Looking to forego the additional equity round and opt for venture debt instead? If so, you’re going to want a firm understanding of the venture debt term sheet before you execute a deal.
As many small business owners know, term sheets can be both confusing and intimidating. But they don’t have to be that way; with a little preparation, you can feel confident going into negotiations to secure the best possible deal with the right lender.
At its core, a term sheet is simply a non-binding document outlining the terms and conditions between a potential borrower and lender.
As a “non-binding” agreement, the term sheet outlines the main stipulations of a funding deal before either party gets too deep in the due diligence process. It covers all the most significant aspects of the deal without getting caught up on every contingency under the sun.
It may, for example, spell out a few basics about the payment terms, closing conditions, and investor commitment. While these pieces of information may help to inform an eventual legal agreement between the lender and borrower, the venture debt term sheet is not a contract in and of itself.
In contrast with other term sheets, a venture debt term sheet does not contain any stipulations about voting rights, as venture debt itself is non-dilutive. In other words, investors don’t get any say over the company’s direction or current leadership.
Below, we’re going to demystify the venture debt term sheet. We’ll dive into the most important terminology, the most critical concepts, and leave you with enough know-how so you can thoroughly impress your lender.
Important Terminology & Concepts to Understand
Certain concepts associated with venture debt term sheets are easy to understand. For example, the amount borrowed, the interest rate, and the length of the loan are all pretty self-explanatory.
Other terms require some clarification for the uninitiated borrower. Here are several common terms that fall into that latter category.
Due Diligence
Before investors enter into an agreement, they perform due diligence to determine whether or not the borrower is viable. Otherwise dubbed as an audit, due diligence is used to confirm the financial integrity of the borrower before an agreement is made.
While this occurs after the term sheet is signed, its execution is often spelled out in the term sheet itself. Be prepared to share historical and projected financials, customer and vendor contracts, tax documents, and more with your lender after both parties have agreed to the venture debt term sheet.
As part of the due diligence process, lenders also commonly review internal procedures and policies, quality assurance measures, and any metrics associated with the company’s growth and position in the market.
Covenants
A covenant is a kind of performance threshold spelled out on a term sheet by the lender. They could be restrictions or prohibitions, or they could be guidelines to which the borrower must adhere. They could, for instance, indicate a prerequisite cash balance before a loan is executed.
If a covenant is violated at any point during the loan term, then you may be in default of the loan. In the rare case of default, this could mean the venture debt company takes control of the company and could choose to liquidate it.
Warrants
Warrants are a type of security that grants your lender the right to buy company stock at a protected price. When a warrant is used, the company is obligated to issue new stock, which could cause some degree of dilution.
Typically, warranties will be issued by the borrower for a specific duration. The price at which a warrant holder can buy stock is dubbed the exercise price. Warrant expirations range from one to 15 years and holders are entitled to a specific number of pre-determined shares.
Borrowers will agree to warrants as a way to attract potential investors. Since venture debt is, by definition, non-dilutive, warrants can be used to elicit a larger investment in the company’s growth.
Draw Period
The draw period, sometimes called the draw-down period, is the allotted time during which a venture loan is available. Often, a specific amount of debt must be drawn down before the initial draw period ends.
For example, consider a revolver deal. In these deals, the borrower secures a revolving line of credit which they can draw from — but only up until a certain point. The line of credit is not offered in perpetuity, so the draw period defines when it can and cannot be used. After the period is over, no more borrowings can be made and the credit expires.
Draw periods can be as long as 18 months but the venture debt draw period is usually structured as a six- to 12-month period, followed by 30 to 36 months of amortization. Amortization refers to the length of time it takes a company to pay off a loan.
Maturity Date
The maturity date refers to the date when everything, including the principal loan amount, interest, and any cash fees, has to be completely repaid.
As a form of inconvertible debt, venture debt does not have the option of being transformed into equity at the loan’s maturity date. By contrast, convertible debts may be converted to equity upon reaching the maturity date.
Final Payment
At the end of a loan, the borrower will usually pay an amount with a higher interest rate than what’s attached to earlier repayments. This final payment is sometimes called the back-end or balloon payment.
By the final repayment, a startup company should be better equipped to handle a larger payment than was required earlier in the amortization period.
Material Adverse Change
Material adverse change, or MAC, is a form of contingency provision that protects the lender. It gives lenders and any other funding parties the right to back out of executing a loan agreement if an event were to adversely impact the borrower’s financial prospects.
Usually, the MAC applies between the time negotiations are initiated and any credit first becomes available to the borrower. This is vital because a significant period can pass between deal execution and first funding.
The MAC will define and quantify what counts as a significant adverse change in borrower viability. Material changes can include any shifts in liabilities, assets, intellectual properties, patents, processes, market access, and licensing.
In the era of COVID-19, lenders have become even more cautious in terms of how they structure MAC clauses. Extreme market volatility has, at least in the short term, shifted MAC stipulations to more lender-friendly terms.
Still, MAC clauses are generally difficult for the lending party to prove. For the MAC to take effect, broad, industry-wide impacts have to incur a proven, disproportionately adverse effect on the borrower compared to competitor businesses.
Additional Questions You Should Ask
Before agreeing to any terms, it’s important to ask key questions to the lending party about the loan. No one wants to be hit with unexpected fees or unexpected loan stipulations.
What is the True Cost of this Loan?
Fundera co-founder/CEO Jared Hecht, writing for Inc., points out that all lenders present their offers differently, and borrowers must do their own due diligence in order to understand just how much they really owe.
That means understanding what fees might be incurred.
Most lenders will charge a closing fee, which is an immediately incurred fee payable in cash when the loan is first funded. Generally, the fee sits around one to two percent of the amount loaned.
The closing fee is generally used to pay legal fees associated with deal execution or to provide a reduction in credit exposure for the lender.
Maturity fees, sometimes called back-end fees, are payable in cash when a loan is repaid. While some loans have no maturity fee, others take a one to three percent at closing.
A prepayment fee is a cost incurred by the borrower if they opt to repay a loan early. Early repayment may mean the lender has not lost any amount on the deal, yet it also means the borrower pays less in interest over time, which is why the lender may seek a prepayment fee protection.
Can I Pay Off the Loan Any Time?
It’s a trickier question than some borrowers might realize. It stands to reason that it is vital to pay a loan off on time, but some lenders also might stipulate a prepayment penalty, in the event a loan is paid off in advance of the agreed-upon date. Such lenders will structure the prepayment penalty per the minimum amount they expect to make off the loan.
A common prepayment penalty would be staggered by years. If a three-year loan is paid off in year one, a three percent penalty could apply, followed by a two percent penalty in year two, and a one percent penalty paid in year three.
Again, the lender wants to make their capital investment worthwhile and achieve expected returns. Think carefully about whether or not it would be financially beneficial to pay off the loan early.
How Do I Make My Payments?
Automatic debits via ACH withdrawals have become increasingly common, and ensure that payments are made in a timely fashion. They also save the borrower money; statistics show that it costs a business $1.22 every time someone writes a paper check.
Of course, there are always security concerns associated with making online payments, concerns that have only been exacerbated during the coronavirus pandemic, as remote work became more commonplace and hackers more brazen. Even the Small Business Administration proved vulnerable.
As a result it is of the utmost importance that borrowers protect all touch points, while at the same time reassuring oneself about the best practices of the lender. It is best to deal with a borrower that uses Secure Sockets Layer protocol (SSL), which is easily revealed with a scan of their URL. If it begins with “https,” then they have this added layer of protection.
What Will You Do With My Information?
There is a saying: Data equals dollars. There is considerable debate as to how much a company’s data might be worth, though Gartner once asserted it can be calculated according to how much it would cost to replace it, how much it contributes to an enterprise’s revenue and how much could be made from selling it.
Suffice it to say, then, that a business owner needs to control the flow of information, as much as that is possible. And during the process of securing a loan a borrower must receive assurances from the lender that that information will be kept confidential and secure.
Final Thoughts
Borrowers don’t need to agree to terms that they barely understand just to get funding. Venture debt term sheets can be intimidating, but with the right foreknowledge and guidance, it’s possible to arrive on an agreement you actually agree with.
When you push away all the jargon, venture debt term sheets are really just a helpful source of information for both the borrower and the lender. The terms let each party know they are entering a deal that makes sense for them.
Beyond the terms themselves, it’s also important to ensure you’re entering into a deal with the right partner. Reputable lenders come in many forms — business development companies (BDCs), private equity firms, and so on — so it’s worth doing your research on which one will provide the best mix of guidance and flexibility for a business at your stage of development.