Considering Venture Debt? Learn the Loan Lingo
If you’ve explored financing options for your startup and have ruled out venture capital and traditional loans, at least at this time, you may be exploring venture debt as another option.
There’s plenty to love about venture debt. It provides cash to fund growth but doesn’t require the same level of dilution as raising VC money, and you retain control over your company (no need to bring on investors as Board members).
If you haven’t been able to qualify for a traditional bank loan because you’re a new startup, venture debt may still be open to you.
Venture debt can also connect you with others in your industry who can help your startup succeed. Just like venture capitalists, venture debt firms often are happy to help you build relationships and partnerships that can help your startup grow.
Before you contact a venture debt firm and start shopping deals, it’s a good idea to familiarize yourself with key terms or loan terminology so that you can fully understand any offer or agreement put before you.
With a loan, amortization spreads your debt repayments out across the loan repayment period. Typically, it’s even over the course of the loan, though some loans can include a period of Interest Only, or IO, at the outset of the loan.
For larger companies, some portion of the debt funding may include bullet repayment terms. The bullet structure doesn’t have amortization from month to month, but does have a lump sum due at the end of the loan period.
You’ve applied for venture debt and reviewed the term sheet (which looks fantastic), but before you proceed, make sure you understand what are called the Conditions Precedent, or “CPs.” These outline actions that you are required to take before receiving the funds.
Some founders may overlook the CPs (they’re typically at the back of the term sheet), but it’s important to review them closely because they might have terms that could trip you up from smoothly accessing the funds.
Some common Conditions Precedent include:
- Due diligence to the investor’s satisfaction (get clarification on what that looks like)
- Presenting a detailed business plan and budget
- Meeting regulatory requirements in your industry
- Securing necessary business licenses or permits
There may also be CPs regarding the investor receiving certain fees, whether the deal goes through or not, as well as stipulating that your startup can’t shop around for a better deal once the term sheet is signed. Bottom line: read the Conditions Precedent to ensure you understand what might keep you from receiving funds.
Term sheets may include financial covenants, which are requirements for your startup for the duration of the loan term. For example, if you are seeking capital to acquire another business, your covenants might state that you must maintain a certain margin or profitability level. Why? The lender will be looking for sufficient earnings capacity to cover business operations and demonstrate continued value creation generally in line with your expectations when borrowing the funds.
If any of the covenants you’ve agreed to are breached, your lender has the right to consider your loan defaulted and take various actions, including demand the loan is repaid in full.
Fees are a familiar topic, at least, but be aware that there are several different fees you may be required to pay with venture debt.
Commitment, or Closing, Fee
Once your loan has closed and all the documents have been signed, you will be responsible for a closing fee, usually around 2%. This fee may be paid in cash or reduced from the capital you receive.
The maturity fee, payable in cash, is due when the loan is repaid in full. Not all venture debt includes a maturity fee, while some use it instead of warrants.
While it would seem a good thing to pay off your loan early, it’s important to realize that there is commonly some fee to do so. The Prepayment fee is compensation for the lender for arranging the funding in case the loan is repaid earlier than expectations and is common. The important question to analyze is what those fees look like, and to make sure you understand how much will be due when you repay or refinance your loan.
Venture lenders provide high-growth companies with capital funding to help accelerate growth but have more limited returns than venture capital investors.
In exchange, as lenders are receiving less upside, they structure loans with security interest to take less risk. Typically, venture lenders take a security interest in all assets of the business including intellectual property. If a borrower can’t pay the loan in full, the lender has the right to the proceeds from assets to cover the unpaid debt.
By familiarizing yourself with loan terminology like the above, you are putting yourself in a better position to understand the terms of your venture debt term sheet. If you have any questions, Get in touch and we can help you.