Venture Debt Fetch

One of the most ambiguous and dangerous event of defaults for a startup. This term is typically used by a bank to create an event of default if the company is not performing. The Bank can call or email the startup's investors and ask them to put more money into the company. If the investors decline or don't follow through with an additional investment to the bank's satisfaction, the bank can put the company into default and pursue remedies including foreclosure. Banks often say they rarely invoke the Investor Support clause, which is true. However, the bank requires this term so that they can use it or at the very least create leverage. This clause can also create a lot of investor leverage to the Founders detriment because the only way to escape foreclosure is to have insiders write another check.

Normally venture debt lenders charge a small pre-payment fee of 1 - 3% of the remaining principal outstanding. If there is a "Final Payment" component of the loan, then that will be due at the time of prepayment as well. Note lenders don't like pre-payments because only their best companies can afford to pre-pay. Therefore the best credits are refinancing out leaving the lender with less attractive borowers.

This venture debt term allows the lender to refuse new loan drawdowns if there has been a Material Adverse Change in the business. This clause gives the lender wide latitude to refuse a drawdown. It's less dangerous than a MAC Default that can put the startup into foreclosure, but it can be used to deny the startup funding. It's an important term if the startup is planning on drawing the capital far into the future. It's less problematic if the startup will draw the capital immediately, since you'll already have the funding from the loan in the bank and won't have to take future drawdowns.

The Advance Rate on Receivables is the percent of eligible receivables a bank will give a startup. Most banks will advance 75% to 80% of an eligible received balance. This creates some margin for error for the lender should the company struggle and a portion of the Accounts Receivable proves uncollectable.

A venture lender does not like old receivables, customer concentration or foreign receivables. Therefore the lender will generally limit the amount one customer or a group of customers, like foreign customers, can make up of the overall receivable balance for the startup that they are lending to. Customer concentration limits are usually around 20% - 30% of a receivable base. After subtracting out old receivables, customer concentration and foreign receivables, the startup is left with a $ amount, or borrowing base, that the lender will advance a percent against.

Venture Lenders realize startups want to extend runway and pay back as little of principal as possible. Therefore lenders will grant interest only periods, usually the first 6 to 12 months of a loan, where the startup is only paying interest on the loan. This period is usually timed to end right after a fundraise will take place. The logic is the startup will be flush with equity capital after the fundraise and will be in a position to start paying back the loan.

Successful startups typically raise future rounds at higher and higher valuations, meaning future capital is less dilutive, or "cheaper" than current capital. Therefore, lenders will often ask for a payment at maturity that boosts the overall IRR of the loan but will be 3 or 4 years out into the future. This effectively backloads interest when it is less expensive for the startup. The lender hits its return hurdle and the startup back loads interest when the capital to pay it back comes from a less dilutive source.

Venture Loans typically run from 30 to 42 months. A typical structure is interest only for 6 to 12 months and then monthly principal and interest payments ranging from 24 months to 36 months.

A/R Loans are typically 18 month commitments. They range from 12 to 24 months. At the end of the loan period, a bank will need to renew the Accounts Receivable Line. A startup should start planning 6 months in advance for renewal.

An Accounts Receivable Line is a type of debt financing based on an advance of the eligible accounts receivables outstanding. Inexpensive debt because Accounts Receivable is really strong collateral. Banks typically control the startups cash too which is a second form of collateral.

A flexible but expensive loan product. A Growth Capital Line is not tied to specific collateral like a Accounts Receivable, but instead collateral will be all of the startups assets. Including Intellectual property into the collateral is negotiable. Often a negative pledge on IP is negotiated meaning the startup cannot pledge the IP as collateral to another lender, but the growth capital lender does not have a lien in the IP. The lack of IP lien can dramatically slow the foreclosure process, so the startup should avoid pledging the IP whenever possible.

Lenders has a lien on All the Assets including IP, they can foreclose much quicker because they don't have to give notice to other creditors. They are the sole beneficiary in a liquidation. Therefore they can foreclose in 10 - 15 days. If the bank had "All Assets except IP," then it's more like a 45 - 90 day process.

Around 4% - 5% is the typical Interest Rate on an Accounts Receivable Line. Note that this is not the All in IRR which is usually around 5% to 6% because of fees.

Around 9% - 11% is the typical Interest Rate on a Growth Capital Line. Note that this is not the All in IRR which is usually around 11% to 13% on Growth Capital.

Venture Debt Lenders ask for equity in the form of warrants to give the lender upside potential on successful companies. This equity component is in addition to the interest rate and final payment. It's normally quoted as a % of total commitment. As an example, 10% warrant coverage of a $3M loan would be $300k in Warrants. The number of shares in a warrant is derived by the dividing the latest preferred share price into the total $ amount of the warrant. Sometimes lenders will take Common Stock Warrants instead of Preferred Warrants.

Typically Warrant Coverage on an Accounts Receivable Line is 0% to 2% of the total commitment amount.

Warrant Coverage on a Growth Capital Line is typically 8% to 12% of the total commitment amount. Sometimes a portion of the warrant coverage will be granted upfront and the remaining amount will be granted upon drawdown of the capital.

The Board is personally liable for any unpaid employee PTO. When the startup's cash balance approaches the outstanding PTO balance, a Board will normally admit insolvency and let the lender take control.

The total amount the lender is willing to lend. However, often the total loan amount is spread over time with separate tranches that can be unlocked by business milestones.

A venture loan is typically available for a fixed amount of time. The draw period outlines the dates by which the borrower must pull down the loan. Often a specific amount of debt must be drawn before an initial draw period ends. If the initial draw is completed, then the remaining loan balance might have an extended draw period into the future.

Lenders want to control the total amount of debt a company carries because 1) the lenders don't want to over-leverage the company and 2) if the lender is not secured in all the assets including Intellectual Property, then the lender must split the proceeds of the sale of assets where a full lien is not secured with the other unsecured lenders. Therefore, Lenders will often dictate how much other debt a startup can take on and often insist it is subordinate debt.

Lenders build large portfolios of startups, and like all investors, want to get more ownership in the very best startups. Therefore they will often ask for the option to invest a specific amount of equity in future rounds. Letting the venture debt firm have too much of your next equity financing round can cause problems if the round is over-subscribed, so be careful with this term.

Lenders will often ask the Borrower to put down a good faith deposit to ensure the startup is serious about the loan and diligence. Most of the time, the deposit will be credited against the lender's legal fees.

When a lender agrees to a deal, they are committing a million of dollars to the startup. Therefore, they want to get paid both in cash interest and some equity upside via warrants. The lender wants as much equity based committed upfront as possible. However, the startup wants to preserve as much option value as possible and will ask for the warrant coverage to be based on usage, or the amount drawn down. Often a startup borrower only draws down a portion of the loan so paying all the warrant coverage upfront on committment seems like a waste. Deals typically end up in the middle with half of the total warrant coming upfront based on commitment and a half on usage. A simple example with easy math is as follows: Warrant Coverage on a venture debt deal is 6% of the total deal amount. About 3% of that would be based on commitment, and 3% on usage. Negotiating warrant coverage to be based on usage can save the startup a lot of unnecessary equity dilution and make venture debt even more attractive.

For startups, Venture Debt functions a lot like Insurance. By taking on incremental capital in the form of Debt, your startup buys itself another three to six months of the runway. Lenders like to put a debt deal in place when the company raises a new round of equity. So the typical series A or series B startups raise 15-20 months of cash via equity. With debt providing an extra three to six months of runway, the startup has additional room to achieve its milestone and raise its next round at an up valuation.

Startups raise venture debt to extend their runway and by enough time to hit milestones, it must unlock to raise its additional capital. Runway extension is the most important reason for Venture Debt. Another reason to raise venture debt is to refinance existing debt. When a startup completes an equity round, it's time to shop the deal and refinance with either existing lenders or bring a new lender into the company. Refinancing debt also extends a startup's runway. A third reason is to fund an opportunistic new project that isn't in the startups budget currently but will add tremendous value. A little extra cash from the debt can fund an optional but value-add project. The fourth reason is to create optionality if the company is in acquisition talks with an acquirer. Venture debt doesn't require resetting the company's valuation in the way a new equity round would reset the valuation. Once the valuation is reset higher, the acquisition price must be higher and the new investor must agree to the deal.

WTI is unique in that in the event of a pre-payment, WTI will ask a startup to pay the future interest that would have been paid in future years. There is no discount on future interest for pre-paying a loan. In fact, it's worse for the startup because the future interest is paid earlier in the loan amortization period so the effective interest rate is actually much higher. Startups typically only do this if they are refinancing into a bigger loan or have raised a lot of equity. Note that because WTI requires the payment of all future interest, the loan is much less attractive to pre-pay. Therefore the borrower is much more likely to stick with WTI and put a larger loan in place rather than refinancing and going with a new lender. WTI's pre-payment language helps it retain the best borrowers.

Debt can be highly effective for a startup to extend its runway and then hit a big milestone that makes fundraising easy and leads to an up round. However, if a startup over-leverages itself and raises too much debt, the company can become impaired and future fundraising gets really difficult. Don't raise too much debt and put your startup at risk! We recommend raising no more than six months of extra runway. The biggest reason debt can hurt your startup is that the next investors will not want to see their new capital go to pay back the lender. They're investing to help grow the company, not to de-risk and pay back the previous lender. Too much debt can create an overhang for new investors. Our simple guidance is to raise three to six months of runway. Startups often unknowingly sign up for dangerous terms like MAC (Material Adverse Change) or Investor Abandonment Clause which can create a default at the worst times. Those terms give the lender a lot of leverage over the startup if things go wrong. To summarize, don't over-leverage your startup and raise more than 6 months of runway in debt, and beware MAC's and investor abandonment clauses.

The first step in Kruze Consulting's Venture Debt process is to sit down with the CEO and determine if the debt is a good fit for the company. When the business is on the downturn, debt is not a good idea because adding a senior secured creditor to the mix only makes life more difficult over the long term. The next fundraise can be messy if a majority of the proceeds will go to paying back the debt. However, if the business is booming and you’ve recently completed a round, venture debt with a forward commitment to draw down is a great tool to put in place. Especially after raising a new VC equity round, the company is in great shape and there is little risk of asymmetric information for the lender. That's when a debt vehicle should be put into place. After determining whether the debt is a good fit, Kruze will make introductions to its preferred lenders. Our team knows all the lenders so it's easy to kick the process off quickly. There is a temptation to talk to tons of lenders but we recommend a bank and two fund lenders to start. Once you get traction, you can do a couple more meetings to help optimize terms. More than three lenders can be a distraction. After introductions, Kruze will assemble a powerpoint pitch deck, historical financial statements, future projections, a cap table, and 409A valuations. These are the core pieces of information that lenders want to review. After the lender reviews the materials, the deal sponsor will engage their credit committees and decide on a term sheet. As soon as the term sheet reaches the startup, Kruze will analyze the offer, explain all the difficult debt terms, explain to the CEO and Board of Directors what the term sheet means for the startup, model out the incremental runway from the debt and overlay the runway with the key milestones for the next fundraise. Kruze will model out the IRR, or cash cost, of the debt so Management knows how expensive the debt actually is for the startup. We’ll also model out and explain the warrant coverage, or equity upside, so Management and the Board know how much of the company it is giving away. Venture Debt is all about extending runway so a startup & CEO should be sure they're buying enough insurance to achieve their milestones and raise an up valuation round. Kruze will also walk Management through downside scenarios -- if the startup is not achieving its milestones, how badly will the debt hurt the company? After negotiating the debt deal and reaching a signed term sheet, Kruze will assist in the documentation process although this is mostly the domain of company counsel. Usually, a term or two become critical during negotiation and Kruze can assist the lawyers to explain the pros and cons of Management. Startups usually engage a venture debt specialist at their favorite law firm and those lawyers do a great job. It's best to use experienced venture debt lawyers who can advise how key terms can affect the company's business. Once the deal is documented, Kruze will advise on when the capital should be drawn down from the lender. That's the venture debt process from start to finish and how Kruze Consulting can help!

All due diligence starts with historical financials. The lender wants to make sure the company has spent its money wisely and can establish a burn rate trend. Second, lenders want to see future projections. Projections or a Financial Model allow the lender to pinpoint the startup's cash out date, recognize revenue inflection points, and model out how long the cash infusion will last the company. Lenders also want to see the cap table so they can see the round prices, especially if the lender is pricing the warrant based on a recent common stock valuation. Understanding the ownership breakdown and which VC's own how much is important as well. Lenders also like to see the 409A valuation. Lenders will need an investor presentation as well so they understand the company's technology, go to market strategy and key performance indicators (KPI's). The credit committee will evaluate all these data points, underwrite the deal, and give the startup a term sheet!