Venture debt
What is it and why use it?
Venture debt is a form of debt financing specifically designed to meet the needs of scaling start-up companies. After the dot-com bubble and during the early 2000s, it became a popular form of financing to assist pre-profit scaling tech companies that don't have tangible assets to provide as collateral to more traditional lenders.
The venture debt market has skyrocketed over the last 15 years, with the most well-known venture debt lenders such as SVB, TriplePoint and Kreos joined by a diverse array of new lenders.
Venture debt can be used for a multitude of purposes. The most common reasons companies choose to take on venture debt include:
Growth
The debt can be used to help the company continue to grow by assisting in funding research, product development, sales and/or marketing.
Runway extension
Depending on the level of cash burn, debt can be a quick and flexible method of extending a cash runway so the company can continue to focus on growth or product development.
Acquisitions and expansion
Often acquisitions prove an effective alternative to funding the development and marketing of a new product as well as enabling a company to gain market share.
Consolidation
Venture debt can be used to streamline shareholder base, return surplus capital to stockholders, streamline the existing capital structure or effect a share buyback to return funds to investors.
Unforeseen circumstances
Whether it's a global pandemic, war or other unforeseen market conditions, there will always be events which delay growth and venture debt can help navigate an unplanned delay.
Venture debt can be used for a multitude of purposes. The most common reasons companies choose to take on venture debt include:
Growth
The debt can be used to help the company continue to grow by assisting in funding research, product development, sales and/or marketing.
Runway extension
Depending on the level of cash burn, debt can be a quick and flexible method of extending a cash runway so the company can continue to focus on growth or product development.
Acquisitions and expansion
Often acquisitions prove an effective alternative to funding the development and marketing of a new product as well as enabling a company to gain market share.
Consolidation
Venture debt can be used to streamline shareholder base, return surplus capital to stockholders, streamline the existing capital structure or effect a share buyback to return funds to investors.
Unforeseen circumstances
Whether it's a global pandemic, war or other unforeseen market conditions, there will always be events which delay growth and venture debt can help navigate an unplanned delay.
Put simply, there's no loss of control when venture debt is taken in the same way there is with equity investment. In addition, the debt is provided by specialist venture debt lenders who are experts in understanding the market and risk profile of early-stage tech businesses.”
Venture debt vs equity
Venture debt ultimately offers a quicker alternative to equity investment while allowing the company to retain equity. This means more return on an exit as well as helping the company to meet targets needed to achieve better terms for raising capital in any subsequent funding round.
The key advantages of venture debt over equity are listed below.
Time
It can take anywhere between six months to two years to secure an equity investment round, while a common time frame to put venture debt in place is only around three months. This means companies can use venture debt to benefit from advantageous market conditions or a time-sensitive acquisition.
Dilution
There's no immediate equity dilution with venture debt (subject to the granting of warrants to the venture debt provider if this is agreed). As a result, venture debt won't decrease potential future earnings in the same away equity investment would due to share dilution.
Control
Put simply, there's no loss of control when venture debt is taken in the same way there is with equity investment. In addition, the debt is provided by specialist venture debt lenders who are experts in understanding the market and risk profile of early-stage tech businesses.
Venture debt terms, structures and security
Venture debt lenders are specialists in their field and the number of lenders and funds now available means that there are more options than ever for companies in terms of the structure a lender will provide debt into as well as the methodology for calculating debt quantum. One often sees loans made calculated against projected runway, turnover or ratio of debt to equity.
There are a plethora of different terms that can be commercially agreed with venture debt lenders (and far too many to cover in this article alone). Having said that, in broad terms you usually see venture debt facilities with a repayment term of between two and five years, with an agreed annual interest rate which can be paid on a cash basis when due or capitalised as needed depending on cash flow.
Loans are often tranched with subsequent tranches being made available conditional on achieving a certain amount of annual growth over, for example, a trailing 12-month period and other metrics such as total debt to ARR ratio. The loan is often structured so that it's repaid in full at the end of the loan term, but the debt can also be serviced during the life of the facility with fixed repayments.
A typical security package granted in favour of a venture debt lender would usually include the following on the assumption there is a single topco entity and a single opco subsidiary:
- Fixed and floating charge security: the venture debt lender will require fixed and floating charge security over all the assets of the topco and the opco subsidiary. This will include security over any key contracts crucial to the operation of the business of the company, bank accounts, IP, machinery, the benefit of insurance proceeds and any real estate with capital value. Under English law, different types of security can be created over different types of assets in a single document called a 'debenture'. In certain jurisdictions, separate security will need to be granted in separate documents over particular assets to achieve the same ultimate aim. In the UAE, assignments in respect of certain key contracts may be executed, and security over certain moveable assets may be registered pursuant to the UAE moveable assets security law.
- Share security: the venture debt lender will require security over the shares owned by the topco in the subsidiary so that the lender has the optionality of selling the subsidiary as a whole in a corporate sale. Venture debt lenders won't seek to take share security in the topco as this would entail the investor base granting security over the equity interests which isn’t market standard for venture debt deals.
- Guarantee: venture debt lenders may require each company that provides security to additionally provide a guarantee in respect of each other company's obligations.
- Subordination: any existing loans between topco and opco will need to be subordinated to and rank behind the debt owed by the relevant company to the venture debt lender. In addition, it's worth noting that all other loans or debt liabilities owed by any company in the structure (eg any convertible loan note obligations) will also need to be subordinated to the senior ranking debt of the venture debt lender which will mean that loan note holders would need to sign up to a subordination agreement with the venture debt lender.
The usual position is that there can't be any distributions to shareholders without the consent of the venture debt lender until the loan has been fully repaid.
Get in touch
If you're considering venture debt or would like to discuss it further, please get in touch and we'd be happy to assist.
