Venture debt terms: What to expect and what to negotiate

Alvaro Morales

For scaling startups, growth is the most important goal. But how do you fuel that growth without sacrificing too much control or ownership? That's where venture debt steps in.

In this article, we’ll explain venture debt terms. We’ll also explain why venture debt offers a unique blend of benefits that traditional loans or even equity financing can't quite match.

Here’s a breakdown of what we’ll cover:

  • Why scaling startups choose venture debt
  • The difference between venture debt and equity financing
  • The most common venture debt terms you can expect and some tips to navigate them
  •  Aspects of venture debt deals you can negotiate and how to do it
  • Common traps to avoid during negotiations and how to avoid them successfully 

Let’s get started by answering a key question that will help us to kick things off. 

Why is venture debt important for scaling startups?

Venture debt is a financing option tailored for startups. It's designed for companies with high growth potential but perhaps not the cash flow to back a traditional loan. It's also not equity, meaning you don't have to give up a chunk of your company to get the cash you need.

What’s the difference between equity financing and venture debt

Equity financing, while powerful, comes with the cost of dilution. You're essentially selling a piece of your company's future. Traditional loans, on the other hand, often require collateral or strong financials — something early-stage startups might not have.

Venture debt bridges this gap. It allows startups to access capital without the immediate dilution of equity. It gives them the financial runway to hit those critical milestones that attract further investment.

Venture debt comes with its own set of terms and conditions, including interest rates and repayment schedules. Some conditions even include warrants that give the lender the right to buy shares in your company. 

Understanding and negotiating these terms is paramount. A well-structured venture debt deal can be a powerful tool for growth. 

In essence, venture debt is about providing startups with options. It's about giving them the flexibility to pursue their goals without compromising their vision. But like any financial tool, it's essential to wield it wisely. 

Key venture debt terms to expect

Considering venture debt means getting acquainted with a venture debt term sheet, which is a document that lays out the key terms of the loan. Let’s break down some of the core elements you're likely to encounter:

Interest rates and repayment schedule

Interest rates on venture debt tend to be variable, often pegged to a benchmark like the WSJ Prime Rate, and typically range from 8-15%. Repayment isn't always immediate. 

Many venture debt deals include an interest-only period, where you only pay the interest on the loan for a set time. The time frame is usually 6-24 months. 

After that, the loan is amortized. The fact it’s amortized means you'll make regular payments that cover both principal and interest until the maturity date.

Warrants

Think of warrants as a "sweetener" for the lender. They grant the right, but not the obligation, to purchase company shares at a predetermined price in the future. 

Warrants offer lenders potential upside if your company takes off, but they also mean potential dilution of your equity. Understanding the terms of the warrants — the number of shares, the exercise price, and the expiration date — is vital.

Covenants

Covenants are essentially the lender's way of safeguarding their investment. Financial covenants might need you to maintain certain financial ratios or meet revenue targets. 

Operational covenants could restrict you from taking on additional debt. They can also keep you from making major changes to your business without the lender's approval. Covenants can impact your flexibility, so it's important to negotiate terms that allow you room to maneuver.

Fees and costs

Beyond the interest rate, there are other costs to consider. You might encounter origination fees, closing costs, and legal fees. 

Additionally, if you decide to pay off the term sheet loan early, you might face a prepayment penalty. It's important to factor in all these costs when evaluating the overall cost of capital.

Collateral and security

Venture debt is typically secured, meaning the lender will require some form of collateral to back the loan. By collateral, we mean your company's assets, including intellectual property.

In the event of a default, the lender has the right to seize these assets. Understanding the collateral requirements and the potential consequences of a default is critical.

Remember, a loan term sheet is a starting point for negotiation. Don’t hesitate to push back on terms that seem unreasonable or restrictive.

What to negotiate in venture debt deals

Negotiating a venture debt deal is about securing terms that align with your startup's growth trajectory. Here are some key areas where you can push for more favorable terms:

Interest rate and repayment terms

Interest rates directly impact your cost of capital, so it's worth exploring whether you can secure a lower rate. Even a slight reduction can translate to significant savings over the loan's lifespan. 

You might also inquire about the possibility of a fixed interest rate instead of a variable one. Having that information is important for you to anticipate interest rate hikes in the future.

Consider negotiating for a longer interest-only period. Engaging in (and winning) negotiations allows you to preserve cash flow in the crucial early stages when you're focused on growth, not debt repayment. A longer interest-only period gives you more breathing room. It helps you hit key milestones before the burden of principal repayments kicks in.

Straight-line amortization is pretty common. You should, however, explore if a different schedule works. Think of a balloon payment at the end, which might better suit your cash flow projections. 

A balloon payment is a large lump-sum payment due at the end of the loan term. It allows for smaller payments throughout the loan's life.

If you anticipate needing a longer runway, negotiate for an extended maturity date. An extension of the date gives you more time to achieve your goals before facing the final repayment.

Warrants and equity impact

Warrants, while offering benefits to the lender, can impact your ownership structure. Here’s what you need to keep in mind:

  • Warrant coverage: Warrants can be a double-edged sword. While they can help secure a lower interest rate, they also lead to future equity dilution. 

    It's essentia
    l to carefully evaluate the warrant coverage. The coverage would be the percentage of the loan amount represented by warrants. Aim to minimize this percentage to protect your ownership stake.
  • Strike price: The strike price is the predetermined price at which the lender can exercise their warrants to purchase shares. Negotiate for a higher strike price to reduce potential dilution.
  • Warrant expiration: A shorter warrant expiration period limits the time the lender has to exercise their option. Shorter expiration period limits could potentially reduce the overall dilution impact.

Covenants and restrictions

Covenants set the boundaries within which you operate during the loan term. Because of this, you want to make them offer you the necessary flexibility. Let’s look at two types of covenants and cure periods:

  • Financial covenants: Lenders want to ensure their investment is protected. However, overly stringent financial covenants can hinder your flexibility. 

    What you can do is
    negotiate for more reasonable thresholds. You should also consider tying covenants to specific milestones instead of fixed metrics.
  • Operational covenants: Push for more flexible covenants that allow you room to adapt your strategy as needed.

    Certain terms, such as restrictions on acquisitions or new product launches, can feel too restrictive. If this is the case, don't hesitate to negotiate for their removal or modification.

    For example,
    you might encounter an operational covenant that restricts you from entering new markets or launching new products without first obtaining approval from your lender. While lenders may include such covenants to protect their investment, they can also hinder your ability to capitalize on growth opportunities. 

    You could negotiate for a more balanced approach,
    such as allowing expansion or product launches up to a certain financial threshold or only requiring approval for actions that significantly impact your financial health. 
  • Cure periods: In the event of a covenant breach, make certain there's a reasonable cure period. A cure period is a timeframe to rectify the situation before facing default.

Fees and penalties

Beyond the interest, be mindful of additional costs that can affect your bottom line. Fees can add up, impacting the overall cost of your venture debt. See if you can negotiate lower origination or closing fees.

Prepayment penalties, which kick in if you repay the loan early, can also be a point of contention. Aim to minimize or eliminate these penalties, allowing you greater flexibility in managing your growing company’s finances.

Remember: Be aware of any additional fees, such as late payment fees or administrative fees. Like with other aspects, negotiate for clarity and fairness in these venture debt terms.

Collateral requirements

Protecting your assets while securing the loan is a critical balancing act. Let’s analyze two key collateral requirements from lenders:

  • Asset pledges: Lenders typically want to secure their investment with collateral. Investment safeguarding is often done in the form of company assets or even intellectual property. Negotiate to protect business assets or limit the scope of the collateral pledge.
  • Personal guarantees: In some cases, lenders may require personal guarantees from key executives. Resist these if possible or negotiate for limitations on the extent of personal liability.

Negotiating a venture debt deal requires a delicate balance of assertiveness and understanding. Remember, it's a partnership — both you and the lender want to see your company succeed.

Common pitfalls to avoid with venture debt terms

Venture debt can be a powerful tool, but it's essential to tread carefully. Like any financial instrument, it comes with its own set of potential pitfalls. Let's explore some common traps to avoid and how to navigate them successfully.

Overlooking warrant impact

Warrants might seem like a small concession in the grand scheme of things. However, their long-term impact on your company's ownership structure can be significant. Don't underestimate the potential dilution that can occur if the lender exercises their warrants.

  • Solution: Negotiate for a lower warrant coverage percentage or a higher strike price to minimize dilution. If possible, explore alternative structures, like a success fee. You’re offering the lender an upside without directly impacting your equity.

Ignoring hidden fees

Beyond the headline interest rate, venture debt deals often involve various fees that can add up. It's easy to get caught up in the excitement of securing funding and overlook these extra costs.

  • Solution: Carefully review the entire fee structure. The structure would include origination fees, closing costs, and prepayment penalties. Ask for clarification on any fees you don't understand and factor them into your overall cost of capital assessment.

Underestimating covenant constraints

Covenants can sometimes feel like shackles on your startup's growth potential. Restrictive covenants can limit your ability to make strategic decisions. It can also harm your efforts to pursue new opportunities.

  • Solution: Negotiate for covenants that give enough flexibility while addressing the lender's concerns. If certain covenants seem particularly onerous, push back and explore alternatives. 

How Orb can support financial planning with venture debt

We've covered how to understand venture debt terms and strategies for negotiation. Armed with this knowledge, you're better equipped to navigate the landscape of debt financing. Most importantly, you should know how to select the option that aligns with your business goals.

A strong financial foundation is key to successfully using any form of debt financing. Consistent revenue and a clear view of your financial health are paramount. Having solid finances is particularly important when managing debt repayments. 

Reliable billing and revenue management solutions play a vital role in maintaining this foundation. Accurate invoicing, timely collections, and real-time insights into your financial performance give you the stability and clarity necessary to manage venture debt before it gets out of control.

This is where Orb steps in. 

Learn how Orb helps you keep your cash flow healthy for effective debt management and how it handles billing for you. Try it out yourself and schedule a free demo.

posted:
September 19, 2024
Category:
Guide

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