Raising Venture Debt
Venture Debt Term Sheets & How to Negotiate
Venture debt is an attractive financing option for growth-stage companies looking to scale their businesses while minimizing equity dilution. This article outlines what to expect when you receive your first venture debt term sheet and tips on what to negotiate for.
A term sheet is a nonbinding document that outlines the material terms and conditions of a potential business agreement.
Venture debt term sheets are usually given after the initial screening and before the full due diligence process begins. The purpose of a term sheet is to outline the terms the venture debt lender is willing to make the investment on.
An important thing to note is that terms are not set in stone and are negotiable. In fact, once a company receives a term sheet, this is when they can and should negotiate prior to signing. After the full due diligence process is complete, the negotiated and agreed-upon terms are found in the final documents.
The top of a venture debt term sheet will outline general information such as the company’s name, the investor’s name, the date, currency, and investment amount.
The currency of the loan is usually the currency the lender and investor operate in.
If the investor and borrower use different currencies, there is associated currency risk. A currency risk is a possibility of losing money due to unfavorable moves in the exchange rate.
The investment amount can either be disclosed in the term sheet as a fixed amount ($3 million) or a range ($5-8 million) since the exact amount will be finalized before the final documents.
Next, the term sheet will outline the structure of the loan. In most cases, a venture debt deal will be referred to as a “Senior Note.” This is another term for senior debt. However, there are situations, particularly in larger, more established companies, where venture debt goes in as a junior/subordinated security position.
The interest rate section states the interest rate of the loan and the frequency of payments. Generally, venture debt comes with monthly interest payments, but they may also be structured to be quarterly or annually as well.
Example:
Let’s say Company A receives a $1 million loan for 1 year and 15% interest to be paid monthly. The total interest for the year is $150,000. If you divide this amount by 12 months, Company A can expect to pay $12,500 in interest each month.
Payment-in-kind, or PIK, is an accrual of interest. This means the interest accumulates and is paid at the end of the loan. PIK is a great option for companies who may want to delay making cash payments until the term of the loan has ended. This helps reduce the company’s cash outflow while it is still investing in growth initiatives.
Another option is to structure the loan with both cash paid interest and PIK. This combines the two structures above where the company pays cash interest and a portion of accrued interest.
Example:
Company A receives a $1 million loan for 1 year and 15% cash interest and 1.5% PIK. This equals out to $12,500 in cash monthly interest payments and $1,250 in PIK interest accrual, paying a total of $165,000 in interest.
The PIK interest is added to the principal amount and is repaid at maturity.
There are two ways a venture debt loan’s principal amount can be paid back.
Amortizing Loans
In amortizing loans, the loan’s principal is paid back in installments every month in addition to the interest payments, similar to a house mortgage.
Non-Amortizing Loans
In non-amortizing loans, often called “bullet loans,” the company only pays interest every month and the loan’s principal is paid off in a single lump sum at the end of the term.
The maturity date refers to when the loan period ends and when the borrower’s final payment is due.
The payment schedule outlines the frequency and amount of each payment. In some cases, an example of a payment schedule is attached to the back of a term sheet for added clarity.
In some cases, investors may offer a short-term interest payment deferral which provides the borrower the opportunity to defer their first X months of interest to be paid at a later month. Usually, the interest is added to the principal, similar to PIK interest, or is added on to the future payments of the loan. This is useful for companies who would like to minimize cash outflow during the first few months after receiving their loan.
A sinking fund is a fund that contains money that is set aside or saved to pay off a debt. These are often used in situations when a borrower needs to pay off a debt in the future and wants to soften the blow of a larger revenue spend.
In venture debt deals, a borrower can buy out of the loan at any time but it comes with a cost. Early prepayment amounts will vary based on how early a company decides to buy out the loan. In term sheets, you may see something like this:
“At any time after 18 months, and with 2 months’ notice, the Company may repay the Note by repaying the outstanding Principal and the company agrees to pay 6-month interest as (the “Early Repayment Fee”).”
The Conditions Precedent section identifies items that must be completed to the investor’s satisfaction prior to closing on the transaction. This could include the closing of a concurrent funding round, an equity co-raise, the repayment of an outstanding debt obligation, or the signing of a contract the borrower mentioned was very important.
The next section of a venture debt term sheet is the Key Employee Commitment, which asks the borrower’s key employee(s) (e.g. Founder, CEO) to commit the majority of their efforts to the business. This is because in venture debt deals, investors are often investing in a person and that person is critical to the future success of the company.
If the founder or CEO leaves the company or fails to devote the majority of their time and effort into the company – this could lead to an event of default.
A secured loan means the borrower provides security that the loan will be repaid. For those familiar with bank debt, borrowers typically provide personal guarantees. Most venture debt investors will not require personal guarantees. Instead, this is commonly done through pledging assets as collateral for the loan.
Venture debt deals are most often fully secured and investors are categorized as Senior Creditors. This places them at the top of the debt stack, but in some cases, venture debt lenders are willing to subordinate to another senior lender, such as a bank.
The most common form of security in venture debt is a General Security Agreement (GSA), which is when the company pledges all of its current and future assets to secure the loan.
In some cases, security may be in the form of share pledges. This is when the founder or CEO pledges their shares in the company to the investor.
Some investors may decide to use personal guarantees. This is the legal promise of the founder or CEO that guarantees the payment of the loan.
Negative covenants are actions a borrower cannot do without the investor’s express approval. This may include:
This section is usually expanded in the final documents once the full due diligence process is complete.
This section outlines where and how the funds are going to be used. Venture debt is usually used to fund growth initiatives, so it is common to see “working capital” or “growth” here.
One of the signature features of venture debt is warrants. Warrants are the right to buy common shares at a fixed price within a specific period of time.
Warrants provide the investor the option to participate in the company’s future growth and, therefore, can help “sweeten” a deal. While some founders unfamiliar with warrants may be hesitant, it should be made clear that warrants are not “free equity.” Warrants are simply the option to buy equity at a fair price and usually only amount to 1-2% of the company if executed. If the investor decides to exercise their warrants, the investor will still need to pay for them, providing cash flow for the borrower.
For more information about warrants, read our Founder’s Guide to Warrants in Venture Debt.
An alternative to warrants is a success fee. A success fee is a non-dilutable perpetual equity ownership position of the borrower’s company and is usually given to the investor for free at the time of the loan.
The success fee is usually expressed as a percentage of the company’s enterprise value and is often used when a borrower’s capital structure is too complicated. Success fees often range from 0.5-1.5% of a company and only become valuable when the company is sold.
When an investment is made in or into a tax-free jurisdiction, there is often a withholding tax at source. This section of the term sheet acts as a catch-all to make sure that if there is any withholding tax, the borrower is responsible to pay net of the withholding tax and ensures the return to the lender is not negatively affected by the withholding tax.
Deposits are used in venture debt deals to dissuade borrowers from shopping around for competitive term sheets. They are usually structured in the following way:
Venture debt investors will aim to keep expenses reasonable, but potential borrowers should expect to pay legal expenses for the lender. Some lenders also charge a due diligence fee.
The last fee you may find on a term sheet is the setup fee. These generally sit around 1-2% of the investment amount and can help cover additional expenses such as excess legal costs, wire fees, and more.
This section outlines what ongoing information the borrower is expected to provide the investor and how often they need to provide this information.
Investors require information such as monthly financials in order to keep track of their portfolio performance and identify any potential problems before they get out of hand.
The Right to Audit provides investors the permission to audit companies. This may be used in situations if an investor wants to double-check all of the information provided to them is accurate. If an investor decides to perform an audit, they are responsible for the cost.
In venture debt, there are two types of defaults: technical default and financial default.
A technical default occurs when a negative covenant has been violated.
A financial default occurs when the borrower has not made a scheduled interest or principal payment.
Defaults will typically come with “cure periods,” which offer a given amount of time for the borrower to fix the problem. In general, venture debt investors will want to work with their portfolio companies to help them manage through difficult situations. However, uncured defaults mean the company is in trouble and the investor will need to exercise its rights to recover its principal.
Defaults might also lead to. the eventual restructuring of the loan and/or the issuance of a forbearance agreement. A forbearance agreement is when the investor agrees to modify the terms of the loan to allow the company to continue to operate. These agreements come at a significant cost to the borrower.
Confidentiality is a legally binding section of the term sheet and discourages the company from sharing the contents of the term sheet, and the eventual loan, with outside parties.
Exclusivity is also a legally binding portion of the term sheet that makes sure the company agrees not to look for alternatives, usually for 60 days, once the term sheet is signed.
Remember – if the company decides to pursue a deal with another lender once the term sheet is signed, they will be forfeiting their deposit.
The No Obligation to Advance section reinforces the fact that the term sheet is not a final contract. Term sheets are used to outline the key terms the lender is willing to do a contract on. Final terms are subject to due diligence, final documents, and final signatures.
The Closing section provides an approximate date for closing.
Term sheets often come with an expiry date, which means the lender will honor the terms until that date. The company is welcome to come back after the expiry date. However, they should expect the terms to change.
As mentioned earlier, venture debt term sheets can and should be negotiated prior to being signed. Everything from payment schedules, fees, interest rates, and warrants are on the table for negotiation. As we like to say at Flow Capital, words are free – there is no harm in asking.
