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In light of macro-economic headwinds, downward pressure on valuations and a tougher fundraising environment, fast-growth businesses are looking for alternative funding options to drive growth, extend runway or bridge to their next round of equity financing.
Early-stage businesses without extensive historic financials may struggle to access traditional bank financing in the same way as more established companies. Therefore, we’ve been looking at other financing options available to fast-growth businesses. Last month we wrote about convertible loan notes and advance subscription agreements (see here).
However, another route may be available in the form of venture debt, which is increasingly being utilised by fast-growth businesses looking to avoid a down-round in a turbulent economic environment.
Venture debt is a form of debt-financing for early-stage companies that originated in Silicon Valley in the 1960s (initially as a form of asset financing for tech businesses looking to buy machinery). Borrowers are usually venture-backed businesses in high-growth sectors with demonstrated traction that may be yet to achieve profitability. Typical lenders include both banks and other specialist non-bank institutions that focus on growth capital lending to fast-growth businesses (Boost, Kreos and Silicon Valley Bank are some of the key players in the market).
The debt is usually provided as a loan facility (or, less commonly, in the form of bonds) repayable over a term of up to 5 years. There may be an initial interest-only period (sometimes extendable following the achievement of certain milestones, such as completion of a further equity financing) following which both principal and interest are amortised across the remaining term of the loan. The loan might be structured to be drawn down by the borrower in tranches (with the availability of subsequent tranches sometimes also subject to hitting stipulated milestones/financial targets).
The debt will be backed up with an equity-kicker, typically in the form of a warrant worth up to 20% of the loan, which gives the lender the right to buy shares in the company at a pre-agreed price (which may be subject to adjustment, e.g. in the event of a down-round).
The loan will usually be secured against the company’s assets in the form of a first-ranking debenture. Any existing third-party debt, including director/shareholder loans, will likely need to be subordinated to the venture debt.
As a venture debt fundraising will not immediately involve the issue of new equity (at least not until the exercise of the warrants), it will be far less dilutive to existing investors than a full equity round. Venture debt may also be preferable, in terms of dilution, to a convertible loan (the full amount of which may convert into equity).
As a venture debt lender will have a higher risk profile than a bank (a good way of viewing venture debt is as a mid-point between venture capital and a bank loan) the covenants in the loan documents will usually be less stringent than a banking facility (there may be minimal, or at least more lenient, financial covenants for example), although this does come at an additional cost (see below). Companies will not usually be required to give away an investor board seat as they typically would on a venture capital equity round. Founders will also not need to provide personal guarantees (which would likely be required for a traditional banking facility).
Given that the rationale of venture debt will be more closely pegged to the company’s growth profile, the end result is hopefully a debt product much more tailored to the stage at which the company is at in the course of its life cycle. This means that the package as a whole should ultimately be structured to facilitate growth and give management greater flexibility in running the business (as opposed to more restrictive banking facility terms).
Obviously, as venture debt is a form of debt finance, it will need to be repaid at the end of the term (as opposed to equity which isn’t usually repayable in the same way).
Also, due to the higher risk profile on venture debt, the coupon tends to be higher than the interest rate on a vanilla bank loan.
It’s also worth noting that venture debt will be subject to an extensive underwriting process involving due diligence on the business and the putting in place of some fairly detailed legal documents. Features such as a first-ranking debenture and the grant of equity warrants can often raise complicated issues that need to be negotiated with existing investors/lenders and resolved during the process. However, as we comment above, the result of this more involved process should be a debt product which is more appropriately tailored for the borrower’s circumstances than a standard banking facility.
If you’re a high-revenue, venture-backed business with strong growth prospects looking to raise some extra cash, but are between equity-rounds and/or are looking to avoid a down-round, then venture debt may be a viable route to consider during a relatively uncertain year ahead.
01 December 2022