The Risks of Early-Stage Debt

Start-ups are turning to venture debt to plug the gaps in equity financing, but these loans come with caveats.

While traditional banks shy away from lending to emerging companies with no cash flow and little assets, some specialized banks and nonbank lenders are quite happy to oblige. In fact, the so-called venture debt market has rebounded from the financial crisis quite nicely.

“It’s as hot as I have ever seen it,” says Rich Bowman, head of debt consulting at Capital Advisors Group. “The venture debt sources went out and raised more money, which improved availability. Structures have loosened, rates lowered, and warrants have come down considerably.”

Venture debt facilities — loans to emerging companies that will likely require further equity support from venture investors — are also larger these days. They generally fall between $5 million and $20 million, up from $2 million to $5 million previously, due to greater capital needs of today’s start-ups, says Kenneth Blohm, a partner in the San Francisco office of Latham & Watkins.

Venture capitalists welcome this form of debt. Biotech and clean-tech companies in particular need greater amounts of capital earlier on in their life cycles, says Blohm, “so they can reach profitability and get off the equity-support lifeline.” Venture debt can fill gaps with nondilutive capital and allow VC firms to diversify their portfolio risk with other investments.

Some boards and executive directors that have experience with venture debt, however, regard it with a jaundiced eye, says Bowman. One reason: when the dot-com bubble burst, some bank venture lenders recouped their loans by draining the operating accounts of struggling borrowers. Venture debt can also be expensive, carrying interest rates of 11% to 14%.

The key, says Bowman, is to use venture debt only when it makes sense — to reach an important milestone or inflection point, such as a clinical trial or a crucial research and development stage. Venture debt can extend a company’s “runway” three to six months (depending on cash burn), but it should not be used just to put more money on the balance sheet, he says: “If you’re just going to add equity behind it, you will be using the more-expensive equity money to pay back the debt.”

The other real issue that arises with venture debt is that the capital is generally needed fast, and not many finance chiefs of venture-backed companies have a wealth of experience with debt. “There is usually a bit of a scramble,” says Blohm. “The company will start contacting debt providers, and they may get a one-page term sheet with very attractive terms. They may sign something, and only when they get into negotiations do they realize that things are more complicated than they thought.”

Here are some of the most important aspects of venture debt that boards of directors and CFOs need to be aware of:

Timing the draw. Any lender likes the borrower to take the money as soon as possible to start the interest clock running, says Bowman. A borrower, on the other hand, may want to put off drawing the funds. But if a CFO waits too long — say, until the company has only a couple of months of cash left — the lender could invoke a material adverse change (MAC) clause. “The lender might not be comfortable anymore,” says Bowman. “They want to you have at least 12 months of cash.”

Careful with collateral. All-asset, first-priority liens on collateral have been the norm with venture debt. Borrowers should specify at the term-sheet stage any specific carve-outs, such as intellectual property. In addition, if the company has foreign subsidiaries, completing a security interest on assets overseas may not be worth it. That would require researching the laws in the specific jurisdiction and hiring foreign counsel, says Haim Zaltzman, an attorney at Latham & Watkins. “The borrower would have to spend too much on legal fees.”

Out clauses. Venture facilities rarely come with financial covenants, because the borrower isn’t generating revenue or cash. Thus the lender usually wants protection so that if the company is failing, it can call the loan, says Blohm. Usually this comes in the form of a MAC clause or an investor-abandonment clause, which allows the lender to declare a default if equity investors start to pull out. Blohm says the latter clause is preferable, because it at least requires action on the part of equity investors whereas a MAC clause is open to interpretation and can be invoked at the lender’s discretion.

The real rate. A lender may claim the borrower is getting a bargain rate of 8% or 9%, but interest rates should always be calculated on an internal rate of return basis, says Bowman. An IRR calculation takes into account all of the different ways the repayment could be structured. For example, a stated rate may not include a facility fee, an interest-only period, or a back-end balloon payment, says Bowman. “There are three or four areas where the lender can get additional return,” he says.

 

 

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