To borrow or not to borrow: key considerations for “venture debt” deals

If you are a tech start-up, or your organisation invests in or helps develop them, you will have seen market speculation that 2023 is likely to be a difficult year for tech businesses to raise venture capital. At the end of last year, we set out some key takeaways from a panel discussion moderated by Slaughter and May titled ‘Fundraising during rockier times’. One of those takeaways was that you don’t necessarily need to delay fundraising in the current climate if you need the additional investment, but you should be clear about how much capital you need and find the right investor to help you achieve that vision. And that doesn’t necessarily mean equity funding. Venture debt is becoming increasingly popular for founders who want to raise in the current climate but avoid a down round. These deals typically involve either conventional debt (often a short-term bridge loan) or funkier hybrid debt such as a convertible bond, structured equity or a participating bond.

Find below our five key considerations for founders contemplating a debt deal.

1. Cash without a down round – many start-ups and investors are turning to debt deals as a means of avoiding a down round (a funding round at a lower valuation than the previous round). Founders and employees are keen to avoid negative market sentiment, and VC investors are motivated to avoid a write-down in the value of a portfolio company. A debt deal allows a company to access cash without a formal valuation, often in the hope that the cash will drive growth and pave the way for a stronger equity raising further down the line. Venture loans tend to be short-term (often around eighteen months, sometimes up to two or three years), and lenders may expect to be paid out of the proceeds of the next equity round. So it can often be a short-term solution to bridge a cashflow gap between equity rounds.
   
   
2. Debt means less dilution (at least in the short term) – unlike an equity round, a debt deal won’t dilute the relative equity holdings of current investors (including founders and employees) or stock options. Lenders don’t take board or voting rights, although they may well require amendments to existing equity documents (e.g. shareholders’ agreements and articles) to reflect the existence of the debt and any security granted by the company. This is particularly relevant for companies in a down round scenario, where existing VC investors enjoy heavy BVCA standard anti-dilution protections (which typically entitle them to an increased share of ownership in the event of a down round, effectively retrospectively reducing the valuation from the previous funding round). However, do bear in mind that hybrid debt instruments which convert into (or carry a right to subscribe for) equity in the future will typically result in a dilution at the time of conversion or subscription – and so often a debt round will delay, rather than avoid, a dilution.

3. Cash needs and balance sheet impact – a loan or debt instrument will typically carry some form of interest or coupon, which requires cashflow to service. Venture debt deals often carry a higher coupon than conventional bond markets, as start-ups and scale-ups (particularly if not yet profitable) are seen as a riskier bet. Servicing this interest will reduce the cash available to drive growth, and for early stage companies with limited cashflow, it may not be a viable option. However, venture loans often carry an option to capitalise interest or begin with an interest-only period during which the company will service the interest but won’t make any repayments of principal, and hybrid instruments sometimes involve a revenue (or even profit) sharing model which can reduce the cash-burden of meeting fixed cash interest payments. Some start-ups are also issuing debt instruments to existing equity investors, who have a vested interest in ensuring that enough cashflow remains available for growth. In general, it’s worth bearing in mind that a significant debt can make a balance sheet less attractive to future investors – but involving existing backers (provided that they’re familiar with debt deals) can mitigate some of those effects, and some investors will enjoy the new opportunities presented by increased leverage.

4. Rights and covenants – debt will carry a higher liquidation preference than (i.e. will rank ahead of) equity on a winding-up and typically on a sale, which pushes existing investors further down the waterfall. That’s often not a huge sticking point in practice, as a new series fundraise would also carry a higher preference. Debt deals typically involve financial and general covenants given by the company, which can be more stringent than the restrictions on day-to-day business involved in an equity deal. The flipside of that is that debt investors won’t typically have as many veto rights as equity investors may have. Regulated fintechs looking to bolster their regulatory capital position may be able to do so with debt, as well as equity, although this will limit lender rights and will generally therefore make any borrowing more expensive.

5. Combinations can work – a debt deal doesn’t have to be a substitution for an equity round – it can be done alongside a smaller round and some investors may like that as it allows them to benefit from the additional leverage (not dissimilar to a more traditional private equity model). Lenders often like to follow hot on the heels of VC investors, and will look at the business plan associated with the most recent equity round (and anticipated timeline for future rounds) when deciding whether to underwrite a debt deal. Lenders will look at the size of a loan in the context of the most recent equity round: a common rule of thumb is that venture debt can raise around 30% of the value of the most recent equity round. For these reasons, venture debt is typically not available to seed-stage companies.

Slaughter and May’s Venture Capital and Growth Company practice advises the full spectrum of investors and growth companies, from early-stage venture funds to large, international VC firms and institutional investors and from start-ups to large public and private companies around the globe. For more information, please see our website and/or contact James Cook, co-Head of Fintech and Emerging Tech.