Venture Debt: Key Aspects of Legal Diligence

In part 17 of his series on venture debt, Zack Ellison from Applied Real Intelligence examines the key areas of legal diligence in venture debt and growth credit transactions.

Legal diligence is one of the most misunderstood aspects of venture debt and growth credit transactions. The process ensures that what the borrower has represented to the lender is accurate and that the loan structure provides the intended protections for both parties.

It’s helpful to think of legal diligence like a pre-purchase car inspection by an experienced mechanic. The car might look great and perform well on a test drive, but hidden risks, like a faulty engine or structural issues, could lead to serious problems down the line. Legal diligence dives deep into hard-to-see but critical areas to uncover potential risks, enabling lenders to make informed decisions.

For most early-stage borrowers, venture debt is unfamiliar territory. Their experience often consists of equity raises using a Simple Agreement for Future Equity (known as a “SAFE”) or agreements based on National Venture Capital Association (NVCA) templates. Lenders should be prepared to educate borrowers throughout the process, using clear communication to build trust, create alignment and ensure an efficient process.

This article serves as a practical primer on legal diligence, providing insights and strategies to navigate this vital step in venture debt transactions.

Organize and Prepare

Preparation is the foundation of an efficient diligence process. A borrower’s ability to stay organized and proactive can significantly affect the deal timeline and cost. “An efficient process starts with the borrower providing a detailed and accurate perfection certificate from the outset. This is equivalent to a detailed ingredient list for a chef,” says Matt Schwartz, DLA Piper’s U.S. finance group leader. This document provides the lender’s counsel with information about the borrower, guarantors and assets needed to perfect security interests in the collateral.

Before due diligence begins, borrowers must establish a well-organized data room accessible to all relevant parties, including the borrower, lender and counsel. This centralized repository should contain all essential documents and provide a clear audit trail of updates to ensure efficiency and transparency throughout the process. Stakeholders should be notified of any changes or newly uploaded files to avoid miscommunication and streamline collaboration.

Chuck Charpentier, partner at Troutman Pepper Locke, notes that “companies that fail to get their house in order before seeking financing often face avoidable roadblocks like old liens, lapsed good standing, unfiled annual reports or unpaid taxes. These issues not only delay the process, but also raise red flags for lenders about management’s preparedness.”

Hire Experienced Counsel

“Engaging counsel with deep experience in venture debt is invaluable,” says Jennifer Post, co-chair of Thompson Coburn’s emerging companies group. “There is a well-defined market for terms, resolution points and key documents. Working with seasoned professionals ensures mutual alignment and an efficient path to closing.”

Schwartz adds, “When borrower and lender counsel have worked across from each other successfully in the past, it creates a much smoother process and ultimately gets deals to the finish line faster and with lower cost to the borrower.”

If the borrower uses inexperienced counsel, it will likely cause delays and increase costs, often requiring the lender’s counsel to do additional work. Hiring the right legal team from the outset is an investment in efficiency and success.

Separate Business and Legal Issues

Setting and maintaining clear boundaries between legal and business discussions is essential for keeping the process focused and on track. When business matters become entangled with legal negotiations, inefficiencies and delays inevitably arise.

It is important to work out a comprehensive term sheet that addresses all the critical business terms from the outset. Then stick with it. “Re-trading – deviating from agreed-upon business details in the term sheet – creates friction, delays and unnecessary costs,” explains Charpentier. “Both sides must approach the deal with discipline, treating the term sheet as a commitment rather than a starting point for renegotiation.”

If changes do need to be made, these should be agreed to with the business team first. The legal team can then focus on drafting documentation without being drawn into renegotiations. “If in doubt, have the business people work it out” is a principle that ensures efficiency by letting each team focus on their area of expertise.

Manage the Process

The diligence process requires proactive management and consistent communication. “To meet closing timelines, borrowers must prioritize third-party deliverables, such as bank DACAs and insurance documentation,” says Post. “Equally important is ensuring clarity on shareholder approval rights, particularly in transactions involving equity investment rights or warrants.”

Weekly check-ins involving both business and legal decision-makers help maintain alignment and prevent small issues from escalating. Overcommunication on the business side can prevent delays. Picking up the phone and having short clarifying conversations is extremely helpful for maintaining alignment and efficiency. What might take hours to write and respond to via emails can often be cleared up in a few minutes between decision-makers.

Ensure Alignment

Alignment between equity and debt holders is critical to avoid conflicts that can derail the process. “From both a legal and business perspective, the lender must understand the company’s equity investors, their rights and their incentives,” says Ben Wiles, a partner at Prospera Law. “Misalignment between equity and debt can cause major headaches for everyone involved.” Consistent communication and transparency are the keys to staying aligned throughout the transaction process.

Legal diligence is a critical component of venture debt transactions, ensuring that risks are identified and managed effectively. While technology and AI are poised to revolutionize the diligence process by automating tasks and uncovering risks more efficiently, the tried-and-true tactics outlined above remain the most reliable course in today’s market. By staying organized, hiring experienced counsel, separating business issues from legal issues, and maintaining clear communication, borrowers and lenders can navigate the process efficiently and achieve a successful outcome.

Zack Ellison is the Founder and Managing Partner of Applied Real Intelligence and Chief Investment Officer 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.

Columns in the Series

Part 1: Venture Debt: A Lucrative Path for Institutional Investors

Part 2: Demystifying Venture Debt Deal Structures

Part 3: How to Structure Venture Debt to Maximize Equity Returns

Part 4: How to Manage Risk in Venture Debt

Part 5: Advanced Risk Reduction Techniques in Venture Debt

Part 6: Exit, Diligence, and Recovery Tactics for Venture Debt

Part 7: Venture Debt: The Critical Role of Operational Due Diligence

Part 8: Venture Debt: Debunking the Top Five Myths

Part 9: Venture Debt: How to Be a PEST When Analyzing Markets and Industries

Part 10: Venture Debt: How to Fundamentally Get It Right

Part 11: Venture Debt: How to Best Evaluate Leadership Teams