What is venture debt?

Role of venture debt

Companies raising venture capital are typically loss-making until a late stage in their growth trajectory and do not usually have the type of tangible assets that can easily be used to raise traditional senior secured debt.   It would seem therefore that the only option for these companies would be to raise additional capital through equity issuance.

We are seeing more and more instances of clients turning to venture debt and a wider range of lenders are now offering the product.

Some of the high street banks are starting to develop, or have developed, products in this space with their versions of venture debt, which typically do not take any share warrants.  We are being asked a number of questions about venture debt and have answered some of these questions below.

What is venture debt?

Venture debt is an umbrella term that is typically used to describe lending arrangements to early stage, high growth businesses that have usually not yet reached profitability. The terms of the debt offered broadly share some similar characteristics. We explore these characteristics in further detail in the paragraphs below.

Why would a company turn to venture debt?

Firstly, when compared with an equity funding round, venture debt is quicker to put in place and there are much lower transaction costs.  The differences in transaction costs and time to execute can be a material consideration for a borrower and will mean that management time can instead be used where it should be – on running the business.

Secondly, venture debt doesn’t dilute equity to the same extent as an equity funding round.  We can’t say that there is no dilution at all because venture debt usually comes with an “equity kicker” requirement for the lender, which is usually in the form of share warrants.  These share warrants will give the lender a right to be issued some shares in the company at a point in the future (for example on a successful exit), but usually will be for a much smaller amount of equity than would be ceded on a pure equity funding round.

Lastly, the venture debt lender usually doesn’t require any board observer rights or rights to appoint a director – typical requirements of an equity investor.

We are seeing the lending criteria, commercial terms and legal documentation involved in venture debt polarise around some market standard positions.

Venture debt facilities can be structured as short-term bridging arrangements or longer-term growth loans.  The key point – and a key difference when compared with raising equity funding – is that the borrower is going to have to pay those funds back (along with the interest accrued) on the terms of the loan.

Companies may seek to raise venture debt as a standalone activity, or in tandem with seeking to close an equity funding round.  Some of the venture debt providers that we have seen in the market will write both equity and debt cheques.

What are the common lending criteria applicable to venture debt?

Venture debt lenders will in most cases require:

1. first ranking security over all the assets of the business (recognising that in most cases these are intangible assets);

2. for the business to already have been backed by a reputable venture capital firm (although some lenders prefer there to be no existing VC investment); and

3. projections and business plans to demonstrate either a route to profitability or a route to a successful exit (for instance a sale or initial public offering).

Increasingly some venture debt lenders are also looking at recurring revenues, for instance subscription revenues of the type seen in software as a service (“SaaS”) businesses.  Indeed some lenders are specifically lending against these recurring subscription revenues.  Although in some respects this looks a little like invoice financing it differs for one key reason: the lenders are lending against potential receivables and the service to which the receivable relates has in most cases, at the time of financing, not yet been provided.  Accordingly there is no due and payable receivable to be assigned to the financier at that time. For that and other reasons they are seen as a riskier proposition than traditional invoice financing and therefore don’t usually attract the same financing terms.

Venture debt is a relatively new phenomenon and is something that differs to traditional lending in that there are often no requirements for the loan to be asset backed or for the borrower to have reached profitability.  Importantly venture debt usually does not replace the need for equity funding in its entirety, there generally needs to have been some equity funding rounds before venture debt is an option for a business.  There are however, examples of businesses that have used debt instead of equity financing rounds and have bootstrapped their way to profitability and/or a successful exit.

What are some typical terms for venture debt? 

Of course, the terms of the venture debt offered will all differ from business to business and will depend on a variety of factors. These factors include: (i) the market conditions at the time; (ii) the appetite of a particular lender to lend; and (iii) the particular risk profile of the borrower and the sector in which it operates.  Nevertheless, we tend to see the key terms in a range around the following values: (i) share warrants in the range of 10 – 15% of the amount of the loan; (ii) a 10% – 15% per annum interest rate; and (iii) a 1-5 years term. Sometimes we also see arrangement, prepayment and/or back ended fees.

Are there potential downsides to venture debt when compared with an equity funding round?

The most important difference to take on board, without stating the obvious, is that being debt it is repayable on its repayment date. If the market conditions change and an exit or the projected route to profitability is no longer possible the debt will still have to be repaid or refinanced on its due date, else the lender will have a number of options available to it. These options will include enforcing its security.  As a debt of the business, it also ranks ahead of the equity on an insolvency – even any preferred classes of equity to which a liquidation preference attaches.

This Insight piece was written by Chris White with input from Henry Humphreys.

If you need advice on a venture debt transaction or any other debt finance transaction then do please get in touch with one of the team.

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice and is not to be relied upon.  Much of the above will no doubt fall out of date and conflict with future law and practice one day.  None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law