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.