A guide to Venture Debt

What’s the fuss about?

Despite European debt activity increasing 6-8 fold in the last 10 years, only 19% of founders are aware of the lending options available to them. This marks a polar opposite to the US, where debt accounts for up to 10% of the entire venture financing market, having been an integral part of Spotify, Airbnb and Uber’s expansion strategies.

Why is Europe behind? Fragmentation of Europe's financial markets, together with the consensus that we hold onto investments for a longer period of time, contributes to a lower risk threshold, resulting in fewer providers.

This guide will help founders and investors navigate the European landscape, including the reasons to consider debt, its structure, what happens if it goes wrong and the factors to consider when choosing a lender.

You may also be interested in revenue-based finance, another form of debt, covered in this article.

What is Venture Debt?

Venture debt is a non-dilutive type of financing offered to companies that don’t have an asset base that traditional banks can use to lend against, often alongside equity rounds. Terms can vary significantly across lenders, and across stages (Series A to IPO).

Venture debt typically has three pricing components:

• The interest rate (8% to 12% per year of the loan amount) paid during the loan period, when milestones are hit or at the end of the period;

• An origination fee (between 1% and 3% of the loan amount) paid at the start of the period; and

• Either warrants (an ‘equity kicker’) - where the lender has the right to buy a portion (typically 5% to 20% of the loan) of equity at a fixed price during the term, or a back-end fee for later stage companies priced around 8-12% of the loan.

Term Loans: Most venture debt facilities operate as term loans. The lender borrows a fixed loan amount typically over 1 to 5 years, with a specified repayment schedule. The repayment structure can include an interest-only period (usually between 6 to 12 months), after which repayments of the principal begins. When you repay the loan early, there is normally an acceleration of the agreed fees.

Revolving credit facilities: In some cases, venture debt is structured via a revolving credit facility (RCF). These are facilities that provide increased flexibility for lenders, with a maximum amount of capital available to be drawn down on demand, over an agreed period. The lender may repay the loan when they choose to do so and may roll the tranched amount over to the next interest period, usually around 3 months long. However, RCFs also feature commitment fees which may further increase the cost of capital.

Who is it relevant for?

Lenders look for at least one of these three scenarios:

1. Companies with a reputable VC involved in a round, validating the product, performing due diligence and providing capital as a buffer to minimise the risk of default in repaying the debt and interest;

2. Profitable companies with £1m+ of EBITDA; or

3. In some cases, companies with recurring revenues above £1m who can show a clear route to profitability within the next 12 months and who can exercise control over their burn rate.

Benefits

• Minimal (via warrants) or no equity dilution, making it cheaper than equity over the long term;

• Quicker to secure than equity financing and a shorter due diligence period;

• Cash runway extended to achieve the company’s next milestone;

• Valuation conversations pushed down the road, with the facility acting as a bridge until the next round of financing;

• Less restrictive on the business operations, with lenders typically not asking for a board seat or additional control over the company; and

• The interest you pay on the loan is tax deductible if a company is profitable.

Challenges:

• Loans must be repaid, with interest, making the total cost of capital;

• relatively expensive;

• If covenants are breached, the lender’s recourse can be drastic;

• Assets such as tax credits, grants, patents may be used as collateral; and

• Venture debt lenders are more risk-averse than equity investors as the upside is more limited.

Covenants: Loans include covenants, which together with milestones are favoured by lenders as they act to provide comfort that companies will pay back the loan. Although covenants can result in a cheaper facility, they may limit the founders' ability to execute their desired strategy if it means a material change to the business. However, they can also act as levers to offer higher loan amounts.

Covenants are promises to the lender that the borrower will do (affirmative covenants such as providing audited statements), not do (restrictive covenants such as asking for approval for further loans, dividends or asset purchases) or maintain (financial covenants such as maintaining a cash balance, revenue allocation or a ratio) specific things.

Founders tip: If a default is likely to occur, let the lender know quickly. This builds trust, providing the lender with more time to propose a solution.

When to raise venture debt

In most cases, lenders will only provide a debt facility for companies in the following scenarios:

• Bridge and insurance - extend the cash runway and hit the milestones for the next equity funding round;

• Growth – grow the business organically e.g. via customer acquisition, or inorganically e.g. via M&A;

• Funding to profitability - use the funding to reach positive cashflows

• Alongside equity - top-up an equity round; or

• Share buy back or cash out – Buy out early investors, or management taking some cash out the business.

When not to raise Venture Debt

• The company isn’t growing as fast as the interest rate on the facility - the advantage of deploying debt relies on the premise that the value created via investment exceeds the cost of capital

• The burn rate is high

• The revenue streams are significantly variable

• The company doesn’t have sufficient future cash flow to service the debt

Factors to consider

• Diligence: fundamentally, lenders will ask themselves is:

• Will this company continue to raise more venture capital?

• Will this company (continue to) be profitable in the future?

• Size: as a rule of thumb, the total debt facility should account for no more than a third of the overall round if raising alongside equity, or no more than a third of the last 12 months revenue.

• Business Model: whether the prospect has a ‘sticky’ model with a large customer base and good level of traction

• Security: some form of collateral such as intellectual property over which the lender can take security.

• VC fund: the credibility of the equity investor and whether the lender has a relationship with the participating VC.

• Team: the track record of the founders.

• Stage of business: it’s extremely hard to raise Venture Debt pre-revenue.

How to select a debt lender

• Find lenders that are a ‘light touch’ by minimising restrictive covenants

• Reference the lenders, much like you would other investors

• Compare more than just the headline interest rate when selecting a lender. Include the total cost of capital with origination fees, early repayment or non-utilisation fees, and other covenants.

• Avoid approaching lenders as a last resort when your cash balance is low

• Build relationships with venture debt providers early on; it’s a relationship-driven industry

• Get in touch with our team who can guide you on what the different providers offer and introduce you to the right lender.

Negotiation tips

• Tailor the provision to your finance needs. Lenders are often flexible on the how, the when and the why.

• Restrict the number of obligations and vetos you give to lenders

• Ask for flexible drawdowns and early repayment opportunities

• Avoid agreeing to covenants set at a level the company is unlikely to achieve in its base case scenario

• Exclusivity - ensure you don’t sign exclusivity to all investors. Limit the exclusivity to only other lenders

• Seek advice - we can help you understand the term sheet, with considerations such as default events, required collateral and covenants

• Founders! Be very careful about any venture debt which includes personal guarantees.

Concluding comments

Venture Debt can be a cost-effective component of capital for companies growing fast, and an alternative to equity funding. It is particularly valuable for those looking to extend their runway between equity rounds, or those who are already profitable and need further capital to grow.

Venture debt deals are not created equal; pay careful attention to the covenants, fees and loan terms before entering signing up. Clear objectives and an operating plan needs are critical.