If you have recently received venture capital or are in the process of fundraising or have recently, you may be considering getting what is called venture debt or a venture term loan. If so, you should soon receive the term sheet. A venture loan lender needs to consider providing you with this document when they feel the possibility of financing your business enterprise.
Now that you understand the basics of venture debt financing, this article will outline the eleven key terms found in a venture debt term sheet.
Key Terms and Concepts in Venture Debt
To properly understand the complex financing landscape, entrepreneurs and investors must have a solid understanding of the main terms and concepts associated with venture debt. Let’s see each one of them one by one.
1. Loan size
The entire amount you obtain from a venture debt facility is called the loan size or commitment. Usually, it represents 20–50% of your prior venture capital funding round. For instance, a firm may be eligible for a venture term loan in the $1–2.5 million range if it raised $5 million in its most recent round.
2. Interest rate
A venture term loan’s interest rate is typically variable. Therefore, the startup will be responsible for interest rate risk. The WSJ Prime rate, which varies in direct correlation with the Fed rate, is the basis for many venture loan rates.
3. Loan fees
Loan fees are additional costs that certain lenders impose; these fees can occasionally be incurred as soon as a loan is finalized. Since the purpose of a venture term loan is to assist companies in burning as little cash as possible, these upfront fees are typically lower than those of standard commercial loans.
As a result, certain loan fees are payable on the maturity date, which marks the end of the loan term. In this instance, these costs are typically represented as a percentage of the entire loan amount and are frequently referred to as final payments.
Some venture debt lenders impose an optional prepayment fee if you repay your venture term loan before maturity. If you settle your loan early, your prepayment penalties might be adjusted to be less.
4. Loan duration
The duration is from the loan’s closing to its complete repayment. Typically, venture-term loans are granted for three to five years.
5. Draw period
After a venture transaction closes, a company has a window of time during which it can use its loan, sometimes referred to as the draw or availability period. Interest is not assessed if the loan is not drawn upon during this time. The draw time varies depending on the lender.
6. Interest-only period
The interest-only period, which usually lasts between 12 and 18 months after the closing of your contract, is when a business is only obligated to pay interest on a loan. A startup needs to pay interest during this time—not the principal. If the interest-only period is longer, a company has more time before it has to begin repaying its debt.
Interest only starts to accrue after a loan is used. Let’s say, for example, that in January 2023, you obtain a venture debt agreement for your small business. You won’t pay interest until you begin utilizing the loan in June 2023, even though the arrangement is finalized. It’s crucial to remember that the interest-only period and the utilization period are frequently very similar.
The length of the interest-only period can significantly impact the loan’s total cost, which includes interest rates and other related expenses. Businesses may be able to negotiate conditional extensions of the interest-only term with some financial institutions if they achieve certain financial performance criteria.
7. Amortization
Amortization is the process used to calculate a loan’s payback timeline. Straight-line amortization, which distributes the principal repayment evenly over a predetermined period (after the interest-only phase), is a common amortization strategy for venture term loans.
An 18-month/36-month amortization plan is possible for a $5 million venture term loan with a 5-year duration. There is a clear overlap between the interest-only and draw periods, each lasting 18 months, and monthly principal repayments for 36 months. The monthly principal payback under a straight-line amortization repayment plan would be around $111,111.
8. Collateral
Collateral is lenders’ “last resort” means of repayment. If you cannot repay the loan, a lender may want your business assets, which may include intellectual property, based on the terms of your agreement. Liens can be used to enforce collateral.
9. Covenants
Covenants are terms and conditions put in place by the lender that, if broken, may result in a default. They could be favorable or unfavorable. Affirmative, commonly known as positive, covenants are a set of commitments the startup makes. These could include submitting taxes correctly, getting the necessary approvals, adhering to specific financial ratios, and fulfilling all regulatory and reporting obligations.
Startups undertake negative covenants, which prohibit activities such as selling the business or taking on extra debt.
10. Material adverse change (MAC) clause vs. Investor abandonment clause
The rights offered to a lender to take action if the firm does not fulfill its commitments as outlined in the venture term loan agreement constitute a significant part of any loan agreement. These rights are expressed as an investor abandonment clause or a MAC clause.
A MAC clause allows a lender to declare a default if it determines that, among other things, (i) the company’s terms, operations, or business have changed fundamentally, or (ii) the company’s capacity to repay debts has been compromised.
Certain lenders might replace the MAC clause default with an investor abandonment clause. Suppose it is determined that the firm’s investors have made it plain that they do not plan to continue supporting the business in the quantity and time frame required to enable the company to pay its loan commitments. In that case, the lender may declare a default under this clause. Essentially, the lender would be able to declare an investor abandonment default if the borrower gets to the point where they are unable to pay back any of their debts to the lender and, consequently, to other creditors, and their investors have declined to fund the company or assist the borrower with a “soft landing” (e.g., selling the business or winding it down).
It’s crucial to remember that there is very little chance that a lender will call a MAC or investor abandonment default.
Lastly, since covenants can be restrictive, they may not be suitable for start-ups in their early stages when finances are unpredictable. Instead of financial covenants, lenders often require warrants.
11. Warrants
Venture debt warrants grant their holder the right, but not the duty, to buy a specific quantity of the company’s stock at a predetermined price (sometimes referred to as the strike or exercise price). Like employee equity options, warrants provide your lender the right to purchase a portion of your business at the valuation in effect when the loan was made. The term of the warrant can be as long as 15 years, but it is often 10 to 12 years. It also exceeds the term of the loan. Although this arrangement is negotiable, the lender will define the class of shares for the warrant (Common or Preferred).
Importance of Understanding Venture Debt Terms
Entrepreneurs must understand venture loan terms since they have a direct impact on their business’s financial stability and future expansion. Understanding these words clearly aids in controlling repayment plans, avoiding adverse circumstances, and maintaining equity. As a result, better conditions are negotiated, avoiding any potential hazards that can endanger the company.
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