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.
We’re excited to introduce a multipart and ongoing series about the basics of (and some advanced topics related to) equity for startup employees and contractors. The “Human Capital” aspect of any enterprise, especially a technology company, is its most valuable asset, and we hope to highlight the…
Stock options are the most common form of equity incentive for early-stage startups. A stock option grants the option holder the right to purchase a specific number of shares of the company within a fixed period of time at a preset “exercise” price, generally following the satisfaction…
The Human Capitalist Series P.3: How Are Stock Options Taxed, and Which Are Better, Incentive Stock Options or Nonstatutory Stock Options?
The U.S. federal taxation of stock options for U.S. taxpayers depends on whether the options are classified as incentive stock options (ISOs) or nonstatutory stock options (NSOs). Incentive Stock Options (ISOs) ISOs may provide a tax advantage to the holder if (i) the optionee does not sell…