In my last post, I compared and contrasted Venture Debt from Banks vs. Venture Debt Firms.
While most Venture Debt term sheets are straightforward and fairly easy to understand, it’s important to understand what each of the terms really means to you and your company. As such, below is my RapGenius version of a Sample Venture Debt Termsheet. I’m not including every term you may see, but rather the key ones you should focus on (I didn’t include financial covenants as most pure play Venture Debt lines don’t have financial covenants).
Sample Venture Debt Proposal
Facility: $3,000,000 Growth Capital Facility
Availability: Through 12/31/13, Borrower may make draws on the line. Draws must be at least $250,000 and shall be limited to six (6).
What it means for you: The draw period is when you can actually use the line. After the draw period is over, no more borrowings can be made and usability expires. Draw periods typically range from 0 to 18 months. In most cases, a longer draw period is better for you as it allows you to borrow on the line when needed rather than being forced to borrow when you have plenty of cash in the bank. Conversely, there IS a risk to waiting to draw as lenders typically have the ability to withhold advances if they believe a significant negative event has occurred with the business.
Amortization Period: Each draw on the line shall amortize on a straight-line basis with equal payments of Principal and Interest over a thirty-six (36) month period.
What it means for you: This is simply the length of the repayment period for each advance made on the debt, and in most cases the debt is repaid in equal installments similar to a mortgage or car loan.
Interest Rate: Wall Street Journal Prime Rate + 2.50%. Fixed at time of each advance.
What it means for you: Not much to see here. This is simply the rate you pay on the amounts you actually borrow. The only thing you’ll want to specify here is how the Index Rate is defined (i.e. if the index is LIBOR, is it a 30 day LIBOR or something else? If the index is Prime, is the Prime Rate defined as Wall Street Journal Prime Rate or is it a Bank specified Prime Rate). You also want to keep an eye out on whether the rate is a fixed rate or floating rate. A fixed rate option will always provide for a higher rate in a low-interest rate environment.
Final Payment (sometimes called Back-end or balloon payment): At the end of the amortization period or upon prepayment, a final payment of 4.00% of advanced amounts shall become due.
What it means for you: Very similar to traditional equipment lease deals, the final payment is akin to a buy back option. Lenders often include this as a benefit to allow companies to make lower ongoing interest payments (when cash is presumably expected to be tighter). Remember though, this payment is made regardless of when you pay off the line, which could make the loan very expensive if you want to pay off early.
Prepayment Penalty: If line is paid off priority to maturity, a prepayment penalty of 3% shall apply in year 1, 2% in year 2, and 1% in year 3.
What it means for you: Well, it means that you’ll have to pay a premium for the privilege of pre-paying your line. Why is it in here? Simple, for a deal to be worthwhile for a lender, they need to predictably lock in certain levels of compensation. Aside from deterring constant refinancing and short-term line usage, the prepayment is a huge defense against portfolio churn. Prepayments can range from friendly (like above) to explicitly draconian (where all future interest payments are accelerated at time of prepay).
Warrant Coverage: Warrant Coverage of 8.00% shall be charged on commitment amount of Facility (line). Class of shares and price per share shall be based off Series B round.
What this means for you: This is the equity kicker lenders take in exchange for providing Venture Debt. A Warrant is no different that an option in structure, with the lender having the ability to buy a certain class of shares at a specified price for a specified period of time (usually 7-10 years).
The dilutionary effects of the warrant are very easy to calculate. In this termsheet, where Warrant Coverage is 8% and the Venture Debt line is $3MM, the math looks like the below. Let’s assume that Price per share of the Series B round is $2.00/Share.
The lender will get 8.00% * $3MM = $240K/$2.00 Share = 120,000 Shares. Divide that by your fully diluted shares, and you have the dilutionary effects.
In most cases, the warrant will represent <2% dilution (<1% is very common). Lenders are also being more flexible with warrants by often basing some of the warrant off utilization of the line (and not just committed amounts).
Right to Invest: Lender shall have the right (but not obligation) to invest up to $500,000 in the next Qualified round of financing.
What this means for you: This requires you to give the lender a right to invest in the next round of financing at their sole discretion.
Collateral: Borrower shall Grant to Lender a first priority security interest in all assets of the borrower (UCC-1 to be filed), including a negative pledge on Intellectual Property.
What this means for you: As it suggests, you are pledging your Company’s assets to the lender as collateral for the loan. As written here, this includes Cash, Accounts Receivable, Equipment, and Inventory. In a liquidation scenario, the lender would be on top of the payment priority stack on these assets over the Preferred and Common Shareholders. A negative pledge on IP means that while the IP of the Company is free and clear, you cannot pledge the IP to another party. Many Venture debt proposals will include IP if the deal is considered extremely risky. While most entrepreneurs resist this out of fear that the lender will seize the IP at the worst possible moment, the reality is that scenario is a rare occurrence. A not so dirty little secret – Bankers and Venture Debt Firms don’t make for the best IP liquidators! The key value IP as collateral brings lenders is being on the top of the payment stack during a liquidation (ahead of other unsecured creditors).
Material Adverse Change: An Event of Default can be called if the Lender, in its sole discretion, determines a material deterioration in the the business has occurred and may impact the prospects of repayment.
What this means for you: Ah, the infamous MAC clause. Many proposals are silent on this topic, but it’s something you should definitely ask about during the initial phase. This term is more commonly found in Bank deals than Venture Debt firm deals and provides the lender the ability to “call” the loan if it is nervous about company’s ability to repay the loan. It’s another reason why all entrepreneurs need to be discerning on who is chosen as the Venture Debt partner. If the lender insists on this clause, you should ask the lender as to whether they’ve ever used the clause, under what general circumstances, and the process they used prior to calling it. Most reputable lenders will have only used this clause on a few, well-defined occasions – and only after all options were exhausted (reputational risk is sky-high for the lender if used improperly).
Many lenders will agree to lighter versions of this clause; either by watering down the MAC clause language, or substituting it altogether with something called an “Investor Abandonment” clause. The Investor Abandonment clause states that an Event of Default can be called if the Company’s investors articulate they will no longer support the company. This is obviously a much more comfortable clause for a borrower as it defines an exact circumstance for an Event of Default.
As mentioned, many Venture Debt firms will not require either of these clauses.