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A Complete Venture Debt Term Sheet Walkthrough
Venture Debt Term Sheets
What to Expect & How to Choose a Lender
Venture debt is an attractive financing option for high-growth companies looking to extend their cash runway and fund growth initiatives while minimizing equity dilution.
Table of Contents
What is a Term Sheet?
A term sheet is a nonbinding bullet-point document that outlines the material terms and conditions of a potential business agreement.
The purpose of a term sheet is to outline the terms upon which the venture debt provider is willing to make the investment. It’s important to note that these terms are negotiable. Once a company receives a term sheet, companies can and should negotiate terms prior to signing and returning the term sheet. In most situations after due diligence, the negotiated and agreed-to terms remain intact and are found in the final documents.
There are certain sections of a term sheet that are legally binding, such as the Exclusivity, Confidentiality, Deposit, and Expenses sections.
Elements of a Term Sheet
The top of a term sheet will outline general information such as the company name, investor name, date, and currency of the transaction.
This section provides the amount of funding the investor and investee have tentatively agreed upon. This can either be a fixed amount (e.g. $3 million) or a range (e.g. $2-4 million). The exact amount will be finalized before the final documents.
Next, the term sheet will confirm the structure of the loan, which will typically be described as a “Senior Note.” This is because venture debt loans are typically senior debt. Although there are situations, particularly in larger, more established companies, where their venture debt loan goes in as a junior/subordinated security position.
The interest rate section states the interest rate of the loan and frequency of payments. In most cases, venture debt loans have monthly interest payments.
Learning Checkpoint #1: Calculating Monthly Interest Payments
Company A receives a $1 million loan for one year with an interest rate of 15%.
How much should Company A expect to pay in interest each month?
The total interest for the year is equal to $150,000 ($1,000,000 * 15%).
By dividing this total amount by 12 months ($150,000 / 12 months), monthly interest payments are $12,500.
The learning checkpoint above is an example of an interest-only loan. However, a venture debt lender may give you the option for payment-in-kind (PIK).
What is Payment-in-Kind?
Payment-in-kind is an accrual of interest which means the interest accumulates and is paid at the end of the loan.
Why Use Payment-in-Kind?
PIK can relieve borrowers of making cash payments until the loan term has ended. This is especially helpful for when you want to reduce your company’s cash outflow.
Cash Paid Interest + PIK
A third option to structure the loan with cash paid interest and PIK. In this situation, the company pays cash interest and a portion of accrued interest.
Learning Checkpoint #2: Cash Paid Interest + PIK
Company A receives a $1 million loan for one year with 15% cash interest and 1.5% PIK.
How much should Company A expect to pay in interest?
The company will pay the lender a total of $165,000.
Monthly cash paid interest payments is equal to $12,500 (($1,000,000 * 15%) / 12 months) and $1,250 in PIK interest accrual.
The PIK interest will be added to the principal amount and will be repaid at maturity.
Amortizing vs. Non-Amortizing Loans
There are two ways a loan’s principal is paid back.
When a loan’s principal is paid back in monthly installments along with any interest payments.
Non-Amortizing (“Bullet”) Loans:
When a loan’s principal is paid off in a single lump sum at the end of the term. Interest is still paid monthly.
Benefits of Amortized Loans:
- Offer a clear, set monthly payment for the borrower (there are no surprises)
- Are easier to track, as the payment amount for each month is calculated in advance
- Often provide a more straightforward process than other types of loan
Disadvantages of Amortized Loans:
- Loans in the form of a monthly payment can be deceptive
- They don’t always show how much the borrower will pay back overall, since the interest is rarely accounted for in the initial loan amount
Advantages of Non-Amortized Loans:
- They provide flexibility to the borrower (for many startup SaaS brands, amortized loan repayments are too high to afford)
- Borrowers can sometimes get access to loans they wouldn’t be able to access as an amortized loan
- Borrowers only have to pay for the accrued interest during each period
- Borrowers don’t have to make payments until the end of the loan, giving them time to build up their business
Disadvantages of Non-Amortized Loans:
- They can be very risky if the cashflow doesn’t come in to meet the final payment
- Borrowers can struggle to make the payment at the end of the loan term, and the lender will then foreclose on any property or business that secured the loan
- They can be refinanced fairly frequently
The maturity date refers to when the loan term ends and when the borrower’s final payment is due. When reviewing a term sheet, you should remember that one of the main purposes of venture debt is to extend cash runway by 3-6 months. In order to take advantage of this runway extension, you should have a long enough term period so you don’t have to pay the debt back before you actually end up using it.
Target Term Period: 30-36 months
The payment schedule outlines the frequency and amount of each payment. In some cases, the lender may attach an example of a Payment Schedule for added clarity.
In venture debt deals, a borrower can buy out of the loan at any time but may need to pay an early prepayment fee. This section of the term sheet will outline how much that amount is based on when the company decides to buy out the loan.
Conditions precedent are items that must be completed to the lender’s satisfaction prior to closing on the transaction.
An example of this in a term sheet could look like this: “The Closing of the Investment is subject to further due diligence and approval of the Investment Committee. In addition, the Company will hire a CFO and close XYZ contract.”
Other examples of conditions precedent include the closing of a concurrent funding round, an equity co-raise, or the repayment of an outstanding debt obligation.
Key Employee Commitment
The Key Employee Commitment section asks the borrower to ensure its key employee (e.g. founder, CEO) commits the majority of their efforts to the business. This is because in venture debt deals, lenders are often investing in a person and that person is critical to the company’s future success.
If the founder or CEO leaves the company or fails to devote the majority of their time and effort to the company – this could lead to an event of default.
A secured loan means the borrower provides security that the loan will be repaid. In venture debt, this is commonly done through pledging assets as collateral for the loan.
Venture debt deals are generally fully secured and lenders 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.
Types of Security
The most common form of security in venture debt is a GSA, or General Security Agreement. This is when the company pledges all of its current and future assets to secure the loan.
In some instances, security is in the form of share pledges. This is when the founder or CEO pledges their shares. inthe company to the lender. This is more often about control than it is about value.
Lastly, some lenders 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 lenders can stop borrowers from doing without their express approval. This section is usually expanded in the final documents once the full due diligence process is complete.
Examples of negative covenants include:
- Incurring new indebtedness and liens
- Repaying existing indebtedness to insiders and related parties
- Forming subsidiaries
- Transferring intellectual property
- Disposing assets, and so on.
Use of Proceeds
This section outlines where and how the funds are going to be used. Venture debt is usually used to extend runway or fund growth initiatives, so it’s 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 certain period of time.
Why are Warrants Used?
Warrants are requested by lenders so they have the option to participate in the company’s future growth. This can help balance the upside potential in deals with higher levels of risk to the lender.
Warrants and Dilution
While some founders are hesitant about warrants because of the associated equity dilution, it should be made clear that warrants are not “free equity,” but instead, the option to buy equity at a fair price. Warrants usually only amount to 1-2% of the company if executed and the lender will have to pay for those shares.
Elements of a Warrant
- Strike Price
- Number of Shares
- Expiration Date
The strike price is the predetermined price warrants can be exercised at. This is usually equal to the fair market value of the company’s stock on the day the warrants are issued. Another option is to price warrants at a discount to a future financing round if the company had not had a recent equity raise.
The number of shares are the amount holders are entitled to on or before the expiration date.
The term of the warrant defines how much time the lender has to exercise the warrants before they expire. This can be anywhere from 2-10 years with an average of approximately 5 years.
The number of warrants a lender receives is expressed as “warrant coverage.” Warrant coverage is the percentage of the total principal invested that the lender gets in warrants. This can vary from 5-50%, depending on the perceived risk of the deal.
Learning Checkpoint #3: Calculating Warrant Coverage
Company A receives a $1 million loan with 20% warrant coverage.
What many warrants is the lender entitled to ($ value)?
The lender is entitled to $200,000 ($1,000,000 * 20%) worth of warrants.
An alternative to warrants is a success fee. A success fee is a non-dilutable perpetual equity ownership position of the borrowing company that is usually given to the lender for free at the time of the investment. This 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 typically range from 0.5-1.5% and only become valuable when the company is sold.
Deposits are used to dissuade borrowers from shopping around for competitive term sheets. They are usually structured in the following way:
- If the lender decides not to proceed with the investment once the term sheet is signed, the deposit minus any legal costs is given back to the company.
- If the company decides not to proceed with the investment once the term sheet is signed, the entire deposit is forfeited.
Venture debt lenders will try to keep expenses reasonable, but borrowers should expect to pay the legal expenses for the lender. Some lenders may 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.
The Information Rights section outlines what ongoing information the borrower is expected to provide the lender and how often they need to provide this information. Lenders will typically require information such as monthly financials in order to keep track of their portfolio’s performance and identify any potential problems before they get out of hand.
Right to Audit
The Right to Audit provides lenders the permission to audit the company. This is used in situations where the lender would like to double-check that all of the information provided to them is accurate. If everything is in order, the lender should pay. If a discrepancy is discovered, the company should pay.
A default is the failure to fulfill an obligation, which then usually triggers the immediate repayment of the loan. In venture debt, there are two types of defaults:
- Technical Default
- 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.
The lender can decide whether technical and financial defaults should be treated the same of differently.
Defaults typically come with “cure periods,” which offer a given amount of time for the borrower to fix the problem. Often, lenders want to work with their investee companies to help them manage through difficult situations. This may lead to a restructuring of the loan and/or a forbearance agreement. A forbearance agreement is when a lender agrees to modify the terms of the loan to allow the company to continue to operate, but those agreements come at a significant cost to the borrower.
In uncured defaults mean the company is in trouble and the lender will now need to exercise its rights to recover its principal.
For borrowers, it’s important to understand the answers to the following questions:
- What is considered an event of default?
- What happens in an event of default?
Confidentiality is a legally binding section of the term sheet to ensure the company does not share the contents of the term sheet and eventual loan with any outside parties.
Another legally binding section of the term sheet is Exclusivity. This section makes sure that once the term sheet is signed, the company agrees not to look for alternatives, usually for 60 days, from signing the term sheet.
Remember – if the company decides to pursue a deal with another lender once the term sheet is signed, they will have to forfeit their deposit.
No Obligation to Advance
The No Obligation to Advance section reinforces the fact that the term sheet is not a final contract, but instead, outlines 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 borrower is welcome to come back after the expiry date. However, they should expect the terms to change.
Choosing a Venture Debt Lender
An important part of reviewing a term sheet is also taking the time to review the lender. Here are some things to consider when selecting the right venture debt lender:
Prior to selecting a venture debt lender, you can try reaching out to current and past portfolio companies to understand how each lender acts during the good, the bad, and the ugly.
Companies should aim to get the best terms they can get from the best lender.
Timely and Dependable Funding
Entrepreneurs should be focused on growing their businesses and adapting to customer needs. Taking the time to select a lender who has a strong reputation of funding on time and per the agreed-upon terms can relieve unnecessary distraction from your company’s development.
Commitment doesn’t end when the term sheet is signed and the transaction is closed. Select a lender that will be a good financial partner over the duration of the loan.
Interested in venture debt?