What Happens to Venture Debt in a Downround?

When a startup goes through a downround, things can be very painful. Typically a downround will impact the founders a lot more than the venture capital investors , but if your startup has venture debt then things could become even more difficult. So what happens to venture debt when a startup goes through a downround, and what can you do at your company to work through that happening?

What is a Downround?

A downround is a funding round in which a startup sells its shares at a lower valuation than in the preceding fundraising round, in order to raise capital. That means that the startup is now worth less than it did after its last fundraising event. Startup valuations have taken a pretty serious drop lately from their levels during the 2021 bubble. That means we’re seeing an increase in downrounds, and it can be a big cause for concern for companies and in the market.

What Happens to Venture Debt?

In the event that a startup has to go through a downround and they have venture debt, there are generally two scenarios you can expect.

Material Adverse Change

In the first scenario the company may have access to venture debt, but they have not used those funds. This is fairly simple. In every venture debt term sheet or agreement there will always be a clause that discusses material adverse change (MAC).

The MAC clause means, in the event that things are no longer going to plan (a downround being a prime example of ‘not going to plan’), the venture debt lender does not have to fund the startup’s future drawdowns.

So if your startup goes through a downround while having access to venture debt, the lender can legitimately say no to funding it. Ultimately, this means that most of the time you’re not going to be able to access that capital. It’s just goodbye.

There is the possibility that you can negotiate with the lender to make a smaller amount of money available to you after the downround. Or if you’ve still got significant amounts of capital coming into the company, the lender may restructure the loan and give you a decent amount of cash in the form of debt.

However, for the most part, lenders are very wary of downrounds. They usually mean part of the VC investors will leave and a pay to play provision might be triggered. Simply put, it is not an ideal situation for a lender.

Debt on the Balance Sheet

The second scenario is when the debt is already on the balance sheet. Your startup has:

  • Drawn down the venture debt
  • Those funds have helped extend your runway
  • You owe creditors money
  • You owe the lender money
  • You’re also doing a downround

This is not a fantastic place to be and it also depends on how much debt is on the balance sheet overall.

If there’s just a little bit of debt, and the terms are pretty friendly, sometimes the downround will just go forward. In that instance the equity investors will typically ask the lender for an extended interest-only period of six to 12 months (up to 18 months in some cases).

The VC investors are essentially saying that they are putting money in and they believe in the company, but they don’t want their capital to simply go toward paying the lenders back. They see that as a waste of money. The startup is going through a downround and it seems pointless to give all of the money back to the creditors.

Understanding A Restructure in a Downround

In a downround, the reality is that investors will need some type of restructure in order to be incentivized to put that money into the company.

The lenders have a few cards to play here too, since it’s possible for the lender to just foreclose and liquidate at this point. However, that’s not always a great situation since lenders usually lose money in startups when they do foreclose. In fact, there’s actually a myth surrounding being able to sell assets or intellectual property (IP) in a foreclosure and get the lender’s money back. In reality, the lender would probably only get around 10-20 cents on the dollar. Not a great outcome.

Therefore, both the VC investors and the lender are typically going to want to restructure. The degree of the restructure will depend on how much new cash is coming into the company during the downround. There are several criteria that impact the way a restructure is treated in a downround scenario.

The amount of investment and cash runway

A big factor in restructuring the debt is how much equity the investors are putting into the company in the downround, and how long that cash will extend the startup’s runway. A big chunk of cash creates a very long runway and that means the lender is more likely to do an aggressive restructure. However, if it’s only three months or six months of cash, that is essentially a bridge to nowhere. If anything it’s just a bridge to selling the company and the lender might do three to six months of interest only, but then use their amortization payments or trigger another conversation.

For example, if you have six months of cash because of new equity and the lender gives you six months of interest-only, everyone around the table knows that in six months you’re either going to have to sell the company or something really good will have to have happened where you will be able to raise more cash. Otherwise, the lender’s going to have to foreclose.

The lender’s debt exposure

If there is a huge amount of debt, but the equity investors still find the company attractive and still want to do the downround, then you’re looking at even more difficult terms for the lender.

For example, the lender may be asked to convert some of their debt to equity or they may be asked to simply write some of their debt off. Lenders do not like to do this. It’s really tough on them since lending is a much lower margin business. They make pennies on the dollar versus VCs who can get 50-100 X returns.

This means lenders are usually very slow to do write-offs or convert to equity, but there are times where it’s better for the lender to play ball, extend, and see if something good happens.

Especially in the middle of a really tough downturn. Lenders will often find it is in their best interest to play ball and restructure if it is a company that has created something meaningful and valuable and may be on the cusp of significant revenue.

Whether the startup has solid traction

Finally the restructure depends on whether the  company has built real IP,  or another asset, that can either be sold or will bring in enough revenue that the company can start repaying its debt.

If you have any other questions on downrounds, valuations, startup investing, startup accounting, or taxes please contact us.

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