clear risk appetite statement and risk limits for venture lending approved by a bank’s board of directors
  
  
• Using internal reporting and management information systems to help identify, measure, monitor, and control venture lending risks, including the ability to aggregate venture exposure across the bank’s business lines
  
  
• Tracking and monitoring any loans categorized as special mention or classified originations, and exceptions to internal bank policies
  
  
• Approving only the loan requests that (i) meet the bank’s stringent underwriting standards, (ii) have sustainable repayment sources, and (iii) are consistent with appropriate concentration limits for this type of lending
  
  
• Implementing a loan monitoring process that includes periodically obtaining a borrower’s financial projections and interim cash reports, including notes on the basis for such projections and reports
  
  
• Increasing structural frameworks to effectively control risk. This could include the ability to sweep cash to reduce outstanding debt upon event of default

Risk-rating venture loan and evaluating repayment sources

The OCC bulletin mentions that venture loans originating with a non-pass risk rating are inconsistent with safe and sound lending standards. A non-pass loan is any loan that has (i) potential weaknesses that could result in further deterioration of repayment process, (ii) well-defined weaknesses that jeopardize debt liquidation and may result in some loss if not corrected, or (iii) weaknesses present at the time of origination that make full collection or liquidation highly questionable and improbable.

To avoid such loans, the OCC recommends that bank venture lending standards discourage the origination of non-pass rated loans at inception, unless it is part of a risk mitigation strategy to improve an existing non-pass loan.

When evaluating and risk-rating venture loans, banks are encouraged to:

• Evaluate and risk-rate venture loans with similar metrics to other commercial and industrial loans based on existing supervisory and policy standards
  
  
• Focus credit analysis on repayment capacity
  
  
  • Examine historical performance against future plans of the company
    
    
  • Examine the company’s ability to generate cash flow sufficient to repay debt and de-lever
    
    
  • Determine whether the company can rely on cash liquidity explicitly reserved for debt repayment
    
    
  • Determine the availability of a company’s committed equity financing that can provide for repayment. OCC examiners will consider whether committed equity financing is contingent on the borrower meeting certain performance milestones, and whether the borrower is likely to meet those milestones
    
    
  • Consider the risk profiles of borrowers and determine, based on expected financial performance and viability, whether there are sustainable primary and secondary sources of repayment
    
    
• Consider the potential effects of changing market conditions on the borrower’s ability to execute its business plan, raise additional capital, maintain equity valuation, or exit via merger or acquisition

Finally, to assist banks with evaluating repayment capacity and protect lenders, the OCC highlighted several examples of what should not be considered a potential source of repayment.

“An uncommitted future equity raise is not a satisfactory primary source of repayment.”

While lenders have traditionally cited potential future equity funding as the primary source of repayment, the OCC clarifies that it is not a sufficient source of repayment. Although new fundraising from investors can be an avenue for loan repayment, banks should avoid underwritten loans from an equity perspective unless there is documentation of a legally binding commitment from reputable venture investors.

Further, banks should only consider fundraising as a repayment source if the legally binding commitment from investors provides the company with the ability to use the raised capital to pay off existing debt.

“A venture borrower’s unrestricted and declining cash balance is normally not a sustainable primary source of repayment.”

Venture borrowers typically have ample amounts of initial unrestricted cash on their balance sheet which can support a credit-positive determination. The OCC guidance instructs banks to continue evaluating a borrower’s source of liquidity when grading risk. This includes analyzing a borrower’s liabilities, cash burn rate, the loan’s maturity date, and structural controls to determine whether present liquidity provides sufficient mitigation to a compromised primary source of repayment.

“Recurring revenue is not equivalent to sustainable repayment capacity.”

Although recurring revenue is credit positive, there can still be challenges for companies that have not yet matured into exhibiting sufficient cash flow, collateral, or net worth to repay debts. Banks should consider all factors when determining whether there is a proper repayment source in recurring revenue loans to borrowers. Banks making recurring revenue lines of credit are encouraged to strictly analyze the borrower’s cash flow projections, planned expenses, and future expected capital expenditures. This strategy may help protect banks in the event of downside scenarios impacting the borrower.

For more information, please contact the authors.