How to Structure Venture Debt to Maximize Equity Returns
In part three of his series on venture debt, Zack Ellison of Applied Real Intelligence explains how to enhance equity upside through smart and creative structuring of deals.
In part 1 of this series on venture debt, I explained how these types of loans give institutional investors access to the same high-growth companies as venture equity, but with significantly lower risk. In part 2, I provided an overview of venture debt deal structures and terms. This month I will explain how to enhance equity upside through smart and creative structuring.
The Upside of Warrants
Most venture debt loans also come with equity warrants that provide lenders with the opportunity to purchase shares of the borrower’s common stock at a predetermined exercise price. In venture debt, warrants typically represent 5 to 10 percent of the loan amount and come with a 10-year exercise period.
The success of warrants is intricately linked to the company’s valuation and specific terms, notably the exercise price and the quantity of fully diluted shares. These factors are crucial in amplifying the lender’s returns, with equity warrants typically yielding 2 to 4 percent annually for non-bank lenders. However, careful structuring and strategic pricing can significantly boost these returns.
Mike Ryan, CEO of Bullet Point Network LP, stressed the importance of underwriting the company’s enterprise value and adapting warrant structures to current market conditions. Ryan works with growth-stage companies and their investors and is a former investment committee member for Harvard’s endowment. “Lenders need to rigorously understand the realistic outlook for the company’s growth and profitability,” he said. “They also now have the opportunity to secure more advantageous equity positions at reduced prices.”
In the current fundraising climate, savvy lenders are well-positioned to negotiate warrant packages that offer greater coverage at lower exercise prices, like “penny strikes” where stock can be acquired for as little as 1 cent per share.
The introduction of minimum gain or put rights within warrant packages is a noteworthy trend, creating a floor value for the warrants. These rights allow lenders to sell warrants back to the company at a predetermined price, ensuring a baseline return.
“Lenders should strive to obtain warrants on the most senior class of preferred shares to benefit from privileges like higher liquidation preference, dividend rights and enhanced protections against dilution,” advised Ben Wiles, a partner at Prospera Law who works with start-ups and venture firms. “Including anti-dilution clauses in both pre- and post-exercise scenarios is crucial to maintain investor value through the company’s growth and fundraising stages.”
Participation, Co-Investment and Conversion Rights
Parker Zangoei, a partner at DLA Piper who advises on venture debt transactions, told me he has seen a significant shift in venture debt structuring: “Beyond traditional warrants, we’re seeing a rise in the use of co-investment rights and success fees, triggered by events like sales, IPOs or major capital raises. These are being offered as either alternatives or supplements to warrants, providing more flexibility and upside potential.”
Participation rights (also known as pro rata rights) offer lenders the option to participate in future financing rounds of the borrowing company on the same terms, conditions and pricing as new investors. Challenges can arise when large shareholders waive their participation rights for all investors, potentially allowing the main lender to assume the entirety of a funding round. This scenario raises questions about the re-entry of (smaller) investors whose rights were waived. To address this, two trends have emerged to protect investors: the backup participation right, often detailed in a side letter, and the springing participation right, enabling smaller investors to rejoin if major investors who waived rights decide to participate subsequently.
Co-investment rights conceptually achieve similar outcomes as pro rata rights by enabling investors to participate in future funding opportunities in various ways. Oftentimes, when the company opens a new funding round or seeks additional capital, investors with co-investment rights are given the option to invest more money alongside the new or existing investors.
Another recent trend gives the lender the option to convert part of their loan into preferred stock. This conversion option, usually at the lender’s discretion, is often priced similarly to, or slightly above, the preferred warrant exercise price. For companies, this conversion option may be more appealing than simply increasing warrant coverage since it also offers the potential to reduce debt.
Right of First Refusal
Another pivotal component in the architecture of venture debt deals is the right of first refusal (ROFR). These rights provide venture lenders with the preferential option to purchase shares or assets or participate in future funding rounds of the borrowing company before these opportunities are offered to external parties.
“A ROFR transforms the lender’s role from a passive financier to a more active participant in the company’s growth,” explained Ryan. “It provides a lever to not only safeguard but also escalate investments in line with company milestones.”
Lenders are best served through a combination of participation rights and ROFRs along with co-sale rights, to align their interests with those of founders and major shareholders. “Co-sale rights are essential in safeguarding investors against information asymmetry, which can occur when company insiders, like management, sell shares based on privileged information not available to lenders,” noted Wiles. “These rights entitle investors to participate proportionally in any secondary sales initiated by founders, ensuring equitable treatment and opportunity.”
Power of Information Rights
One crucial aspect often overlooked but gaining importance is robust information rights. Lenders must insist on comprehensive financial reporting and access to key company documents such as the capitalization table, charter, and purchase/merger agreements for the life of the warrants, rather than the life of the loan. This continuing access is vital for accurately valuing warrants and confirming payouts in exit events. It’s a common pitfall for lenders to accept limited warrant information rights, only to later realize their inability to properly assess their investment’s value.
Looking Ahead
In next month’s column I will explore the key aspects of protecting downside in venture loans through effective structuring.
Zack Ellison is the founder and managing partner of Applied Real Intelligence and CIO of the A.R.I. Senior Secured Growth Credit Fund. Send comments or questions to zellison@arivc.com and visit A.R.I.’s website at www.arivc.com.