Key Features to Watch for in Venture Debt

Introduction

Venture debt plays a prominent role in the Canadian venture capital market, and the size of the venture debt market continues to expand. According to the Canadian Venture Capital and Private Equity Association, in the first nine months of 2024, the Canadian venture debt market totalled C$528-million, exceeding 2023 levels by 21%. Q3 of 2024 saw a sharp 119% increase in debt financing from Q2, largely fueled by two C$100+ million transactions. While venture debt activity in Canada in 2023 lagged behind 2022 levels, in part due to the impact of the failures of Silicon Valley Bank and Signature Bank, venture debt remains a vital option for Canadian startups facing fundraising challenges and seeking alternative financing solutions.

When Should You Use Venture Debt?

Venture debt is a specialized product with strategic use cases that startups should consider. The most obvious use case is to stretch the company’s runway to another financing round or a potential exit. Hitting certain milestones is key to raising in a future round at a high valuation. If the company’s product is delayed for whatever reason, venture debt can bridge the startup to the next equity round by financing the completion of the milestone. Without venture debt, the company may have to raise money at a lower valuation (because the product milestone was not hit, for example), which could be very dilutive to the existing shareholders. In the worst case, the company may reach the end of its runway, unable to raise money without hitting the milestone.

A more strategic use of venture debt can be to use it as jet fuel in conjunction with an equity round. Consider a case where a startup raised C$10-million on a Series A financing and projects a run rate of C$5-million, which would set the company to raise at five times revenue for its Series B round. If the company obtained C$2.5-million in venture debt right after its Series A, it could use the extra money to supercharge growth. This would increase its run rate, thus increasing the valuation of its Series B round, so existing shareholders are less diluted by the Series B round.

In each case, venture debt may act as a starting point or financing source for startups not yet ready for traditional lender financing or startups that do not want to raise equity, given they may be financing through angel funding, friends and family or similar sources of equity.

What Is Venture Debt?

Venture debt is a type of financing that is tailored to startup companies, especially their inherent risks, limited short-term debt servicing capacity and need for flexibility. Venture debt compliments venture capital funding and is intended to support the growth and scaling of a startup company. The following describes some of the key features of venture debt.

Amount 

Venture debt loans are typically 20% to 40% of a startup’s most recent equity round. This amount is typically expected to be sufficient to provide the startup with up to six months of cash runway.

Duration

Given the unpredictable future of startup companies, venture debt loans are generally offered on a shorter-term basis, usually three years, as opposed to the more typical five-year term of conventional debt. The loan term may be structured to incorporate both a “draw period” and an “interest-only period.” The draw period is the time in which advances may be made to the borrower, and the interest-only period is the time before the borrower must start making principal payments to amortize the debt.

Pricing

Various pricing elements, including interest and other fees, work together to compensate lenders for the risk associated with lending to a startup.

The interest charged on venture debt loans is usually a margin above prime, historically ranging between 7% to 12% but increasing in the current market. Borrowers of venture debt are typically only required to pay interest on the principal drawn each month. Interest may be structured as (1) “cash paid interest,” where the interest is paid as a percent of the loan; (2) “payment-in-kind,” where the interest is added to the principal balance and is paid out at the end of the loan term to accommodate cash flow challenges; or (3) a combination of the two.

A lender may also be compensated through various other fees, including an origination fee or an administration fee. Some lenders offer a deferred pricing structure whereby a “back-end loan fee” is payable upon maturity or when the loan is refinanced. Deferred pricing permits the borrower to pay with future earnings rather than using up the company’s current liquidity.

Warrants

Warrants are another common element of venture debt loan pricing that differs from the conventional loan market. Warrants serve as an alternative to some upfront fees or excessively high interest rates, which, for many startups, would consume too much cash. A warrant gives the lender the right to purchase shares in the startup at an agreed-upon price, which is an opportunity to participate in upside corporate growth. While warrants are a security, warrant holders do not have liquidation preferences and, therefore, assume the risk that the company could potentially fail prior to the warrants being exercised.

There are four principal elements of a warrant: (1) coverage, (2) strike price, (3) expiry date, and (4) security.

• Coverage refers to the number of shares the warrant holder is entitled to purchase and is expressed as a percentage of the loan amount. Warrants typically represent between 5% to 20% of the loan.
• The strike price is the fixed price at which warrants may be exercised. The strike price usually reflects fair market value at the time of issuance; however, the parties may agree to an alternative negotiated amount.
• The expiry date is the date by which the warrant needs to be exercised. This may be anywhere up to 15 years.
• Security refers to the stock the warrant holder is entitled to purchase. Lenders are unlikely to exercise a warrant prior to a liquidation event and, therefore, do not benefit from receiving preferred shares. Executed warrants typically translate to up to a 2% ownership interest in the company.

Restrictive Covenants

Loan agreements generally contain covenants that restrict the borrower from taking certain actions that would impede the lender’s ability to be paid. Covenants are typically tied to events of default such that if the borrower breaches a covenant, the loan must be repaid immediately.

Venture debt loan agreements often include covenants tailored to activities a startup has control over and may include restrictions on the borrower taking on new indebtedness, repaying existing indebtedness, transferring intellectual property and disposing of assets. These are similar to conventional covenants but with more flexibility.

In the venture debt context, it is often inappropriate to impose stringent covenants since the ordinary course for startups is to act aggressively in pursuit of growth opportunities and strict covenants would impede their ability to do so. Consequentially, venture debt loan agreements often include limited covenants giving the borrower greater flexibility to operate their business.

Financial Covenants

There are often limited financial covenants in venture debt loan agreements. Specifically, venture debt loan agreements usually do not include leverage covenants, debt service covenants or debt or fixed charge coverage ratio (FCCR) covenants, but they may contain monthly recurring revenue and growth covenants.

Venture debt loan agreements may include an event of default triggered by a material adverse change to the business or investor support. While these events of default serve a similar purpose to financial covenants, the lender has more discretion in deciding whether a breach has occurred such that additional funding should be cut off.

Security

Traditional loans are usually secured by positive cash flow and tangible collateral, while venture debt is secured chiefly by intellectual property. Venture debt lenders typically do not require a personal guarantee. While venture debt is most frequently structured as a senior secured debt, some lenders will accept a junior position in certain circumstances and with commensurate increases in pricing. In addition, certain venture debt lenders may agree to subordinate venture debt to traditional senior debt from banks or other traditional lenders with a significantly lower cost of capital, viewing it as positive for the startup.

Why May a Startup Opt for Venture Debt Over a Traditional Equity Raise?

While venture debt complements and is typically used in conjunction with venture capital equity raises, there are distinct differences between the two and unique benefits to venture debt. For example, because warrants usually represent under 2% of the company’s ownership interests, venture debt is relatively non-dilutive. Consequentially, despite the higher costs associated with venture debt, it may often be a cheaper option, particularly on a cost of capital basis, than equity. While there are many benefits to obtaining venture debt, startups should exercise caution as the funds will have to be paid back at the end of the loan term regardless of the startup’s financial situation, which could create significant pressure for the borrower.

Who Is Venture Debt Right for and When Should a Startup Consider Obtaining a Venture Debt Loan?

Venture debt is offered by both bank and non-bank lenders who favour borrowers who have raised capital from institutional sources such as venture capital firms rather than private investors. In determining whether to lend to a startup borrower, venture debt lenders will consider the historical performance and reputation of the venture capital firm involved. Lenders prefer scalable startup companies that have a high existing or expected growth rate.

The best time for a company to qualify for venture debt is when the startup has an existing cash runway (for example, shortly after a capital equity raise). This is when the startup has peak creditworthiness and its highest bargaining power.

Before taking out a venture debt loan, a startup should consider the unique characteristics and risks associated with venture debt. If a startup decides that venture debt is the right course of action, there are several options for where to apply for a venture debt loan in Canada.

For more information, please contact the authors or any other member of our Emerging Companies & Venture Capital group.