Introduction: what is venture debt?
In this increasingly austere period of fundraising, debt financing is for many start-ups the only option to tide over this difficult period. Yet, institutional lenders often refuse or are unable to lend to early-stage companies. There is an alternative to institutional lenders – venture debt – nonetheless, from our experience, it remains a relatively unfamiliar option for many start-ups in Southeast Asia. This article aims to shed some light on venture debt, demystifying its terms and the venture lending business in Southeast Asia.
Venture debt is, at its core, debt that is specifically provided to early-stage companies and start-ups. This fundraising paradigm was first conceived and developed in the United States and has grown in deal flow to almost USD30 billion annually in the past few years.[1] As with traditional debt, venture debt can comprise of term loan facilities, revolving facilities or other types of debt financing.
Compared to equity financing, debt is attractive to founders as it permits them to extend their cash runways with minimal or no dilution. This is complementary for early-stage companies seeking to raise capital to meet commercial objectives or to achieve meaningful milestones, so as to justify a higher valuation at the next funding round. However, start-ups and their founders often cannot access financing from institutional lenders, because such lenders assess debt repayability of start-ups based on their financial track records, positive cash flows, and assets over which security can be granted, all of which are not readily available in early-stage companies. To this end, venture lenders try to meet this demand in a manner that benefits all parties.
To compensate for the inherently higher risk assumed by venture lenders by lending to start-ups, venture lenders charge interest rates that are higher than those charged by institutional lenders. Venture lenders may also ask for security in support of their loans. Typical security may include, amongst others, personal guarantees from the founders, all-asset debentures granted by the borrower, and charges on specific bank accounts and/or account receivables of the operating subsidiaries. There is no market standard on the type of security to be provided, and much depends on what is commercially acceptable and reasonable to the parties.
In addition, a common condition for venture debt is the borrower’s provision of share warrants that are redeemable into shares at a specified exercise price. The number of share warrants to be provided is typically expressed as the ‘warrant coverage’ over the loan amount, such as ‘20% of the loans drawn down’. This would mean, assuming a loan amount of USD1 million, that the venture lender can subscribe for an equivalent of USD200,000 in shares at the specified exercise price under the share warrants. Such share warrants are ‘detachable’ and are, after their issuance, often expressed to be transferrable to third parties. However, it must be noted that the terms of the warrants, the exercise price, the type of shares and the warrant coverage are all matters to be negotiated between the venture lender and borrower at the outset. There are no market standards for how such share warrants should be constituted.
Venture debt should not be confused with convertible debt or other equity instruments, as they are not convertible – the share warrants are exercisable upon the payment of the specified exercise price for each share.
Venture lenders vs institutional lenders: differences in perspectives, approaches and processes
While institutional lenders usually comprise banks and financial institutions, venture lenders can include not just such financial institutions but also family offices, private equity, hedge funds and high net worth individuals. Because of the nature of their business, venture lenders are not constrained by capital adequacy and regulatory requirements that are imposed on institutional lenders, and therefore can assume a greater amount of risk.
In making a lending decision, unlike institutional lenders, venture lenders focus beyond the start-up in question and will also consider the private equity, angel investor and/or venture capital firms (collectively referred to as “venture capital firms”) involved with the start-up. This is for several important reasons:
- Traditional metrics for assessing debt repayability do not work on start-ups. Venture lenders must decide based on their assessment of the long-term sustainability of the start-up, as well as the possibility of follow-on fundraising. However, venture lenders may not (unlike venture capital firms) have specialist knowledge or the technical skill to assess the underlying products or services. In addition, unlike the comprehensive due diligence carried out by venture capital firms, there is little or no due diligence carried out in venture lending. As such, the involvement of a good venture capital firm serves as a powerful indicator of start-up quality, to the extent that venture lenders generally do not extend venture debt to start-ups until venture capital firms are involved.
- From a logistical perspective, the assumption of debt, the undertaking of security and the grant of share warrants are often board reserved matters and/or shareholder reserved matters. Without the consent of venture capital firms and their nominated directors, venture lending cannot proceed.
- Venture lenders face a great deal of information asymmetry. While venture lenders usually have monitoring mechanisms and covenants built into their facility documentation, they do not have the benefit of a board seat, veto rights or other forms of operational control over the company. As such, having a good venture capital firm involved and actively monitoring the financial health of such start-ups is complementary to the venture lender’s ongoing monitoring of their borrowers.
- There is often an implicit understanding that some portion of the future rounds of fundraising may be used to repay venture debt, which would otherwise be impossible without the close cooperation of venture lenders with venture capital firms.
In addition, the manner in which negotiations are run by institutional lenders and venture lenders are different. Institutional lenders assume that borrowers are sophisticated, capable of understanding complex documentation, and have the resources to engage qualified advisors. When default occurs, institutional lenders have recourse through their transaction security and recoverability is high. However, start-ups do not have the same resources and collateral as their established counterparts and are often under-represented or even unrepresented. As such, the consequences of the borrower’s negligence, breaches and defaults are much heavier to a venture lender. Consequently, some venture lenders choose to take a greater degree of control in the lending process, such as requesting for voluntary disclosures from the borrower (which will be elaborated further below), assessing if the required consents under the borrower’s constitution and shareholders’ agreement have been properly obtained, and providing template resolutions, registers and other documents which the borrower must use.
Finally, while institutional lenders may rely on a variety of financial covenants to monitor borrower’s risk profile, the risky nature of start-ups means that venture lenders place heavy emphasis on monitoring the cash runway and bank account balances of their start-up borrowers.
Venture lending in Southeast Asia from a Singapore perspective
Having explained what venture lending is and how it differs from institutional lending, how does venture lending in Southeast Asia compare to other regions such as the United States or Europe?
We set out below some observations we have noted in our deals in the past few years.
- Despite recent improvements, the legal landscape of Southeast Asia remains fragmented and divergent relative to the United States and/or Europe. It is not uncommon for the fundraising holding company of a Southeast Asian start-up to be incorporated in one jurisdiction and its operating subsidiaries in various jurisdictions with each entity being subject to different laws on borrowing from offshore entities, taking and enforcing security, and foreign ownership. In this context, venture lending is often extended to the holding company (being the entity under which venture capital was raised), pursuant to a facility agreement governed by laws and in a format comfortable to the lender, and some of the supporting transaction security may be granted by the operational subsidiaries pursuant to foreign law security documentation of that jurisdiction.
- As noted above, institutional lenders assume borrowers understand the loan documentation as a sophisticated party. Where the representations and warranties set out in the documentation may not be accurate or complete, institutional lenders assume that borrowers will negotiate limitations or exceptions and disclose the reasons why. In the institutional context it is unheard of for borrowers to give disclosure letters to such representations and warranties. However, in the Southeast Asian venture lending context, where recoverability is limited and borrowers may not be sophisticated, some clients have insisted on borrowers giving disclosure letters – with the sole purpose of forcing their management team to read through the representations and consider the documents in great detail. We can attest that this method works: we have had deals under which no comments were received during the negotiations of the loan documentation, but disclosures were subsequently made when the borrower was forced to draft the disclosure letter.
- Given the financial conservatism of Southeast Asian lenders and longer runways to future equity fundraising rounds, venture lenders are often hesitant to extend venture debt if there are too many loans on the start-up’s books. Venture lenders often make exceptions for existing loans granted by institutional lenders and may be happy to rank junior to such loans, but will otherwise scrutinise other types of debt, including shareholder loans and convertible notes. In such situations, some venture lenders will require that these other lenders expressly subordinate their debt to their venture debt.
- In the United States, we understand that some venture lenders do not use extensive loan covenants – going so far as having ‘no-covenant’ or material adverse change clause-only deals as the market standard.[2] In the Southeast Asian context however, venture lenders are more risk-adverse and have extensive positive and negative covenants relating to, amongst others, the dissipation of assets, the assumption of further debt, and the use of loan proceeds. Nevertheless, the fast-changing and unpredictable nature of start-up businesses means that waivers are often requested for many of these covenants, which renders their compliance irrelevant in the first place. Venture lenders are aware of this and use such covenants to maintain a conversation with start-up borrowers and venture capital firms, so as to find mutually acceptable compromises for all parties.
Conclusion
In conclusion, aside from equity funding and institutional lending, venture debt is another fundraising option that start-ups should consider and explore. While there are differences between venture debt and traditional debt, we have endeavoured to demystify such differences and explain the dynamics between the parties involved in the venture lending process.
For further information, please contact:
Chun Bin Soh, Partner, Zico Law
info@zicolaw.com
[1] Darian M Ibrahim, ‘Debt as Venture Capital’ (2010) 4 University of Illinois Law Review 1169, 1194.
[2] Marina Temkin, ‘Large-scale investors flock to venture debt’s ‘phenomenal returns’ (PitchBook, 30 September 2022) <https://pitchbook.com/news/articles/venture-debt-financing-blackstone-KKR> accessed on 27 October 2022.
