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.
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
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.
At Mighty, we lend against general business security only; personal guarantees are never required.
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 exist to give lenders visibility and early warning if a business is tracking off-plan — not to control how you run it
Covenants should be flexible by design — but with some lenders, they can end up restrictive and difficult to comply with, limiting your ability to run the business and pursue 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
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 set timeframe. They're a way for lenders to share in some of the upside if the business performs well, alongside the interest earned on the loan.
Whilst significantly less dilutive than equity, and often reflecting a very small position on the cap table, warrants do still represent a real cost of the debt — so it's worth understanding them as part of the overall terms, particularly if retaining ownership is a priority for you.
Summary
Understanding the detail of any venture debt arrangement matters — it's what determines whether the terms work for your business, not just on paper. We hope this gives you a few more considerations for your toolkit when weighing up a debt arrangement.
At Mighty Partners, we provide highly flexible funding, with terms tailored around your specific business needs. Our solutions are designed for founders, by founders themselves. 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.
