Bank or private debt and venture debt are separate segments in the debt financing market. In contrast to venture debt financings, which relate to start-ups, bank or private debt financings involve the financing of established companies that have already generated profits, can provide collateral and service the debt from the start.
Venture debt financings are also different to venture capital financings, as it is funding provided at an early stage of the start-up (but after the initial seed and venture capital has been provided), so venture debt complements venture capital.
A start-up’s development cycle begins with equity provided by founders, ‘angels’, ‘seed’ and venture capital investors. The start-up uses this equity to develop its concept or product, to enter into its relevant market, to build up its corporate structure, to establish its sales activities and to expand its production and sales. Venture debt is therefore a type of debt financing which provides funds at an early stage which is used for the funding of commercial activities, acquisition of assets, capital raising or to assist the company to the next round of equity injection. The latter is often the focus for venture debt lenders, as the amount made available will usually depend on the amount of equity raised by the company up until that point. An attractive feature of venture debt is that it prevents further dilution of the company’s equity, which in turn encourages existing investors to adopt it as a method for raising capital.
Furthermore, venture debt does not usually require that (extensive) collateral be offered as is typically found in other forms of debt financing. Venture debt financing is also particularly useful for start-ups that need capital, but are already high valued, making a new venture capital financing round unattractive to new investors. Although venture debt will generally be raised after the venture capital financing rounds, it can also be helpful as a bridge financing if investors have indicated that they do not want to contribute “fresh” venture capital until a further milestone (requiring liquidity or capital) has been achieved.
Venture debt is a type of debt financing specifically tailored for early stage and fast growing companies (start-ups). Venture debt is different to other types of lending to the extent that the borrower generally does not, at the point of funding, exhibit positive earnings (EBITDA) or cash flow and cannot provide significant assets as collateral. Venture debt financing will therefore only become an option when the start-up has reached a level of maturity which allows it to make repayments and pay interest at fixed times. The debt service does not, however, require a positive cash flow or a positive EBITDA, as venture debt is generally granted to bridge the gap between the venture capital financing rounds and the cash flow break-even.
From a lender’s perspective, it is crucial that the borrowing start-up has a viable business model and a strong and sustainable revenue growth (projected or actual). The start-up’s management needs to be sufficiently experienced and its products or services must be at least market-ready to rule out material technology risks.
A key indicator that a start-up is a suitable borrower is whether it has attracted venture capital investors. Such investors generally conduct a comprehensive commercial and operational due diligence review prior to investing, and continually measure a start-up’s progress against its business plan using the rights to information to which they are entitled as shareholders. Due to the venture capital investors having already conducted this comprehensive due diligence, it is most often sufficient for the venture debt investors to conduct a financial due diligence before providing venture debt financing.
Venture debt carries strong and stable interest rates, making it attractive for fund investors or certain development finance institutions. Although the potential returns on venture debt (in contrast to venture capital) are, in principle, limited from the outset, above-average returns can be generated due to higher margins and fees in comparison to those generated by ordinary bank or private debt. In addition, lenders who are not direct shareholders of the start-up can benefit to some extent from the increasing value of the start-up via equity kickers or warrants/options.
How Venture Debt Financing Works
Venture debt financings are generally structured as term facilities where the terms of such facilities usually range from three months to three or four years. In the early stage of development of the start-up, a maximum amount of around 25–50% of the most recent venture capital round is granted. At a later stage, the volume depends on the collateral base and cash flow of the start-up.
Depending on the purpose of raising capital and the stage of development of the start-up, term loan facilities can be structured as a final maturity/bullet loan or an amortising loan. As venture debt is often raised to achieve a milestone or as a bridge financing to reach the cash flow break-point, the agreed repayment start date for amortising loans is usually not until 6–12 months after the utilisation of the loan. This is done in order to protect the liquidity of the start-up. After that, the repayments and interest payments are generally made together at the end of each interest period, either monthly or quarterly.
Instead of term loan facilities, venture debt is sometimes provided as revolving credit facilities. In this case, the borrower is able to raise a short-term loan with a flexible loan amount and a term for an interest period of one or up to three months, if necessary, with the opportunity to extend the term of the loan for another interest period.
Both term loan facilities and revolving credit facilities are generally provided with a considerable broad purpose provision, meaning that the loan can be used for the borrower’s general corporate purposes.
Provisions of venture debt financing:
- A borrower has to pay interest and fees and, in many cases, must also offer a participation in the development of the start-up’s value or revenue in the form of an equity kicker or a venture kicker (see below) as an additional financial reward to the lender.
- As a rule, the return on investment expected by venture debt lenders is between approximately 10% and 25% of the capital amount per annum.
- Interest rates for venture debt are comparatively high. Depending on the start-up’s risk profile, the usual margins are between approximately 8% and 15% – 20% of the capital amount. In an event of default, the margin is usually raised by another 3 to 5%.
- As with other kinds of debt financing, the interest rates agreed for venture debt can be fixed or variable, or a hybrid of the two with a certain minimum fixed rate.
- Besides interest, the borrower usually has to pay fees in venture debt financings, including legal fees for the documentation.
Direct Equity Kicker – warrant/option
- An equity kicker often constitutes a significant element of the compensation scheme under a venture debt financing. By way of an equity kicker, the lender can participate in an increase in value of the borrower’s shares (which constitutes the upside potential) as the lender either receives a direct shareholding in the borrower through a warrant or option (in the case of an exit). The lender will become a party to the borrower’s shareholders’ agreement if the warrants/options are exercised.
Virtual Equity Kicker
- As an alternative to a direct shareholding pursuant to a direct equity kicker, the borrower can grant the lender a cash participation in the exit proceeds in the form of a cash payment. This avoids the formal requirements of an equity increase.
- A virtual equity kicker is not usually payable until the loan has been fully repaid. The payment is due at a predefined exit event, e.g. once the majority of the shares in the borrower have been sold by the shareholders through an asset deal or a share deal, or once an IPO has occurred.
- The lender could get a profit participation component in the form of a claim to a once-off payment linked to the start-up’s revenue (which is payable on maturity of the venture debt loan). In such a venture kicker, the borrower is obliged to pay to the lender a bonus of say 10 – 30% of the credit amount if the annual revenue exceeds a predefined amount. This is another way for a lender to participate in the borrower’s business development (which constitutes the upside potential).
- As with other types of debt funding, venture debt agreements contain provisions regarding conditions precedent, voluntary prepayment (with penalty), mandatory prepayment, representations and warranties, information and other undertakings, events of default.
- Despite the rather high risk of default, venture debt is sometimes granted without any financial covenants to give the borrower more (financial) freedom in its business development.
- As venture debt is subject to higher default risks for the lender than other forms of debt financing, it is important for the lender to include contractual covenants that restrict cash leakages through dividend payments or shareholder loan repayments, and to also restrict the addition of new (senior ranking) lenders.
- The lender may agree to subordinate its claims to assist in preventing a start-up’s insolvency because of over-indebtedness.
- Venture debt may be secured or unsecured. If secured, the security is usually limited due to the nature of the start-ups business, and often is limited to security over the borrower’s intellectual property rights (such as trade secrets), receivables and its shares. The borrower must regularly provide additional collateral because it can be assumed that its overall value will increase during the financing term.