The economic downturn has made it more important than ever that venture debt borrowers and lenders understand the potential pitfalls.

The history of success of venture capital (VC) in the United States and Europe continues to attract investors looking beyond the Coronavirus (COVID-19) pandemic, which has upended lives and shifted daily routines on a global scale. A Stanford research study from June 2020 indicated that 42 per cent of the US labour force was working from home full time, with another 33 per cent not working at all owing to lockdown measures. A World Economic Forum report noted that the pandemic has resulted in over 1.2 billion children worldwide being shut out of classrooms.

These changes, as well as a myriad of others that are fundamentally reshaping the world as we know it, are creating a demand for inventive solutions. Even with a vaccine and the departure of the virus from the world stage, many of the shifts from the past few months will remain in place in a post-COVID-19 world.

Venture investment into start-ups, early, middle, and late stage businesses focuses largely on technology, fintech solutions, and other novel enterprises. These types of businesses are well positioned to thrive, as they support the “new normal”. Other sectors, like the travel, construction, entertainment, and hospitality industries, are likely to lag for the foreseeable future.

Crunchbase reports that global venture funding increased 1 per cent quarter-over-quarter, and 9 per cent year-over-year. Data shows increased investment in the first three quarters of this year versus the same periods of last year in healthcare, apps, payments, online education, and gaming, and many other industries are showing growth owing to their ability to provide innovative solutions for dealing with the impact of COVID-19.

According to Pitchbook, European venture capital investment is skyrocketing, with year-to-date deal value on pace to set a new annual record at year-end. Pitchbook also notes, however, that, because of the risk inherent in venture investment, companies “may turn to debt financing as an alternative to traditional equity rounds, as they attempt to avoid down rounds, dilution, and unfavorable terms.”

Given the prospect of significant growth in the global venture debt market, venture debt borrowers and lenders should be aware of the array of types of these investments, as well as typical intercreditor and subordination issues that can arise and play major roles in any downside scenarios. Given the economic downturn caused by COVID-19, understanding these key issues and potential pitfalls is critical for any venture debt borrower or lender.

Working Capital Facilities and Asset Based Facilities

Many commercial banks and other venture lenders provide working capital facilities based on the value of a borrower’s accounts receivable and inventory. In these working capital financings, the lender constructs a borrowing base that should not be less than its likely recovery in the event of a liquidation of those borrowing base assets.

Additionally, because many VC-backed borrowers in the early, mid and even later stages of growth will face fluctuations in their operating income during certain periods, working capital facilities work to smooth over inconsistent cash flows and provide borrowers with the liquidity to meet their working capital needs. Venture lenders have expertise with the intercreditor and subordination issues that frequently arise in this context.

Junior or Unitranche Venture Debt

Junior capital and unitranche specialty venture lenders are proliferating in the venture debt world, because they provide more aggressive levels of growth capital than commercial banks. While banks offer a lower cost of capital, and possess pricing advantages in their debt offerings, the non-bank lenders that dominate the junior capital and unitranche venture debt markets offer speed of delivery and the flexibility to provide tailored debt solutions.

These lenders offer second lien debt that sits between a working capital facility and equity, and they frequently provide a menu of pricing and amortisation options for the borrower, equity co-investment and warrant rights for the lender, and fewer and more relaxed financial covenants than a working capital facility.

Junior capital and unitranche specialty venture lenders are proliferating.

Unitranche facilities in the venture debt world, even though they originate as all-in-one investments, usually feature carve-outs for future working capital loan facilities as a means of providing flexibility to prospective VC-backed borrowers to access cheaper capital in the future. These interlocking credit facilities require an intercreditor and subordination agreement to determine the relative rights and obligations of the working capital and junior capital or unitranche lenders.

Intercreditor and Subordination Agreements

When entering into a venture financing transaction, prudent venture lenders and their borrowers should be aware of the key provisions in intercreditor and subordination agreements.

Debt subordination refers to the agreement by a junior lender to defer repayment of its debt until some or all of the senior loans are paid in full. Typical working capital and junior debt intercreditor arrangements provide for partial payment subordination that allows the junior lender to receive some or all of its interest payments and scheduled principal payments. Some, however, contain full debt subordination, meaning that junior lenders do not receive any principal or interest payments until payment in full of the working capital or other senior loan facility.

Once an event of default under the senior facility occurs, most intercreditor agreements provide for a temporary (90 to 180 days) payment blockage for non-payment events of default, and a permanent payment blockage upon failure to pay any portion of the senior debt. These intercreditor agreements also provide for lien subordination, whereby the working capital lender would collect on the proceeds of its collateral before the junior lender, and the junior lender would agree to some short period before taking any action against shared collateral.

While the working capital facility’s borrowing base is intended to cover the liquidation value of eligible accounts receivable and inventory, senior lenders place great importance on these remedies’ standstill provisions in situations where the borrowing base components were not reported accurately. While junior lenders do not want to be subject to a remedies standstill when the senior lender’s debt does not appear to be at risk of being unpaid, the senior lender wants to be able to control the process for at least 90 days

It should also be noted that VC-backed borrowers frequently incur debt in the form of subordinated convertible notes that provide a bridge to a borrower’s next stage of growth. While intercreditor arrangements with convertible note purchasers are preferred by other lenders, such arrangements are often embedded in the terms of the notes.

Prudent venture lenders and their borrowers should be aware of the key provisions.

The basic terms of convertible subordinated debt include requiring that it i) be clearly permitted by the terms of the more senior debt facilities, ii) have maturity dates extending at least 90 days outside the maturity of the senior facilities, iii) be unsecured, and iv) not provide for any cash payments inside the maturity of the senior debt facilities.

With the expectation of increased venture capital debt investment around the world over the next few quarters, borrowers and lenders should make sure they are aligned on the types of debt offerings they are interested in pursuing, and should make sure they are in a position to mitigate the risks associated with their investments. Failure to appropriately document subordination arrangements will likely result in lenders experiencing greater pain for their borrowers that encounter distressed situations.