High inflation, geopolitical tension, increasing interest rates, and economic volatility have meant that raising capital from venture capital (“VC”) investors has become increasingly expensive. Against this background venture debt is gaining ground as a means of helping growth stage VC-backed companies extend their cash runway and bridge the gap between equity raises or to an IPO or sale.
What is venture debt?
Simply put venture debt is a type of loan provided by banks and specialist funds to growth stage companies which have already secured (previously or at least simultaneously) the backing of institutional VC investors.
Venture debt tends to take the form of a loan, with a short to medium term (one to four years) maturity, usually (but not always) secured by a debenture over all the assets of the company, including intellectual property rights.
Most venture debt loans are amortising but frequently start with an interest-only period of 6 to 18 months, after which the company starts repaying the loan principal. Unlike “traditional” bank debt, venture debt rarely requires extensive covenants given companies are often still loss-making businesses.
Given this increased credit risk, interest rates on venture debt are typically higher when compared with traditional bank debt.
Venture debt providers will also take an equity kicker, worth a percentage of the loan. This gives a venture debt provider exposure to the potential increase in the value of the company, again to compensate for the increased credit risk. This equity kicker is structured as a warrant and gives the venture debt provider the right to buy a small amount of equity at a fixed price during the term of the loan. The warrant is exercisable against a predetermined strike price, which is generally linked to the company's valuation at its most recent equity raise or to its valuation at a future equity raise with a discount.
Typically, in the venture debt market, companies are able to tap around 25 to 50% of the amount raised during their most recent equity raise. But generally speaking, loan size, term and pricing will all depend on the stage of the company (Series A/B/C), the industry in which it operates, the objective for which the debt is being raised as well as the identity of the VCs.
The identity of the existing VC investors is an important consideration for venture debt providers as they indicate the quality of the company as well as the likelihood of future equity raises through which the venture debt will be repaid. Indeed, a venture debt provider’s decision to extend a loan to an early-stage company may be based on the reputation and stature of the VC firms and other institutional investors in the company rather than the creditworthiness of the company.
How can venture debt help a growth company?
Venture debt has many advantages.
- Extends cash runway: Venture debt can be used to extend the cash runway until the next equity raise. By extending the runway, the company will have more time and funds to execute its business plan and hit milestones for a higher valuation at the next equity raise.
- Non-dilutive/limited dilution: Venture debt is largely non-dilutive meaning companies can raise additional funds without giving up equity. The company does not have to issue additional shares when taking on venture debt therefore avoiding shareholder dilution. Indeed, it has been suggested that the extended runway period also results in the ability to raise equity less expensively at the next equity raise, which reduces the dilution for existing shareholders even further. Some dilution may result from the exercise of an equity kicker by a venture debt provider, but this will be less dilutive that an outright equity raise.
- Protect valuations: Venture debt can be used to avoid “down rounds” (ie raising equity at a lower valuation than the previous raise). Venture debt can fund the gap until the company is back on track to achieve a higher valuation at its next round of equity financing.
- Fund to profitability: Venture debt can bridge a company to profitability, by providing an extra source of funds to push a company forward during a critical phase of growth. This can eliminate the need for a final equity raise and further dilution.
- Improves IRR: Institutional VCs may benefit if the amount they draw down from their limited partners is reduced. This can improve their internal return on investment. The leverage effect of using debt may also be beneficial if the venture debt is used correctly, again benefiting the return on equity.
- Fast: Obtaining venture debt is often faster than going through an equity raise. Arranging venture debt usually takes between 4 to 8 weeks. Venture debt providers typically loan to companies that have already raised capital from institutional VC investors, so there's no need to repeat the extensive due diligence process.
- Flexible: Loans typically contain no or limited covenants as growth stage companies need flexibility to adjust to market conditions and financial covenants can often incorrectly show a company is under-performing. For example, EBITDA covenants would be problematic for growth stage companies with volatile or negative EBITDA for the foreseeable future.
- Cost: Despite increasing interest rates, venture debt is still cheaper than equity
When to raise venture debt
It's recommended that growth companies raise venture debt when they don’t need it, and ideally concurrent with or immediately following an equity raise.
At this point, the company’s cash flow is at its strongest and the company is likely to have greater bargaining power when negotiating terms with venture debt providers. Furthermore, companies will be better placed to provide up to date business information to the venture debt providers.
How Mills & Reeve can help you
At Mills & Reeve, we are experienced in advising both venture debt providers and companies on all stages of venture debt transactions, from negotiating term sheets and loan agreements, to advising on bespoke security packages and warrant instruments, all the way through to closing.
Examples of our experience include:
- Advising a leading API platform provider in connection with a loan facility from Kreos Capital
- Advising a digital advertising tech company in connection with a loan facility from SVB
- Advising a venture debt provider in connection with a loan facility for a company developing cutting-edge technological tools for use in biological research, diagnostics and drug discovery
- Advising a digital media management platform in connection with a venture loan from Barclays
Supported by our VC team who have a wide range of expertise in fund creation and fund structuring, as well as portfolio management and exits, we understand the whole VC fund life cycle, which is coupled with our deep sector expertise in technology, life sciences and healthcare. This means we can identify and address the core issues quickly and effectively, saving you both time and money.
If you would like to speak to a member of the team about venture debt, please contact Andy King.
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