Negotiating a Venture Debt Financing
It’s important to recognize that equity financing is not the only source of capital for fast-growing startups. Another source is the fast-growing area of venture debt financing (VDF). VDF is a short-term loan from banks or venture capital firms to companies with the expectation that the loan will be repaid back by the company throughout the loan period. VDF is a different from convertible notes/SAFEs and is a different product class. An important feature of VDF is that, there is little to no equity dilution for entrepreneurs and existing investors since the investor is not acquiring preferred shares in exchange for the investment. In addition, VDF gives the company some available cash, i.e., the company is more liquid, pending an equity financing. But most importantly, since VDF provides the company with available cash to achieve higher revenue targets, it has the capacity to increase the company’s pre or post money valuation at the next equity financing. It should be noted that VDF is not intended as a direct substitute for equity financing but is instead complementary to it because most venture capital firms will not provide a VDF to a startup that has not completed at least one round of equity financing. In fact, typically, VDFs are used as a bridge financing to an equity finance to help extend the company’s liquidity before an equity round is required.
How VDF is different from other Debt Financing.
Sometimes, startups use the occasional convertible notes or simple agreement for future equity (“SAFE”) as a form of financing via debt. The major difference between the VDF and these methods is that, these other methods are considered convertible debt, i.e., there is the intention of that the debt will eventually convert into equity, usually at the next financing round, or at a liquidation event, e.g., an acquisition or a merger. But for a VDF, the intent is that company will repay the loan sum to the venture capital firm. Additionally, VDF is usually repaid in monthly payments over the life of the loan, while most convertible debts have no option for repayment except upon debt conversion to equity. Lastly, it is common to find VDF with higher interest rates (10–15%), unlike convertible debts which have average interest rates of 3–8%. This high interest rate is due to the high-risk nature of the VDF for the investor — If the company defaults, the investor’s debt cannot convert to equity.
Essential VDF Terms.
We believe VDF really is a smart way of raising capital for fast-growing startups that have plans for an upcoming equity round and have accurate metrics on their monthly expenditure, and monthly recurring revenue (MRR). Here are key terms to take note of when negotiating one:
VDFs are usually short- to medium-term in nature, i.e., about 36 months to 72 months. One main reason for this is that VDF have higher interest rates and the longer the term of the VDF, the more interest that will accrue and will need to be repaid. Additionally, it is the case that most startups that opt for VDF have an upcoming equity round — usually in two to three years from the VDF, therefore, it only makes sense to have the VDF terminate right before the equity round.
Another important VDF point is the loan amount. This is very much dependent on the scale of the company; the quantity of equity round the startup has raised till date and the company’s reason for raising the VDF. First, for a business with an MRR of $300,000 and a monthly expenditure of $250,000, it makes no sense to enter into a VDF where the monthly repayment sum if $100,000. This means that the amount to be repaid by the company monthly is more than the company can spare monthly. Secondly, it is the norm that the amount raised in a VDF is usually determined using the amount raised at the last equity financing — usually between 25% and 50% of this amount raised, as a result of which early-stage VDF loans are much smaller than VDF loans available to later-stage companies. Lastly, if a company is entering into a VDF for a particular purpose, such as, for acquisition purposes or to purchase an equipment, the price of such acquisition or purchase is to be considered when entering a VDF. Since this is a loan that would be repaid (with interest), it is important that the company does not overstretch itself.
The company should consider tailoring its access to the VDF loan sum to its actual needs. This is where the draw-down mechanism is most important. Where a startup is required to draw-down the entire principal sum upfront, whether or not it has a need for the whole sum, this essentially means the company would be paying interest on excess capital it cannot and is not utilizing effectively, which is capital inefficiency. However, where the loan is structured in such a way that lets the company draw down capital when it is required, the company would only be required to pay interest on the drawn-down sum, starting from when it is drawn-down. A sure-fire way of raising capital efficiently! One way of structuring this is by having the draw-downs conditioned on the company achieving certain milestones or by making it time based, e.g., a drawdown every six months.
Negotiating this VDF term requires that the founder have a complete understanding of the company. As mentioned earlier, as a result of the high-risk nature of VDF for the investor, it is not unusual to see VDFs with average interest rates of 10–15%. Therefore, for a startup, borrowing at 15% makes absolutely no sense if the company is only growing at 10%. This will overstretch the company and defeat the purpose of the VDF. Therefore, knowledge of company’s growth is essential to negotiating the interest rate. Additionally, in order to get the best interest rate possible, the founder needs to also understand the VDF investor’s lowest rates. This can be done by reaching out to VDF portfolio companies of the investor and comparing rates. The founder may also, before signing a termsheet with any investor, shop-around for the lowest interest rates available with other VDF investors and use that as a bargaining tool with the company’s preferred investor. However, where the company is unable to get a desired interest rate, it may be in company’s best interest to obtain a conventional loan or a convertible debt which usually has relatively lower interest rates.
VDF typically has three pricing components — the interest rate, stock purchase warrants granted to the lender (which will be discussed below) and fees. These fees can range anywhere from closing fees, administration fees, standby fees, early prepayment fees, etc. When negotiating a VDF, it is important to consider how the fees will affect (or increase) the amount to be repaid to the investor. For example, using a VDF of $4,000,000 and the terms of the VDF term sheet sample provided below, the fees the company would be paying are as follows: –
(a) a 1.50% Closing Fee — payable on the loan amount ($60,000);
(b) a 0.50% Maturity Fee payable on the loan amount at time of maturity (($20,000); and
© Early Repayment Fees –
(i) 3% if repaid before first anniversary of closing ($120,000);
(ii) 2% if repaid before second anniversary of closing but after first anniversary ($120,000); or
(iii) 1% if repaid after second anniversary of closing ($40,000).
This means that, in addition to the principal sum and accrued interest, the company has an obligation to pay investor the fees of $80,000 (Closing and Maturity Fees) and if there’s any early repayment from the company, an additional fee, depending on the timing of the early repayment. When it comes to VDF, fee transparency and simplicity is the best way to go.
As mentioned earlier, most VDF loans have to be repaid within three to four years, i.e., the term of the loan. However, depending on the parties’ agreement, a VDF may start out with a 6- to 12-month interest-only (I/O) period, where the company only pays accrued interest, but not principal sum. After this I/O period is complete, the company will then be required to pay down the principal loan balance. In some cases, some lenders offer the option of interest-only loans over the entire term, with the principal due in full upon maturity. The repayment terms are very much dependent on the company’s needs and the parties’ negotiation. The parties may agree to an advance payment requirement, i.e., where, upon the close the VDF transaction, the company pays the investor a sum equal to and that will be applied in and towards the VDF’s last month’s repayment amount. One other important repayment term is the monthly date of repayment (first date or last date of the month). This date affects how the interest rate is pro-rated for repayment and most importantly, with this, the company is aware of when to remit payment to the investor.
Warrants — Possible Dilution
In VDF, the third and final pricing component is the warrants. It is common for investors in a VDF to request for a warrant on the company’s common or preferred equity as a part of the compensation for VDF’s high repayment default risk. With this warrant, the investor would have the right (but not obligation) to purchase some shares of the company at an agreed price, usually at the per-share price of the last equity financing round or a future round. This warrant, if requested, usually represents about 5–20% of the principal amount of the loan, i.e., at a VDF of $4,000,000, that’s $200,000 — $800,000, and if exercised, is likely to translate to only about 1–3% of the company — a significantly lower dilution than one occurring from an equity round. However, it is important to note that while it’s a significantly lesser dilution, it is nonetheless still a dilution and should be negotiated with the existing shareholders’ interests in mind. Another important question is — whether the investor would be required pay to purchase the shares upon the exercise of the warrant? or if the warrant can be exercised by converting a percentage of the loan to equity? In the sample provided, the investor is required to pay the purchase price in order to exercise its warrant. Finally, it is important to determine how long the warrant is exercisable for and what happens to the warrant in the event of a liquidation event.
Warrants –Share Type and Strike Price
Furthermore, depending on the negotiation between the parties, it may be agreed that the warrant convert to either common or preferred shares. Some investors prefer exercising their warrants to preferred shares due to the various rights associated with such type of shares, e.g., voting rights, liquidation preference, etc. Although rare, it is possible to find investors that prefer exercising their warrant to common shares, particularly where such investors have no need for the rights associated with the preferred shares because they plan to exercise their warrant immediately before a defined liquidation event. The parties also need to agree on the warrant strike price. Typically, this strike price is usually the price of the shares offered at the next equity financing round, subject to a discount rate (usually 15–30%) or a valuation cap (see VDF termsheet sample language). A final point for clarification when granting a warrant to the investor, is what type of rights the VDF investor will have when it exercises its warrants — usually these rights are similar to the rights of the investors in that next equity financing round.
There is no doubt that VDF is a high-risk loan — the investor can only be repaid monthly and unlike convertible notes or SAFEs, cannot convert the loan sum to equity. This means the investor will suffer a loss if the company defaults on its repayments. As such, when entering a VDF, the founder should be prepared to grant the investor a security interest on the assets of the company, e.g., cash, inventory, intellectual property, etc. This is expected in VDF transactions. However, more negotiations may be necessary to determine how to prioritize the investor’s security interest where the company has an existing debt or plans to acquire future debt. Most VDF investors will request for a first priority security interest — i.e., if the company is unable to pay off its debt, and the company’s assets is to be used to settle its debt, then the VDF investor’s debt will be settled first. However, where there’s already an existing debt in the company with first priority, then the VDF debt may take a subordinated priority (i.e., subordinate to the first priority debt). However, it is important to understand that where a VDF investor takes a subordinate priority, it is taking on a larger risk, since in the event of a bankruptcy, the company’s assets (after settling the first priority debt) may not be sufficient to repay the VDF loan sum, and this risk will likely be reflected in higher loan costs, such as a higher interest rate or more fees.
Most conventional loans have numerous covenants and where a company defaults on one or more of these covenants, the loan become repayable, and if there’s part of the principal sum still available to be drawn-down, the company may lose the right to draw-down that remainder. On the other hand, VDF transactions have less covenants than conventional loans, particularly if from non-bank lenders. This is to ensure that VDF agreements do not contain unnecessary covenants that increase the risk of company’s defaults or excessive restrictive covenants that reduce the capital that the company can actually draw-down. Since the intention of a VDF is to provide capital to fund growth for companies, having a lot of these covenants and restrictive covenants will defeat its purpose. Therefore, founders should watch out for VDF term sheets with too many covenants. Some common covenants to expect in a VDF include — a limitation on company’s right to future debt (or a requirement of the VDF investor’s consent prior to such debt creation); and granting the VDF investor consent rights prior to any related party transaction, merger and/or acquisition, or material change ii n business. In some cases, since the VDF investor would not have a seat on the board, it is not unusual to see VDF investors requesting for observer rights.
Being knowledgeable of the different ways of raising capital for a startup is important to maintaining a balance of equity and debt to build the business. Better still, understanding the essential terms of a VDF is important to negotiating an advantageous VDF that would help in growing the company. As mentioned earlier, VDFs have numerous advantages — achieving a higher valuation at next equity round, less equity dilution resulting in founder maintenance of control, readily available cash for business expenditure, and strategic flexibility — and the terms of any VDF transaction should reflect this. Where the terms do not, seek alternative financing.