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If you've raised venture capital recently or you're currently raising, you might be thinking about getting venture debt, also called a venture term loan. If you are, you might see a term sheet soon. This is a nonbinding agreement that a venture debt lender will give you when they’re considering an investment in your company.
This sheet will set the terms of your deal, including the size of your loan, your interest rate, and the warrants that your lender will take. It will also set the tone for your company’s future, whether it’s when you take on your next VC round or when you look into other forms of financing. With so much riding on the term sheet, there’s no question that the agreement should be negotiated to ensure that you’re safeguarding your company’s best interests.
Once you've grasped the basics of venture debt financing, it's time to understand what you'll find on a typical venture debt term sheet. In this article, we’ve decoded the meaning behind the most important terms you should know before negotiating and signing your term sheet.
Venture debt terms to know
The loan size, also known as a loan commitment, is the total amount that you receive from a venture debt facility. It’s usually between 20–50% of your previous venture capital round. For example, if a startup raised $5M in its last round, it might be able to get a venture term loan in the range of $1–2.5M.
The interest rate on a venture term loan is generally variable, meaning the startup will have to take on interest rate risk. Many venture debt rates are based on the WSJ Prime rate, which fluctuates in direct correlation with the Fed rate.
Loan fees are miscellaneous fees that some lenders charge, sometimes triggered as soon as a loan is closed. In general, these upfont fees are lower than what traditional commercial loans charge since the goal of a venture term loan is to help startups burn as little cash as possible.
Hence, some loan fees are due at the end of the loan duration, known as the maturity date. In this case, these fees are often known as final payments and are usually quoted as a percentage of the total loan amount.
Some lenders also choose to charge an optional loan fee called a prepayment fee if you repay your venture term loan prior to the maturity date. These fees may be structured to be lower if you prepay your loan closer to the maturity date.
The loan duration refers to the total time from when the loan is closed to when it is fully repaid. Venture term loans typically have a loan duration of 3–5 years. For example, Mercury’s loan duration goes up to 48 months. The loan duration can also be broken up into the draw period, the interest-only period, and the principal repayment period.
The draw period, also known as the availability period, is the period of time during which a company can draw down on its loan after closing a venture deal. Interest is not charged during this period if the loan is not drawn. The draw period differs based on the lender.
The interest-only period is a duration of time — starting when your deal is closed and typically running 12–18 months — during which a company is only required to pay interest on a loan. During this period, a startup only has to pay interest (not the principal). The longer the interest-only period, the more time a startup has before it needs to start paying off its loan.
Interest charges only begin once a loan is drawn. For example, your startup might wrap up a venture debt agreement in September 2021. Your interest-only period will begin then, but you won’t actually be charged interest until you draw your loan in March 2022. Note that the draw period and interest-only period will often closely overlap.
The length of the interest-only period tends to influence the price of the loan (the interest rates and the warrant pricing). Some lenders allow startups to negotiate conditional extensions if their startup hits certain performance milestones.
Amortization refers to how a loan’s repayment schedule is determined. Venture term loans often follow straight-line amortization, meaning the principal repayment is spread out equally over a certain period (after the interest-only period).
For example, a 4-year $4M venture term loan may have a 12 months/36 months amortization structure. In this case, the interest-only period and draw period directly overlap, both taking place over 12 months, followed by 36 months of monthly principal repayments. Under a straight-line amortization repayment structure, each monthly principal repayment would amount to about $111,111.
For lenders, collateral serves as a “last resort” source of repayment. If you haven’t been able to repay your loan, a lender might ask for your business assets — depending on what you’ve agreed upon in your term sheet, this might also include intellectual property. Collateral can be enforced via liens.
Covenants are terms and conditions imposed by the lender that can lead to a default if violated. They can either be positive or negative. Positive (sometimes known as affirmative) covenants are lists of actions the startup promises to undertake. These might cover things like following all regulatory and reporting requirements, obtaining relevant approvals, filing taxes appropriately, or sticking to certain financial ratios.
Negative covenants are things the startup promises not to do, like selling the business or taking on additional debt.
Material adverse change (MAC) clause vs. Investor abandonment clause
One major component of any loan agreement is the set of rights granted to a lender that allows them to take action if the company fails to meet its obligations as laid out in the venture term loan agreement. These rights are stipulated in the form of either a MAC clause or an Investor abandonment clause. While most lender agreements include a MAC clause, Mercury gives companies the option to choose the clause they prefer for their loan agreement.
A MAC clause gives a lender the right to call a default if it is deemed that (i) there have been fundamental changes to the company’s business, operations, or conditions, or (ii) the company's ability to repay any of its obligations has been impaired.
Some lenders may permit the substitution of an Investor abandonment clause in place of the MAC clause default. This clause gives a lender the right to call a default if it is deemed that the company’s investors have made it clear that they do not intend to continue funding the business in the amount and time frame necessary to enable the company to meet its loan obligations. In essence, if a borrower reaches a point where they are unable to repay any of their obligations to the lender — and subsequently, to other creditors — and their investors have refused to fund the business or help the borrower with a “soft landing” (e.g., selling the business or winding it down), the lender would have the right to call an Investor abandonment default.
It’s important to note that the likelihood of a lender calling a MAC or Investor abandonment default is very low.
Finally, because covenants can be restrictive (e.g., mandating the startup to not breach certain financial parameters), heavy covenants may not be appropriate for earlier-stage startups, where financial performance is less predictable. As a trade-off to having no financial covenants in place, lenders often require compensation in the form of warrants.
Venture debt warrants give their holder the legal right (but not the obligation) to purchase a certain number of shares of the company’s stock at a fixed price, known as the strike or exercise price. Warrants work like the equity options you might give out to employees — they give your lender the option to buy a small portion of your company, valued at the time that the loan was created. The warrant duration is most commonly 10–12 years but could go as long as 15 years. It is also longer than the loan duration. The lender will specify the class of shares for the warrant (Preferred or Common), but this arrangement is negotiable.
If you’re interested in learning more about Mercury’s Venture Debt product, click here.