Four Tips for Companies Considering Venture Debt Financing

Authors: StartupPercolator

Many of the benefits of raising a Series A round are obvious—improved team morale, validation from outside investors and, of course, cash.  Another benefit may be less obvious—raising a Series A round can open up new sources of capital, including venture debt.  “Venture debt” is a type of debt financing available to venture-backed companies that, because they often lack positive cash flow or significant hard assets, may not be credit-worthy based on traditional lending metrics.  Venture debt lenders are often willing to lend to venture-backed companies based, in part, on the lender’s (i) confidence that the company’s equity investors will continue to fund the company until the debt is repaid, and (ii) desire to share in the company’s growth potential through an equity kicker (typically warrants).  Venture debt is an attractive option for many companies because it can allow the company to extend its runway to a future equity round without as much dilution to the founders as if the company raised additional equity.

Before raising venture debt, companies should consider the following:

  • Expand the Term Sheet.  When evaluating a venture debt term sheet, companies should consider more than just pricing terms.  Experienced counsel can help you identify issues relating to the covenants, events of default and required collateral that will make compliance easier (and cheaper) if addressed at the term sheet stage.  When dealing with venture lenders, a company has the most leverage at the term sheet stage.
  • Timing Is Everything.  Companies using venture debt to increase runway should be careful to structure their debt facility so as to minimize unnecessary increases in their short-term burn rate.  Venture lenders will frequently agree to interest-only periods.  The length of these periods is a key item for negotiation.  Another strategy that companies can employ is negotiating a “draw period” for term loans, allowing the company to lock in financing on day one without borrowing the full amount upfront.  This allows a company to delay incurring interest until the capital is needed.
  • You Are Giving Up (Some) Control.  Unlike convertible notes (which typically include few if any covenants), venture debt agreements impose various covenants restricting the borrower’s freedom to operate its business.  These covenants limit a company’s ability to, among other things, raise additional debt, repurchase stock and sell material assets.  Experienced counsel can help negotiate exceptions and limitations on covenants that will increase your flexibility, but even a well-negotiated loan agreement will put meaningful limits on a company’s ability to execute major transactions without the lender’s consent.
  • Trust Matters.  Because venture lenders make lending decisions based in part on subjective factors (i.e., expectations that institutional investors will continue to fund the company in the future), they typically expect to be able to declare an event of default and exercise remedies against a borrower based on subjective factors as well (e.g., upon a material adverse change or an “abandonment” of the borrower by its investors).  With this in mind, it is imperative that a company borrow from a lender that it trusts and that has a good reputation for partnering with venture-backed companies, in both good and bad economic times.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.