In the last installment of this series on venture debt, I wrote about the difference between traditional middle market lenders and “venture lenders” – who provide debt financing to pre-profit companies with little in the way of tangible assets. I also talked about the various financing solutions that venture lenders provide, such as loans that bridge to a startup’s next equity round, provide growth capital for new hires, etc. In this installment, I’ll talk about typical venture debt terms and the implications of each.
While there are many factors to consider, the borrower’s stage of commercialization and capitalization generally dictates the amount of venture debt available to startups – I’ll explain why another day. For early stage companies (i.e., pre-revenue, Series A-B), lenders will typically commit 25%-50% of debt relative to the last round of equity (e.g., $1,000,000-$2,000,000 of debt for a Company that recently raised a $4,000,000 Series A). Expansion stage companies (i.e., post-revenue, Series C-D) may be able to obtain upwards of $7,500,000 of debt. Later stage companies (i.e., early profitability, Series E+) typically garner as much debt as collateral coverage or cash flow can support (similar to middle market lending, but venture lenders generally provide it sooner than others). At the end of the day, prudent borrowers and lenders will err on the side of “how much debt is necessary” rather than “how much debt is possible.”
Most venture lenders offer two types of debt facilities: term loans (whereby the borrower advances against the facility during a 6-12 month interest-only period, then reduces debt over 24-30 equal monthly payments thereafter) and revolving lines of credit (much like a credit card, the borrower can borrow and pay down debt over a set period of time – generally 12 months). Depending on their needs, borrowers may favor one type of facility over the other. For example, term loans provide the ability to defer repayment until later, which works well for early stage companies that are not (yet) generating sufficient income to service debt repayment. Alternatively, expansion stage companies that are selling products may utilize a revolving line of credit (usually with advance rates up to 80% of accounts receivable or 3x monthly recurring revenue) to bolster cash position between the period of time in which they make the products and receive customer payments.
Venture lenders generally obtain a lien against the borrower’s assets that either includes intellectual property (IP) or excludes IP with a negative pledge (meaning the Borrower agrees not to pledge its IP to anyone else). The borrower’s risk profile, the venture lender’s risk appetite, and market dynamics dictate the inclusion or exclusion of IP. This is a hot-button topic, so I would simply caution entrepreneurs, VCs, and venture lenders to choose their partners wisely.
To verify the ongoing financial health of its borrowers, venture lenders require periodic reporting, including monthly income statements, balance sheets and compliance certificates (a notification that the borrower is abiding by the terms and conditions of the loan agreement). On an annual basis, borrowers also provide Board-approved plans and audited financial statements – though, given the costs of conducting an audit, venture lenders are often satisfied with annual tax returns or whatever level of CPA oversight is required by the Board of Directors (e.g., reviewed financial statements). If loan advances are governed by the borrower’s assets, venture lenders will often perform periodic collateral audits to verify the value of the collateral against which they are lending. No matter what type of information is shared, proactive, transparent and honest communication between borrowers and lenders is key to a successful relationship, with surprises often leading to issues.
Financial Covenants & Pricing
I’ve paired these terms together because of the inextricable link between a venture lender’s risk vs. reward, and because this is the primary point of differentiation between venture banks and venture debt funds. Most venture banks require financial covenants (e.g., minimum revenue at 75% plan, maximum net loss at 125% plan or minimum equity raise by a certain date), but the overall cost of capital is relatively low (interest rates at 4%-8%, upfront fees at 0.25%-0.50% and warrants at 3%-5%). Conversely, most venture debt funds do not require financial covenants (but do contain provisions around how and when loans will be made), but have a higher overall cost of capital (interest rates over 10%, upfront fees over 1%, and warrants over 5%). Another point of distinction is that venture banks tend to focus on a company’s entire relationship (e.g., checking and savings accounts, debit and credit cards, wire services, letters of credit, foreign exchange, etc.), whereas venture debt funds tend to focus solely on the loan transaction itself. There’s no “one-size-fits-all” solution for any given borrower.
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