Unveiling the Power of Venture Debt: A Legal Guide for Startup Founders

Entering the world of entrepreneurial ventures is akin to embarking on a daring expedition where the terrain is often unpredictable, yet brimming with promise. Amidst the myriad funding options available to startups, venture debt is a reliable form of capital at the growth stage of the venture, providing a unique blend of financial support and strategic leverage. As a leading law firm that specializes in working with startups and helping them determine the right capital structure at each stage of the startup lifecycle, we have witnessed firsthand the transformative power of venture debt in fueling the aspirations of scaling enterprises. This blog post aims to answer common questions founders have about debt financing options for early stage and growth stage startups, including what venture debt is, when it might be available to your business, and common market terms. We recommend founders contact SPZ early on in the process of seeking venture debt so we can advise you through term sheet negotiations and the documentation process. 

What is venture debt and how is it different from traditional debt?

The term “venture debt” is a broad term encompassing the non-dilutive debt financing available to startups. It can take the form of a term loan (a one-time lump sum loan) or revolving loans (that can be repaid and reborrowed). Traditionally, banks base decisions to make corporate loans on cash flow projections, and lenders secure their loans by taking a security interest in the assets of the borrower as collateral. But startups do not typically have the cash flow metrics to support a loan or assets to collateralize, and the future success of the company is less certain than later stage companies. Debt was not easily available for companies with this risk profile, so a space emerged in the lending market for higher risk loans to early stage companies. Rather than relying solely on financial projections, lenders take some comfort in the fact that borrowers are backed by venture capitalists. 

Because of the higher risk that borrowers won’t be able to repay the loans, venture debt (usually) comes with a shorter time to maturity, higher interest rate and potentially higher fees than the term, rate and fee structure given to later stage borrowers. 

When might my company be eligible for venture debt? 

Lenders in the venture debt space are looking for companies that already have some form of venture backing, so the company needs to be at a stage where it has already raised some funds from a priced round. Generally, venture debt is available to companies that have completed at least a Series A round. Venture debt is typically not available to very early stage companies as lenders want to see that the borrower has stable revenue and a path to profitability. Prior to that, outside funding will need to come from equity or convertible equity investors, bootstrapping, a business line of credit, or grants. Investors can be useful in connecting companies with lending partners, and borrowers have more leverage in negotiations shortly after an equity financing round. The amount of funding available to borrowers is usually a fraction of the amount that the company raised in its last equity financing. 

How does debt affect my cap table?

It doesn’t!* As non-dilutive funding, shareholders will not be diluted when you take on venture debt. On a dissolution or an exit event, creditors come first in the distribution of funds and will be fully repaid before equity investors receive any return on their investment. Note that, depending on the terms of your equity financing documents, you may need to get stockholder consent prior to incurring venture debt.

*Venture lenders often ask for what’s called an “equity kicker” or a piece of equity in exchange for debt. The equity kicker usually takes the form of a warrant to purchase 5-8% of common stock in the borrower as part of their venture debt package. Warrants issued to lenders would appear on your cap table, although they do not dilute shareholders right away.  

What are common venture debt terms, and what should I look for when considering a venture debt deal?

Of course, you’ll want to compare economic terms such as the amount of principal available, the interest rate and any fees (including termination or breakage fees). But you should also consider the covenant package required by the lender and how much operational control you would cede. Loan agreements may require the company to keep a minimum cash balance, use the proceeds for a specific purpose, maintain a certain leverage ratio, or require lender consent for various corporate actions not taken in the ordinary course of business. Lenders may even go so far as to request a director or board observer seat. 

Defaults in a venture credit agreement can also differ from those in financing agreements for more mature companies. Because venture lenders base their decision in part on the company’s current and potential venture funding, the failure to continue to receive funding from VC firms (a.k.a. an “investor abandonment” clause) may be an event of default under a venture debt loan agreement. In the absence of an investor abandonment clause, venture lenders usually require a default for a “material adverse change” (“MAC”) or “material adverse effect” (“MAE”). MAC/MAE defaults typically center around the financial condition of the borrower and its operations, assets, liabilities and business prospects; depending on how the MAE/MAC is defined, losing a top customer or falling short of projections could constitute a material adverse change. Industry-wide or systemic issues should be carved out from the MAC/MAE definition. 

Whether the loan agreement has an investor abandonment clause or a MAC/MAE clause, the default language should be carefully reviewed in consultation with counsel. Lenders can accelerate (immediately demand) loan repayments when the company defaults, which could put a company in the position of not having equity investments on the horizon or having experienced some other material adverse change and having to pay back a loan they had not expected to have to repay for another couple years. Lenders want a more ambiguous MAC/MAE clause that gives them some subjectivity, whereas borrower-friendly default language will place objective parameters around lenders calling a default for investor abandonment or a material adverse event. 

Many commercial banks entered the venture debt market as a way to bring in more banking customers. Often, borrowers seeking a loan from a commercial bank are required to transition their banking services over to the lender in connection with the debt financing, although this practice may start becoming less common in the wake of the Silicon Valley Bank collapse.

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Especially now, as the venture debt market recalibrates following the SVB collapse, venture debt terms may vary widely. SVB was responsible for over half of all venture debt loans in the 20 years prior to its collapse. Now, several months after the collapse, the makeup of lenders is changing, and direct (i.e., non-bank or alternative) lenders are becoming more dominant in the space. These direct lenders tend to have more flexibility with deal terms than heavily regulated banks. As of the time of this alert, demand for venture debt is higher than supply, meaning lenders are getting favorable terms. SPZ recommends shopping around for lenders to make sure you are getting the best deal. We encourage you to reach out to SPZ to discuss your venture debt options. 

This blog post was written by Elizabeth Thorne, Ryan Shaening Pokrasso, and Becky Mancero