Venture debt is an actively emerging form of venture funding that is targeted for VC-backed businesses looking for additional funds to fuel growth. Venture debt is very much relationship driven — since it is a complement to equity capital, it is important that entrepreneurs and investors alike are aware of it and build relationships with venture debt providers early on. A smart infusion of debt financing might significantly boost a startup’s growth potential and often makes the fundraising process much simpler and more transparent.
Venture Debt is a financing solution tailored to early-stage companies that can be a supplement to the equity financing.
Venture Debt has been present on the US market as long as since 1970’s and is widely used by startups. The value of venture debt transactions in 2020 amounted to over 27bn USD, accounting for almost 18% of all VC investments in the USA. For US startups, Venture Debt has been an essential part of building the best tech companies in the world.
Despite Europe being a significantly younger and less developed ecosystem, Venture Debt has been thriving in the region for the last twenty years. In 2020, the amount of Venture Debt transactions in Europe reached 1.5bn, ca. 5% of total VC financing with the region. As the ecosystem matures, more and more startups decide to fuel its growth not only via equity money only, but via some debt financing as well.
Venture Debt is a financial product positioning itself between the equity and banking financing. Equity financing is the most popular capital source for early-stage companies, but it comes with a price as most of the Venture Capital funds are seeking the opportunities able to grow at least ten times over the investment period.
Banking financing is on the opposite side of a financing spectrum, being able to provide the cheapest financing on the market, especially during the low interest rates era. However, banks usually are unable to finance companies, that are loss making and do not have a significant collateral, which is mostly the case with early-stage companies. Additionally, banking financing is usually subject to financial covenants, which limit the flexibility of the management.
Venture Debt is filling the gap between these two financing options, being able to finance the fast growing, but still loss making and asset light businesses. It is more expensive than banking financing, with the interest rates being at low to mid teen percentage points. Still, it does not limit the company’s capabilities via financial covenants or a collateral.
Venture Debt is a financing tool, that can help to optimize the capital structure of the company and lower the total cost of capital. However, the debt instruments should be used by the companies that have already achieved certain milestones on its growth path, found the product market fit, and want to focus on scaling up the operations.
There are several scenarios, that Venture Debt is commonly used.
The most common use of Venture Debt is topping up the recent equity round to increase the run rate of a company, diminish dilution for all the founders and existing shareholders, and provide additional cushion in terms of any delays in the business plan. In such a case, the debt facility is closed by a company simultaneously or shortly after closing the recent equity round. The facility allows to maximize the amount of cash available for the growth of a company.
Another popular use case of Venture Debt facility is a bridge towards the next equity round. It allows the founders to postpone the next capital increase and thus being able to further grow a company, which results in a higher valuation. In some cases, it also gives the founders additional time for meeting the milestones which are often required by some investors at later stages (e.g. reaching the 10M ARR threshold). Last, but not least, a debt facility raised prior to the next equity round gives the company a better negotiating position, not being afraid of running out of cash soon. Thanks to its virtually non-dilutive characteristic, Venture Debt is a great alternative against internal equity bridges.
Venture Debt is also an option for the companies, that are on a clear path to profitability, but still need to finance its operation between now and then and would prefer to avoid raising additional equity and the dilution accompanying.
Pricing of the Venture Debt loan consists of the interest rate and additional fees agreed by the parties.
Interest rate is the single most discussed term of the debt facility, which determines both the return for the lender and the cost for the borrower. The interest rate for Venture Debt facilities varies from low to mid teen percentage points and depends on the credit risk score of the debt provider. At Flashpoint, current scale of the business, unit economics, and the cap table are amongst the key elements that impact the assessment.
Apart from the interest rate, there might be some additional fees included in the term-sheet such as:
– Closing Fee, a fee payable in cash when the facility is signed or funded. It usually varies between 1 and 2% of the total amount of the loan.
– Maturity Fee, a fee payable in cash when the facility is repaid.
– Early Repayment Fee, a fee payable if the borrower decides to pay down the facility in advance.
Warrants are the essential part of most of Venture Debt deals and provide an additional reward for the lender for taking the risk associated with supporting early-stage companies. Warrants stand for an option to purchase shares of the company in the future for a specified price. For a lender, it is a way to align its interest along with all other stakeholders of the company.
Warrants are exercised by the lender in the future, if there is a liquidity event at the price which is higher than the strike price of the warrant. Usually, the lenders prefer to sell the shares of the borrower immediately post exercising the warrant. It is also common to include the net issuance clause in the warrant documentation. Net issuance is a way to simplify the process of exercising the warrants for both parties. It means that in terms of exit, the lender shall receive the difference between exercise price of the warrants and current price in cash.
When it comes to warrants, there are several terms that might be considered as crucial, when negotiating a deal. Those are:
– Warrant coverage. This term tells you exactly how much worth of shares, the lender shall have the right to purchase. It is often described also as warrant dilution. In this case, it tells you how much dilution for the whole company will occur when the warrant rights shall be exercised.
– Strike price. The strike price defines at which price the lender shall convert his warrant rights. One of the biggest advantages of Venture Debt is that it allows companies to avoid the valuation process. Therefore, usually the last equity valuation of the company is assumed here.
– Class of shares. The term-sheet should also specify the class of shares, that the warrant will exercise into. The standard approach is to assume the most recent round of shares. Usually these are the preferred shares that equity investors subscribe to as well.
Now, let’s take a look at some examples. Let’s assume that the borrower received a Venture Debt offer for a 1M facility, with a 12% warrant coverage and 20M strike price. This means, that the lender will have a right to buy shares for 120k, at a price per share equal to 20M divided by number of the borrower’s shares. In such a case, the dilution to the company would amount to ca. 0.6% (assuming no further capital increases) or lower (if additional capital increases occur between granting the warrants and exercising them).
The alternative wording you might see is to replace the warrant coverage with a warrant dilution. Let’s assume the same case, in which the borrower received an offer for a 2M facility, with a 0.6% warrant dilution and 20M strike price. This means, that at the time of exercising the rights, the lender would receive such a number of shares, that would equal to 0.6% stake in the company (even if additional capital increases occur in between).
Please note that the dilution with Venture Debt is not only substantially lower that vs. equity financing, but it is also delayed in time (until the liquidity event at a price higher than the strike price) and happens only if founders and other investors of the borrower are making money too. Thanks to this, Venture Debt allows not only to preserve additional value for the company’s shareholders, but also it aligns interests of the borrower and all other parties involved.
Shareholder’s dilution is one of the biggest worries for both founders and investors, as the companies are growing bigger. However, Venture Debt is a financing tool that allows to limit it.
One way to address the dilution issue via Venture Debt instrument, is to directly replace part of the equity coming to the company with a debt. Let’s assume a company, that has the opportunity to raise 2M, via equity, convertible loan, or debt facility. The pre-money valuation for equity round was set at the level of 20M, for convertible loan the cap was set at 40M, and for Venture Debt facility warrant coverage was set at 12%.
In this case, equity is diluting all the current shareholders by 9.1% (2M divided by post-money valuation of 22M). The dilution for convertible loan, assuming the best possible scenario of converting at cap, is at the level of 4.7% (2M divided by post-money valuation of 42M). For Venture Debt, the dilution is at the level of 1.2% (240k divided by post-money valuation of 20.24M).
Another scenario, that might be used by the companies, is to postpone the next equity round, instead of partially replacing it with debt. Let’s assume the company that is growing its revenue and the valuation at the pace of 50% every 6 months, that is burning 200k each month. The company would like to raise 7M of additional money, that would allow them to sustain the growth and cover the expenses for the next 2 to 3 years. The company is able to raise this equity round at the valuation of 20M, and with 25% dilution. The alternative scenario is to raise a 1.5M bridge round via a debt facility, that would cover the company’s expenses for the next 6 to 9 months, and then raise the 7M equity round at a higher valuation equal to 30M, and with a dilution of 19%.
By postponing the equity round, current shareholders of the company are able to increase both the valuation of the company and their future stakes in it.
Covenants are the commitments, the borrower makes to the lender, when taking the loan. There are many different types of covenants, with the financial covenants being most popular and most limiting for companies.
Covenants are mostly associated with bank loans. It can sometimes happen, that the company would receive a financing offer from a bank, at attractive terms, but with some restrictive covenants that would make the effective cost of this capital much higher. E.g. the borrower can receive a 1M loan with 5% interest and a covenant of having at least 0.5M of cash on its balance sheet. In such a case, the effective interest rate on the capital is higher, since there is a significant portion of debt, that can not be used.
Venture Debt facilities are characterized by lack of financial covenants, making it a flexible tool. However, some non-financial covenants are a standard for all the debt deals, such as limitations on permitted indebtedness or sale of the company’s assets.
It is common for a lender to ask for a capital deposit equal to the last instalment of the loan at the time of the funding. For a lender, it is a way for de-risking the investment in the company. From the borrower’s perspective, it means that the actual amount of the money the company gets will be minimally lower than the amount of the loan.
It is the most common for any Venture Debt lender to be a senior secured lender in the company. Seniority describes the order in which different stakeholders shall receive the proceeds in terms of the exit or liquidation of the company.
Senior secured lenders are one of the first to be repaid in case of selling the company. The simplified structure of the seniority looks as follows:
1. Government and employees.
2. Senior secured lenders.
3. Junior secured lenders.
4. Trade creditors and unsecured lenders.
5. Preferred shareholders.
6. Common shareholders.
The type of security taken by a Venture Debt lender varies by a company and jurisdiction. In general, a significant security or collateral is not needed for Venture Debt, as it is a product tailored for young tech companies, which usually do not have significant assets. However, from the lender perspective, obtaining a senior secured lender position is a key. Simultaneously, as the loan amount is usually substantially higher than market value of the borrower’s assets, a floating charge over all of the company’s assets is the most common approach towards the security.
In general, there are three documents that need to be signed when closing a Venture Debt transaction.
– Facility agreement, which is a document containing all the key information on the facility’s terms and conditions. The facility agreement is the main document of any Venture Debt deal and follows standard loan clauses.
– Warrant agreement, containing all the key terms of the warrant right.
– Security documentation, which can widely differ depending on the jurisdiction.
When working on a Venture Debt facility, it is important to remember that debt products are completely different than equity. Therefore, co-operating with a lawyer who understands, and has experience with Venture Debt is key, and allows to save both money and effort during the negotiation process.