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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. This month, I will demystify the intricate world of venture debt deal structures. Here are some of the key terms and concepts you need to understand.

 

BORROWERS AND LOAN PARTIES

 

In venture debt transactions, it is common to have both the primary operating company (the borrower) and its subsidiaries as co-borrowers or secured guarantors. This arrangement provides the lender with additional collateral and strengthens the credit profile of the loan. Most term loans are provided by one lender, although “club” deals of two or three lenders occur on occasion. It’s also common for borrowers to have a revolving credit facility provided by a bank and a larger term loan provided by a non-bank lender. The term debt is almost always longer maturity, larger size and priced at a higher interest rate than the revolving debt facility.

 

VENTURE DEBT SENIORITY

 

The seniority of venture debt refers to its position in the borrower’s capital structure. Venture debt typically holds a senior secured position, granting it first claim on the borrower’s assets in case of default. This seniority provides an extra layer of protection to the lender.

 

COLLATERAL AND CONDITIONS

 

Collateral in venture debt deals customarily encompasses all assets of the borrower and its subsidiaries, providing the lender with a first-priority lien on intellectual property (IP), accounts receivable, inventory, equipment and property, among others. This collateral helps mitigate risk, protecting the lender’s investment by enhancing recovery value in the event of a loan default.

 

Both closing and funding conditions in venture debt transactions ensure that the borrower continues to meet agreed-upon criteria and that the lender’s interests are protected throughout the life of the loan. Examples of conditions to closing include completion of due diligence, credit committee approval, definitive documentation, absence of material adverse changes and financial conditions related to the borrower’s health. Some lenders may even require borrowers to raise additional equity capital before disbursement.

 

REPAYMENT

 

Standard venture loan maturities range from three to five years but are often repaid sooner, particularly when the borrower is able to raise additional equity capital. Monthly interest payments are the norm, with an initial interest-only period, normally spanning six to 12 months, preceding a transition to straight-line amortization. This amortization process involves the gradual paydown of the loan principal over the remaining loan term.

 

Historical data reveals that, on average, venture loans are fully repaid in approximately two and a half years. However, this repayment timeline can fluctuate significantly based on the accessibility and cost of capital. In times of cheap capital and easy access to funding, borrowers tend to expedite their loan repayments. Conversely, during periods of elevated costs and scarcity of capital, loans naturally extend closer to their final maturity date.

 

FUNDING TRANCHES AND MILESTONES

 

Venture loans range in size from as little as a few hundred thousand dollars to hundreds of millions, with an average deal size of $12.2 million during the 2018 and 2022 period, according to Pitchbook data. The total commitment in a venture debt deal can be divided into tranches, often contingent on specific milestones tied to performance or equity capital raised. Tranche 1 is typically funded in full at closing, while Tranche 2 and Tranche 3 may become available upon reaching predefined equity or performance milestones. This structure aligns the loan disbursement with the borrower’s achievements, while ensuring manageable leverage.

 

USE OF PROCEEDS

 

Venture debt is generally earmarked for growth, such as expanding operations, product development, tech stack enhancements and scaling sales and marketing efforts. This allocation ensures that the capital is utilized strategically to enhance the company’s growth.

 

COMPONENTS OF RETURN

 

Most venture debt coupon payments consist of a floating rate, often tied to the Prime Rate (currently at 8.5 percent) plus a credit spread ranging from 400 to 800 basis points. A portion of the interest may be paid in kind (PIK), allowing the borrower to defer cash payments while providing the lender with additional returns.

 

In 2022, about 8 percent of deals had a PIK interest component, averaging 3.4 percent, according to my analysis of publicly traded venture debt-focused business development companies. Notably, more than 90 percent of venture loans made by these BDCs in 2019 were floating rate, but that number decreased to approximately two-thirds in 2021.  In hindsight, it’s clear that the borrowers benefitted from the hot market in 2021, pushing lenders to lock in fixed rate loans while interest rates were low. As we saw in 2022, fixed rate securities had devastatingly poor performance as benchmark rates increased rapidly. I expect we will see a return to more floating rate structures as credit conditions tighten and lenders regain bargaining power in the next phase of the credit cycle.

 

FEES

 

Venture debt deals involve various fees, including a closing fee (also known as an origination fee or upfront fee), a final exit fee (often termed a “success” fee) and a prepayment fee. The vast majority of loans have closing fees of 1-2 percent and exit fees that average 6 percent. Prepayment fees can be structured as full interest make-whole payments or as a percentage of the outstanding loan amount. These prepayment fees incentivize borrowers to keep loans outstanding for the agreed-upon term while providing the lender with some compensation for the interest income they would have received had the borrower not prepaid the loan.

 

WARRANTS

 

Most venture 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. The percentage of fully diluted shares and the exercise price are key terms to watch, as they impact the potential equity upside for the lender. Exact returns on equity warrants are unknown but observable data indicates that while returns vary widely, they tend to cluster in the range of 2 percent to 4 percent per annum for non-bank lenders.

 

COVENANTS AND REPORTING

 

Protective covenants represent the borrower’s commitment to safeguard the lender’s interests. These covenants often revolve around liquidity, such as maintaining a minimum cash balance, and performance, including revenue growth targets. Stringent financial reporting requirements usually mandate monthly submissions and covenant adherence. Some lenders even secure non-voting board seats as observers.

 

FINDING GEMS

 

Looking ahead to next month, Part 3 of this series will delve deeper into the factors that make venture debt deals attractive and explore how these structures align with the strategies and goals of institutional investors.

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