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The venture debt term sheet

A term sheet is a nonbinding agreement that a venture debt lender will give you when they’re considering an investment.

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’re looking at other forms of financing. It can—and should—be negotiated.

In this article, we’ve debunked the most important terms to know before negotiating and signing a venture debt term sheet.

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Terms to know

Loan size: The loan size, also known as a loan commitment, is the total amount that you receive from a venture term loan. It’s usually between 25% and 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 between $500K and $2.5M.

Interest rate: The interest rate on a venture term loan is generally variable, meaning the startup will have to take on interest rate risk. Many loans (including Mercury’s) are based off WSJ Prime.

Loan fees: Loan fees are miscellaneous fees that some lenders charge. They may be triggered once a loan is closed. In general, these upfront fees are lower than traditional commercial loans—the aim behind 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. They’re often known as final payments and are usually quoted as a percent of the total loan amount.

Another common type of “optional” loan fees are prepayment fees (or more aptly, penalties). If you repay your venture term loan prior to the maturity date, the lender may charge prepayment fees. They may be structured so that they are lower if you prepay your loan closer to the maturity date. Most banks use prepayment penalties to retain customers—Mercury does not charge a prepayment fee.

Loan duration: 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 three to five 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.

Draw period: The draw period, also known as the availability period, is the time that a borrower has after closing to draw down on their loan. Interest is not charged during this period. The draw period differs based on the lender. For example, Mercury has a draw period of up to 18 months.

Interest-only period: The interest-only period starts when your loan is closed. 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 (it typically runs 12-18 months), but you won’t actually be charged interest until you draw your loan in March 2022.

During this period, a startup only has to pay interest (not principal). The longer the interest-only period, the more time a startup can go without starting to pay off their loan. 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: 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. This means it has an interest-only period of 12 months followed by 36 months of monthly principal repayments. On a straight-line amortization basis each monthly principal repayment would amount to about $83,333.

Collateral: 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. This can be enforced via liens.

Covenants: Covenants are terms and conditions imposed by the lender that can lead you to default if violated. Covenants can 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: This clause gives the lender the right to call a default if anything is determined to be “materially adverse.” If something bad happens to your company, the lender can call a default. Mercury does not have an MAC.

Finally, because covenants can be restrictive (e.g. mandating the startup not breach certain financial parameters), heavy covenants may not be appropriate for earlier-stage startups, where things are much more unpredictable. As a compensation for no covenants, lenders often ask for warrant compensation.

Warrants: Stock warrants give their holder the legal right (but not the obligation) to purchase a certain number of a company’s stock at a fixed price—known as the strike or exercise price. Warrants work like the equity you might give out to employees—they give your lender the option to buy a small portion of your company at a later stage, valued at the time that the loan was created.

When negotiating warrant compensation with your lender, there are a few things to know:

  • The warrant duration is likely to be longer than the loan duration. Seven to ten years is common. Lenders will try to push for a longer duration, while you should try to negotiate a shorter one.
  • Be clear about what class of stock the warrants will convert to. If it’s preferred stock, then the lender will enjoy any additional advantages that your VCs get. For example, Mercury takes its warrants from the common stock.

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Manage your money with Mercury
Scale with checking and savings, custom made tools, and our entire investor network
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Mercury Team
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