Venture debt emerges as a financial alternative to drive the tech ecosystem in Spain

Startups often struggle to secure funding because they lack solid financial results, which at the same time makes it difficult for them to obtain traditional financing. As a result, startups frequently seek funding by offering equity (non-repayable financing) to venture capital investors.

In the past few years, influenced by Silicon Valley and introduced by specialised financial entities and funds, a new form of financing has emerged in Spain. This alternative financing model combines traditional debt financing with participation in equity by the lender.

This type of risk financing is referred to as venture debt, which, as previously stated, consists of two variables: a loan and an equity kicker.

The loan

This is a long-term senior (secured) loan. Like any other loan, it entails the obligation to pay interests and repay the loan amount (usually, in full, upon maturity), so it is an alternative financing that, in principle, is only suitable for emerging companies in growth phases, operating at break-even (or close to reaching break-even) and with the expectation of reaching sufficient earnings before interest, taxes, depreciation, and amortisation (EBITDA) levels to be able to repay the loan at maturity.

Given the high risk of the investment in comparison to traditional financing, the interest rate required by lenders is significantly higher and stands at 10-15% per year, payable monthly or quarterly (although it is common to agree on grace periods of up to 12 months). The maturity period generally falls between three to five years, and the borrower must repay the entire principal amount at the end of the term, known in the finance industry as a "bullet loan."

Finally, since it is a secured loan, lenders will usually ask for security interests (such as pledges and mortgages) on most, if not all, of the company's assets.

In Spain, it is important to note that the security interest system does not allow the creation of a "floating charge" over all of the debtor's assets, so as many security interests will have to be granted as there are types of assets in the company (pledge on customer credit rights, mortgage on intellectual property, pledge on inventories, etc.) and each of these security interests will entail additional costs (for lawyers, notaries, registries and, in certain cases, stamp duty) which can substantially raise the overall transaction expenses. Especially, when it comes to the main asset of a tech company, which is its intellectual property or software; in Spain, this requires prior registration in the Intellectual Property Registry and the subsequent registration of the mortgage deed in the Movable Property Registry, along with the payment of stamp duty.

Therefore, whenever a term sheet for venture debt financing is negotiated, it is important (especially when dealing with foreign investors, who are unfamiliar with the costs associated with the Spanish system of security interests) to carefully define the security package that will be provided to the lender based on a cost-benefit analysis.

The equity kicker

The equity kicker provides an additional incentive for the financing, enabling the lender to secure a higher return by becoming a shareholder in the event of a successful exit for the company.

This equity kicker gives the lender the right to acquire company shares at a predetermined strike price, typically in line with the price per share from the latest financing round. This right can be exercised over a period of eight  to ten years. However, lenders usually only exercise this right upon an exit (i.e. when the company is sold for a price higher than the warrant's exercise price). This is often done cashless to avoid paying the subscription price before selling the shares.

In international practice, equity kickers are typically implemented through warrants, which are options to acquire new shares issued during a share capital increase. In Spain, however, the little flexibility offered by the legal regime of limited liability companies in terms of acquiring new shares means that, in small-value venture debt operations (where lawyers' fees negotiating a contract of issuance of warrants or options is not justifiable), alternative systems are implemented where the lenders acquire the shares at nominal value, through the capitalization of an invoice as a commission for structuring the operation (arrangement fee).

The dilution generated with this equity kicker is much lower than what would occur if the financing had been provided as equity, instead of debt. The warrant coverage ratio is usually between 10% and 20% (in Spain, it can reach up to 25% in early-stage companies), meaning that the total value of shares acquired by such lenders is equivalent to said percentage.

For instance, a venture debt financing of €5m with an equity kicker of 20% would entail the acquisition of shares (in the form of warrants or options) worth €1m to the lender. In practice, since the amount of venture debt financing is tailored to the company's valuation of the company, this generally results in an effective equity dilution ranging between 1% and 2%, compared to the traditional dilution of an equity financing, which is around 20%. In our example, if the company's valuation were €60m, the effective dilution would be 1.6% (= €1m / €61m).

Main advantages and disadvantages of venture debt

Advantages

• Minimises equity dilution. This option enables the founders to extend the company's runway, assuming a lower equity dilution in comparison with equity financing. Moreover, the percentage of equity (warrants) held by the venture debt investor decreases like any other shareholder as the company issues more shares in future financing rounds.
• Low impact on governance. Venture debt investors do not intervene in the management, this is, they typically do not request board seats (at most, they may ask for an observer role and information rights) and generally do not insist on strict financial ratios or an exhausting list of covenants (covenant-lite financing).

Disadvantages

• High interest rate. The interest rate is higher than traditional bank financing, in line with the increased risk associated with the investment.
• Priority of payment. Since this is a senior loan, meaning it is secured by the company's assets (secured loan), the lenders will have priority of payment over these assets in the event of insolvency.
• Cost of the security package. This loan is senior and thus secured by the company's assets, potentially leading to higher legal expenses and taxes.
• Repayment capacity. The startup needs the financial capability to repay the loan and cover the interests, so it is suitable only for (nearly) break-even companies anticipating a positive EBITDA in the short to mid-term.

Osborne Clarke comment                                                       

Venture debt can be an appealing financial alternative for tech startups in the growth stage, especially those anticipating profitability, as a supplementary source of non-dilutive financing. Nonetheless, its nature as a debt instrument means that it may not be suitable for all startups.