In recent months, early stage company deal reports have suggested an uptick in venture debt financing for companies unable or unwilling to access the capital markets. Rather than pursue what may be a down-round equity financing, and often at the encouragement of their venture investors, early stage companies are lining up venture debt facilities for additional working capital and to shore up their balance sheet. Before taking on a venture debt credit facility here are 10 things you need to know.

1. Non-Dilutive (Mostly). A major advantage of debt over additional equity is that debt is non-dilutive to the capitalization of the company. However, most venture lenders require an equity kicker, in the form of a right to co-invest in the next preferred equity round, or, more often, the issuance of a warrant (a right to purchase equity interests). The warrant is typically for common stock or the most recent preferred equity round, priced either as a penny warrant or at the price of the most recent 409A valuation/price of the last preferred equity financing, if available. The number of warrant shares is typically based on a certain, resulting ownership percentage or calculated based on a percentage of the principal amount of the loan.

2. Stage of Company. Most institutional venture lenders will expect at least one preferred round of equity financing before being willing to provide a venture debt facility.

3. Form of Loan. Funding may occur in the form of a single term loan distributed in full at closing. It may also be a delayed draw term loan, with additional amounts becoming available as the company achieves certain pre-agreed milestones following closing. The size of the debt facility may also be determined by the calculation of a "borrowing base," where the aggregate principal amount outstanding cannot exceed an agreed percentage of the value of the company's eligible receivables, inventory, or recurring revenue.

4. Collateral. Venture lenders typically receive a first-priority (senior) security interest in all assets of the company. It is common for intellectual property (IP) to be excluded from the collateral grant, but remain subject to a negative pledge (prohibiting the pledge of the IP to anyone else). Excluding the IP from the security package allows a company to provide outbound licenses of its IP to third parties without the interference of a lender.

5. Approvals Required. There will be consents and approvals that will need to be obtained in connection with any venture debt financing. Consent of the board of directors will be required and often shareholder consent is also needed in connection with the warrant issuance and the incurrence of debt over a certain amount. Additionally, venture lenders typically require that all existing debt of the company, including convertible notes, is subordinated to the new debt facility, and the maturity date of all debt is later than the maturity date of the new debt. Any existing noteholders (including convertible noteholders, founder noteholders and/or friends and family noteholders) will need to sign subordination agreements and possibly amend the terms of the existing notes.

6. Third-Party Items. In addition to the consents mentioned above, a secured lender will require a company to seek certain deliverables from other third parties. Some institutional venture lenders will require a company to move all of its depositary accounts to the lender bank. If not, then the venture lender will require that company put in place a tri-party agreement among the company's depositary bank, the lender and the company, providing the lender the right to take control of the deposit accounts following the occurrence of an event of default under the loan agreement. Venture lenders will typically also require that the company obtain an agreement from its current landlord(s), providing the lender the right to access the leased space and remove the company's property following the occurrence of an event of default under the loan agreement. Additionally, lenders require that endorsements are added to the company's general liability and property insurance policies naming the lender as an additional insured and loss payee, as applicable, on the policies.

7. Restrictive Covenants and Reporting Obligations. Venture debt agreements contain tight restrictions on a company's ability to engage in certain activities, such as the incurrence of additional debt and liens, making investments, acquisitions and distributions to shareholders, and material changes to the capital structure. Venture lenders expect a company to seek its consent to any transaction not permitted by the loan agreement, and a venture lender may withhold consent for any reason. Loan agreements also contain periodic reporting obligations, including the delivery of annual audited financial statements and either quarterly or monthly company-prepared financial statements.

8. Compliance With the Business Plan. Lenders use financial covenants to track a company's performance in line with the business plan shared with the lender during its due diligence process. Financial covenants for emerging companies are typically limited to EBITDA growth (often as a declining negative number), or liquidity. It is not uncommon for a venture debt agreement to not have a financial covenant at all, given the early stage of the company, instead relying on an event of default that is triggered if there is a material adverse change (MAC) with respect to the business. A MAC event of default is intended to serve the same purpose as a financial covenant, allowing a lender to cut off additional funding, exercise remedies and/or re-negotiate the loan agreement if the company is not performing as expected. Unlike a financial covenant, there is more room for a lender's discretion in determining if a breach has occurred.

9. Debt Service and Fees. Companies with venture debt facilities must have cash flow or another cash source in order to pay principal, interest, fees and expenses associated with the loan. When the term sheet is signed, the lender typically requires a deposit that is non-refundable but is applied against its diligence and documentation expenses. At closing, a borrower will typically pay an upfront fee to the lender, as well as all reasonable expenses of the lender, including its attorneys' fees. For the first year to 18 months of the facility, usually only interest payments will be required. Thereafter, the borrower will need to make regular installment payments of outstanding principal. There may also be annual monitoring or administrative fees and a final "exit" fee at payoff. If the company wishes to terminate the facility early, there is often a prepayment premium (that may decline over time).

10. Personal Guaranty. For an early stage, pre-revenue company, the venture lender may request a personal guaranty from the founders. Not all personal guaranties are created equal. The most punitive is a full backstop of the company's obligations to the lender, with the lender being able to seek repayment from the founders without exhausting remedies against the company. A more limited version of this would be a capped dollar amount and a requirement that the lender first seek repayment from the company. The most limited form of personal guaranty is what is often called a "bad acts" guaranty; limited to indemnification by the founders in the event of certain specified actions of a founder, such as fraud or misappropriation of funds. It is important to have a clear understanding at the outset of what type of personal guaranty a venture lender is requiring.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.