Let’s discuss what these loan terms mean for your business and why you included them in the planning.
Why Loan Terms Are Essential?
One of the most flexible, founder-empowering forms of SaaS funding available on the market is venture debt financing. Despite the availability of several other alternatives, the debt financing model remains the best option for keeping founders and owners operationally and strategically free. This is due to the flexible loan terms it offers, which I’ll explain shortly.
By using debt financing, a borrower can achieve total ownership and make their own decisions. At the same time, lenders employ debt contracts to shield themselves in case the borrower defaults. Keep these points in mind—they’re practical, make sense, and usually help build better relationships between lenders and borrowers.
As borrowers have different risk tolerances, lenders do as well, and their loan terms reflect that. For SaaS leaders and owners, it is important to assess these conditions right from the beginning. You should keep a sharp eye out for lenders with stringent conditions to make sure you don’t experience any nasty surprises. Let’s go deeper.
Venture Debt Warrants: Incentive or Ownership Risk?
Venture debt with warrants, referred to as ‘equity kickers’, is traditionally provided to investors as an incentive. They allow their holders to buy firm stock at a fixed price up to the warrant expiration period. In terms of coverage, they are expressed as a percentage of the loan amount. For example, your lender may require that you provide 10% warrant coverage, especially if your SaaS firm secures a $1 million venture finance loan. This means you would give them a warrant qualifying them to purchase stock worth $100,000 in your business.
The problem with warrants is that, although they don’t immediately grant investors ownership of your business, they offer them the opportunity.
The investor will get a stake in your business if they exercise the warrant within the allotted time. Some lenders may use warrants to acquire the right to participate in your subsequent equity round on the same terms, conditions, and pricing available to investors if you have already secured venture capital investment.
While investigating venture capital lenders, examine the use of debt warrants as a component of loan terms. Although they are not necessary for all venture debt lenders, those who do can acquire an ownership stake if the warrant expires.
Covenants: Agreements for Performance
Loan constraints, known as venture debt covenants, establish minimal performance and financial standards as part of the loan contract. They are intended to control the borrower and reduce risk for the lender. You might have to maintain a specific number of new customers or monthly recurring income while lowering your burn and churn rates if you accept venture debt financing with a covenant arrangement. These parameters could be assessed quarterly or monthly.
Failing to fulfill these conditions allows the lender to take several actions, a situation known as “tripping” a covenant.
The lender would normally work with you to fix the issue, but you would be in some challenging situations if it persisted beyond the first violation. In the worst situation, the lender can declare all your debt due, raise your interest rate, or deny you access to further borrowing. Even if the latter is a drastic step, it can make it impossible for a SaaS company that is in default to continue operating.
Venture financing lenders don’t always require covenants, just like warrants. Borrowers and lenders should thoroughly negotiate covenants to establish terms that align both parties.
Covenants aim to ensure borrower performance, and lenders impose them with no intention of using covenant remedies unless absolutely necessary. However, if you accept this form of financing, a covenant might act as a sort of barrier to keep your company from going backward and to keep it going forward.
Guarantees: Making a Personal Commitment
We wanted to discuss this final loan condition since it can be a tool you come across outside of debt financing. The agreement is a personal guarantee. Venture debt financing firms have a greater stake in the company, idea, and past (and anticipated) performance of the business than banks and other lenders, which may demand a personal guarantee if the company cannot pay back the loan.
A personal guarantee agreement is frequently unnecessary, partly because venture debt firms favor assets like intellectual property or a general claim on all assets.
However, this is not a generalization. During your research, you can find a lender that needs your personal guarantee as the company’s founder and owner. You must carefully consider that risk. Do you wish to bear personal liability for the debt that your company is incurring?
This is just one of the numerous benefits that debt financing as a funding model offers to your business. Creditors might not become part owners of your company nor occupy a seat on the board within a short time, which can result in further disadvantages. You can adjust financing criteria, allowing you to structure a loan that promotes your business expansion instead of discouraging it.
In venture debt, recourse can be a dangerous business proposition, where a personal guarantee can be given, citing the company’s value. However, it is possible to contradict the benefits of receiving financing with a certain risk factor. Even though not all venture debt lenders demand personal guarantees, paying attention to them and knowing all the terms is always useful.
All types of businesses, from start-ups and high-turnover businesses to businesses with remotely located employees, should consider the terms of the loan carefully, argue on the need for a guarantee, and weigh their chances of repaying the loan without selling their personal belongings.
Make Your Finances Simple with Cheqly!
For small businesses seeking to streamline financial planning and manage expenses effectively, Cheqly offers robust support tools, including simplified budget management, clear forecasts, integration with current systems, and user-friendly features to help you stay on track. Open a Cheqly account today for straightforward finance management!