Venture Debt

What is venture debt?

Venture debt (a growth loan for venture-backed companies) refers to loans to growth companies that are financed by venture capital investors but do not yet generate the cash flow needed to support conventional bank financing. The lender bases its decision mainly on the quality of the equity investors, the liquidity on hand and the prospect of further funding rounds. It is therefore betting that the loan can be repaid from the next round or from a sale. In return for the higher risk, it usually receives, besides interest and fees, a warrant, that is, the right to acquire shares later at a price fixed in advance.

Venture debt complements an equity round but does not replace it. Companies usually take it up shortly after or in parallel with a round from institutional investors in venture capital. The aim is to extend the runway to the next milestone without giving up further shares. Providers are specialised credit funds (venture debt funds), individual banks with a dedicated growth financing unit and public development banks, at European level for example the European Investment Bank. The contractual basis consists of the loan agreement, the security agreements and an agreement on the warrants.

Structure and cost of venture debt

The total cost is made up of several components that allow a comparison only when taken together:

• Interest: fixed or variable, as a rule well above the interest rate on a secured bank loan.
• Fees: an arrangement fee on signing and a commitment fee for portions not yet drawn (tranches). A final payment at the end of the term and a prepayment fee, which compensates for the lost interest on early repayment, are often added.
• Warrants (option rights): Their size is usually expressed as a percentage of the loan amount (warrant coverage), and the price is often based on the last funding round. The number of warrant shares is then loan amount × warrant coverage / exercise price per share.

The term is often three to four years. The first six to twelve months are often free of repayment, so the company pays interest only. After that, the loan is repaid in equal instalments; repayment in a single amount at the end of the term is less common. Larger loans are often paid out in tranches, with drawdown tied to revenue targets or to the closing of the next equity round.

Warrants in a GmbH

Unlike the Aktiengesellschaft (German stock corporation), a GmbH (German limited liability company) has no conditional capital, that is, no capital increase that takes effect automatically when subscription rights are exercised. The rules of German stock corporation law on warrant bonds do not apply to it either. Warrants granted to the lender are therefore agreed by contract: the shareholders undertake, on exercise, to resolve a capital increase and to admit the lender to subscribe for the new shares. Authorised capital under Section 55a of the German Limited Liability Companies Act (GmbHG) can make implementation easier, because the management may then issue the shares without a further shareholder resolution.

Where shareholders undertake to take part in a capital increase or to transfer existing shares, questions of form arise. An obligation to assign shares in a GmbH requires notarial recording under Section 15(4) GmbHG. Virtual warrants, which grant a payment claim equal to the increase in value instead of shares, are therefore also widespread. If the lender exercises genuine warrants, it usually accedes to the shareholders' agreement.

Exercise also has consequences under insolvency law. If the lender becomes a shareholder, its loan may rank as subordinated in insolvency as a shareholder loan (Section 39(1) no. 5 of the German Insolvency Code, InsO). Repayments made in the last year before the insolvency filing would then be open to challenge (Section 135(1) no. 2 InsO). Excluded are non-managing shareholders holding no more than 10% of the share capital (small shareholder exemption, Section 39(5) InsO); with the usual small warrant percentages, this exemption generally applies. Irrespective of this, exercise is usually economically worthwhile only on a sale or stock market listing, by which time the loan has often already been repaid.

Covenants, collateral and ranking

Venture debt agreements contain conditions (covenants), usually monthly reporting obligations, a minimum liquidity or a minimum cash runway and a ban on further financial debt. There is also a ban on granting security to third parties (negative pledge). Conventional financial ratios such as the debt ratio in relation to EBITDA take a back seat because the earnings of young companies are often still negative. Some agreements additionally tie a right of termination to a material adverse change (material adverse change).

Typical collateral consists of a global assignment, that is, the assignment of all customer receivables, the pledging of bank accounts and shares, and the transfer of fixed assets by way of security (Sicherungsübereignung). Where transferable, rights in intellectual property are added. The pledging of GmbH shares requires notarial recording. As a rule, the lender demands first ranking. Where bank loans exist alongside, an intercreditor agreement regulates the order of priority; some providers also offer venture debt on a subordinated basis, in which case at higher cost.

If the company breaches a covenant or an instalment is missed, there is a contractual ground for termination (event of default). After any cure periods in which the breach can be remedied, the lender can then terminate the loan and enforce the collateral. Calling the loan due can lead to illiquidity and thereby trigger the management's duty to file for insolvency under Section 15a InsO. In practice, negotiations usually first take place on a waiver or an amendment to the agreement, which causes additional costs.

Relationship to the next equity round

The economic purpose of venture debt lies in the next round. If the loan extends the runway far enough for the company to reach a milestone, the following round becomes possible at a higher valuation and with less dilution. Lenders therefore often base the loan amount on the size of the last equity round.

The risk lies in the opposite case. If the next round does not materialise or is delayed, repayment continues and consumes liquidity when it is scarcest. New investors also examine how much of their capital flows into repayment and sometimes demand refinancing or a deferral of repayment. The lender's warrants appear in the fully diluted ownership overview (cap table) and dilute all shareholders slightly.

Worked example: cost of venture debt and comparison with equity

A software company has closed a Series A of EUR 10 million at a valuation of EUR 40 million after the round. There are 100,000 shares, and the price per share is EUR 400. A credit fund offers EUR 4 million of venture debt. The loan runs for 36 months, of which 12 months are free of repayment, followed by 24 equal monthly instalments. Interest is 11% per year on the outstanding amount, the arrangement fee is 1% and the final payment is 3%. The warrants cover 10% of the loan amount at the Series A price.

• Interest in the phase free of repayment: EUR 4 million × 11% = EUR 440,000
• Repayment: EUR 4 million / 24 = around EUR 166,667 per month; on average, (EUR 4 million + EUR 166,667) / 2 = around EUR 2.08 million is outstanding in this phase, and the interest for 24 months comes to around EUR 458,333
• Fees: EUR 40,000 arrangement fee + EUR 120,000 final payment = EUR 160,000
• Total running costs: EUR 440,000 + EUR 458,333 + EUR 160,000 = around EUR 1.06 million; this corresponds to an effective annual interest rate of around 13.5%, that is, the actual annual burden including fees, excluding the value of the warrants
• Warrants: EUR 400,000 / EUR 400 = 1,000 shares, after exercise around 1.0% of the capital (1,000 / 101,000)
• Comparison with equity: EUR 4 million at the same price would result in 10,000 new shares and a dilution of 10,000 / 110,000 = around 9.1%

If the company is later sold for EUR 200 million, the warrants are worth around EUR 1.58 million (1,000 / 101,000 × EUR 200 million minus the exercise price of EUR 400,000). Interest, fees and warrants then cost around EUR 2.6 million together. Even with repayment of the EUR 4 million, only around EUR 6.6 million flows to the lender. Additional equity, by contrast, would have cost the existing shareholders 9.1% of the proceeds, that is, around EUR 18.2 million. If the company fails, the picture reverses: the loan remains to be repaid, whereas equity would have shared in the loss.

Distinctions: venture debt, bank loans, convertible loans and RBF

• Bank loan: presupposes that interest and repayment can be met from current cash flow (debt service capacity) and requires collateral customary for banks. Venture debt relies instead on the funding strength of the equity investors.
• Convertible loan: is generally not repaid but converted into shares. The venture debt loan, by contrast, is repaid; only the warrants lead to a small shareholding.
• Revenue-based financing: repayment as a share of revenue up to a fixed multiple, usually without warrants and for companies with highly predictable revenues.
• Bridge financing: umbrella term for bridging finance until a foreseeable event. Venture debt can also serve as such bridging finance.
• Mezzanine capital: subordinated funds, usually unsecured and repaid in one amount at the end of the term, mainly for profitable mid-sized companies (Mittelstand). Venture debt is generally secured, first-ranking and repaid in instalments.

Common mistakes

• Taking it up only in a liquidity squeeze. Lenders mainly finance companies that have just received equity. Requests made with a short runway lead to worse terms or end without a commitment.
• Repayment not factored into the runway. After the phase free of repayment, the monthly instalments shorten the runway considerably. The liquidity plan must contain interest and repayment in full.
• Covenants not tested in a conservative case. A minimum liquidity that is met in the base case can be breached if a round is delayed by six months.
• Scope of collateral underestimated. A global assignment and the pledging of accounts restrict later financing such as factoring or a credit line from the company's house bank.

Frequently asked questions

From when does venture debt come into consideration for a company?

As a rule after an equity round with institutional investors, often from Series A. Prerequisites are ongoing revenue, a sufficient cash runway and investors whom the lender trusts to provide further funding. There is no fixed revenue threshold.

How expensive is venture debt compared with equity?

Considerably cheaper in the success case, more expensive in the failure case. Interest, fees and warrants result in effective costs above those of bank financing, but they are capped. Equity, by contrast, costs a permanent share of the later proceeds, but does not have to be repaid.

What happens if the next funding round does not materialise?

The loan must still be repaid according to schedule. If liquidity is insufficient, a breach of covenants and termination are threatened. Negotiations on a deferral of repayment are then usual; if they fail, the lender can enforce the collateral, and the management must examine its duty to file for insolvency.

Does the lender become a shareholder?

Only when it exercises its warrants, and that usually happens only on a sale or stock market listing. With virtual warrants, it never becomes a shareholder but receives a payment.

Do the shareholders have to approve the borrowing?

Often yes. Externally, the management can validly bind the company even without a resolution (Section 37(2) GmbHG). Internally, however, shareholders' agreements and rules of procedure regularly provide for a reservation of consent, and for the warrants, resolutions on a capital increase or on authorised capital are required.

The Roemer Capital view

As a fractional CFO, we model venture debt offers in the financial model with all payments: interest, fees, final payment and repayment schedule, in each case in the base case, the conservative case and the optimistic case. What matters to us is the runway after repayment, not on the day of disbursement, and the distance to each financial covenant if the next round is delayed by several months.

We compare several offers on the basis of the effective annual interest rate and the value of the warrants in different sale scenarios, and set them against an extension of the last equity round. The company's law firm reviews the contracts; we take part in negotiating the commercial terms.