Is Venture Debt Right For Me?

The venture debt trend continues to grow rapidly year-on-year and the extent of the take up is perhaps even greater than the levels being reported. Venture debt capital raises are rarely publicised, typically not offering the same buzz and perceived status as a like-for-like equity raise. Although maybe they should?

Debt can be a valuable funding tool to help a business achieve its financial objectives. It is often used as complementary to equity to help founders drive business growth, whilst maintaining a bigger piece of the ownership pie.

Some of the benefits to venture debt include:

1. Taking advantage of growth opportunities
2. Minimising overall equity dilution
3. Extending cash runway

While a debt offering may seem simple to understand, founders should make sure they are well across all the details before signing an agreement. Failure to do so can be detrimental to the business and potentially, have personal implications…

So, what are the most relevant considerations when exploring or negotiating a venture debt agreement to see if this is right for your business?

Cost of funding

The cost of funding can fluctuate based on a fixed or floating interest rate. Fixed rates have the benefit of being locked in when you sign up to the debt, meaning that you know exactly how much you will need to pay each period.

In a rising interest rate environment, a floating interest rate debt will have increased monthly interest costs and could make it challenging to service the loan payments.

Depending on the financial arrangement, the monthly repayments may be fixed or fluctuate based on future revenues. If you find it helpful for your budgeting to know exactly how much will be paid to your lender, fixed payments may be of benefit to you. 

Usually, the cost of venture debt is predominantly reflected in the interest component BUT it is important to be aware of other costs involved in the financial arrangement that may mean your overall cost is higher than you think:

• Legal costs associated with negotiating and reviewing the documents for the debt
• Establishment fees that need to be paid upfront
• Ongoing administration fees
• Charges for early and late repayment
• Potential broker fees paid to people who introduce you to the lender

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Repayment period

The repayment term affects your total cost and the size of your monthly payments.

A longer repayment period can lower your monthly payments but will increase the overall cost of the debt due to the accumulation of interest over time.

On the other hand, a shorter repayment period can result in higher monthly payments but a lower overall amount of interest to repay.

Always look to negotiate venture debt terms based on what you intend to do with the funding. Consider whether you would benefit from a shorter repayment period, or whether you need access to the funds for a longer period.

Repayment penalties

What happens if you want the option to repay the loan before its due date?

Often, lenders will require that you pay them a minimum return for lending you the money. This is called a repayment penalty or “make whole” requirement. You are essentially required to pay a premium or “make-whole” amount to compensate the lender for their lost interest from the loan being retired early.

This amount is usually calculated based on a formula that takes into account the remaining term of the loan, interest rate, principal amount or an IRR multiple.

This provision can be a complex and a controversial issue in venture debt negotiations, so it is important that you fully understand the terms and implications before signing.

Any security interest?

The lender may require collateral as security for the loan. Security can take many forms and effectively adds extra comfort to the lender that you will repay your loan, or that if you don’t manage to repay, that they can rely on the collateral that you provided to recover some / all the money they lent you.

As a business owner, you should ensure that the collateral offered is reasonable and that you understand and are comfortable with the potential consequences of default.

Restrictions on taking other capital?

In some cases, you may be prohibited from taking on other debt, regardless of whether there is a security interest or not.

It is vital that founders are aware of this as it can restrict the business from having the ability to raise additional funding when needed and potentially limit the business’s growth.

Any restrictive covenants?

Covenants are conditions placed on you and on the business operations that you must fulfil during the loan term.

Covenants can be restrictive or difficult to comply with, which can limit your ability to operate the business and achieve its strategic goals. Examples include:

• Limitations on business operations – i.e. restrictions on hiring, investing in new ventures etc.
• Financial ratios – requirements to maintain specific ratios or other financial metrics
• Reporting – onerous reporting requirements or regular audits that can be defocusing
• Limitations on dividend payments or salaries to key executives
• Limitations on management changes or ownership changes

You get the drift… make sure you understand the fine print!

Are there warrants?

Warrants are financial instruments that give the lender the right to purchase a specific number of shares at a predetermined price within a specific time. Warrants are a way for lenders to increase their potential return on lending to you and give them the ability to get some ownership in your company if you do well.  

For business owners seeking to retain the ownership of their business, warrants should be considered carefully because they represent a real cost of the debt, and potentially could be worth a substantial sum to the holders.

Summary

As with everything in life, the devil is in the detail, so it’s important that you understand the venture debt arrangement you are entering. We hope you’ve now got a few more considerations in your toolkit when taking on a debt arrangement.

At Fundabl, we provide highly flexible funding, with terms tailored around your specific business needs. Our solutions are designed for founders, by founders themselves. For example, we typically do not require any personal guarantees, and have light covenant requirements meaning fewer restrictions and greater flexibility for your business.

Our experienced advisors will help you negotiate terms and ensure that you understand the implications of any funding agreement so you can make an informed decision for your business.