Introduction
Over the years, venture debt has become popular, especially for founders in low-interest environments. Despite this increase in popularity, venture debt is still misunderstood within the tech ecosystem, even by experienced founders and attorneys. In this brief piece, we break down a bit about what venture debts and warrants mean. You will find this extremely useful if you are a founder, attorney, or tech enthusiast.
What is “Venture Debt”?
Venture debt is financing provided to venture-backed companies by specialized banks and non-bank lenders to fund operating expenses. This type of debt is usually used as a complementary method to equity venture financing. Other alternatives include debt financing. However, an essential advantage of venture debt is that it helps prevent further dilution of the equity stake of a company’s existing investors, including its employees.
A venture debt facility is an option for a specified period (12-18 months) during which a company can draw down a predetermined capital. If the company exercises the option for debt, a loan is created, and that capital plus interest needs to be repaid over time. Once drawn down, venture debt is senior to equity and, as such, is refunded first in the event of an exit or bankruptcy.
How does venture debt financing work?
Venture debt does not require any form of collateral because startups generally do not own assets of substantial value that can be used as collateral. So, lenders are compensated instead of collateral with the company’s common equity warrants.
Venture debt is usually provided to startups participating in several equity financing rounds. They are suitable for companies that have been operating for a while but do not have the sufficient cash flow to obtain conventional loans. Venture debt is usually used to reach anticipated milestones and acquire the required assets.
What are warrants?
On the other hand, a warrant is a feature of venture debt deals. Warrants are securities that give the holder the right (but not the obligation) to purchase company stock at a specified price within a specific period. The company usually issues them. The guaranteed price at which the warrant holder has the right to buy the stock at what is often called the strike price or exercise price.
However, this price is only valid for a finite period, during which you can exercise the warrant. Expiration dates can range anywhere from 1-15 years. A typical warrant contains the following elements; Number of shares, strike price, and expiry date. The ‘number of shares’ provides the specific number of shares holders would be entitled to on or before the expiry date.
The expiry date refers to the date on or before which the warrant needs to be exercised. The total value of the distributed warrants generally represents 5% to 20% of the principal amount of the loan.
For instance, let’s say a venture debt lender provides Company R with a $1 million loan with 10% warrant coverage. Company A issues a warrant to the lender for $100,000 worth of shares in the company with an expiry date of 3 years.
The lender now holds a warrant that allows them to invest $100,000 to buy shares of Company R at the price of Company R’s most recent financing round on or before the expiry date.
Merits and Demerits of Warrants
There are some advantages and disadvantages to warrants for the lenders and the company seeking financing. Aside from the fact that it encourages additional participation in the company’s growth on the lender’s part, there is future cash flow for the company should the lender decide to pay for the shares by exercising the warrants.
On the other hand, warrants may be disadvantageous for lenders. Warranties do not last forever. This means you must exercise them on or before the expiry date. Additionally, the contracts can lose value depending on the company’s worth. When this happens, the equivalent of the entire investment value is lost. Warrant holders do not receive dividends, nor do they receive control rights compared to shareholders.
For companies, warrants also have their demerits, one of which is future dilution. Exercised warrants could result in 2% dilution. Additionally, if the equity value is higher than the strike price when the contract is exercised, the shares are being purchased cheaply at a discount.
Conclusion
As a founder, securing funding can be tricky sometimes. Thus, the temptation to explore ‘non-VC’ options may arise. While venture debt and warrants may be a valuable alternative When you are considering convincing a lender to invest in your company, you have to consider the risks and whether or not you are willing to accept them.
When in a pickle such as this, the best thing to do is to speak to an experienced attorney, who may be able to guide you on the matter and give advice.