Venture debt contract structuration
Why raise in venture debt
In the case of venture debt raised to bridge to the next equity round of financing, it extends the company’s runway, and which will likely postpone the date of the next equity round. In such a case, there are two main benefits for the founders:
- Non-dilutive funding to increase the runway and have more time improving key metrics to raise the valuation at the next equity round which will help preserve the founder’s ownership.
- To negotiate a valuation at the next equity round with already commited cash which will help in the negociation.
This obviously assumes that the loan has been well allocated to organic growth (equipment purchases, acquisitions, international expansion, investment in sales teams, etc.).
When the loan repayment starts, it is expected that there will be additional cash flow generation from the growth phase since a venture debt contract is meant for companies with a strong organic growth, which is also expected to allow the long-term sustainability of the loan.
Main venture debt clauses
Venture debt is structured to defer repayment and preserve the borrower's short-term cash flow.
This is achieved by offering an interest-only period were the borrower only pays interest and not the principal. Some funds even offer a grace period where the borrower does not have to repay anything.
During the interest-only period, the borrower uses the cash extension of the loan to focus on growth, which theoretically increases the company's valuation.
Drawdown in facilities
The full amount of the loan is committed at the beginning of the investment period, but most Venture debt loans are structured in facilities.
The entire loan amount is not allocated at once but is split into facilities. The first facility is available without any constraint and should be delivered quickly after the contract is signed. Subsequent facilities however are often conditioned on the achievement of milestones (e.g., target ARR, equity fundraising…).
It is a financial instrument similar to an option that allows its holder to acquire the borrower’s shares in the future at a predetermined conditional exercise price (the strike price). It is one of the most critical clauses in a venture debt agreement and is a way for venture debt funds to increase the return on their loan.
The strike price is usually calibrated on the last valuation event, either an equity round or a convertible note, but it can also be anchored as a discount price at the next equity round, usually around 20%.
The more early-stage the borrower is, the higher the percentage associated with the requested warrant, due to greater uncertainty carried by this borrower.
Funds usually charge one-time fees to cover their management costs and to detach these fees from the return on the loan. When these fees are set to be paid upfront, they are called Arrangement fees and when paid at the end of the amortization period, they are called end-of-term fees. These fees are usually set between 0.25% and 1% of the amount of the loan. It is however possible to negotiate their payments attached to each facility to limit the impact on the borrower’s cash flow.
These fees also increase the IRR (Internal Rate of Return) of the loan especially when paid upfront.