Venture debt financing is one of the most flexible, founder-empowering forms of SaaS funding available on the market. While a number of other options are available, debt financing stands above the rest when it comes to keeping founders and owners operationally and strategically free.
However, while debt financing allows borrowers to maintain complete ownership of both their businesses and the decisions needed to run them, some debt financing lenders use contractual instruments to protect themselves in the event a borrower defaults on the loan. Note that these aren’t necessarily negatives. They’re logical, practical, and fair, and often, they can make a positive impact on how the lender–borrower relationship proceeds.
But just as borrowers have varying degrees of appetite for risk, so too do lenders. These instruments are the representations of those appetites. For SaaS leaders and owners, it’s important that these instruments are weighed early on. This way, there are no surprises should you work with a lender that requires them. Let’s get started.
Venture Debt Warrants: Incentive or Ownership Gamble?
Typically provided to investors as an incentive, venture debt warrants (also known as “equity kickers”) give their holders the right to buy stock in a company for a certain price up until their expiration date. They are expressed in the form of coverage, which is a percentage of the loan amount. For example, if your SaaS business receives a venture debt loan for $1 million, your lender may require 10% warrant coverage. This means you would provide them with a warrant that gives them the right to purchase $100,000 of your company’s stock.
The challenge with warrants is that while they don’t give investors an immediate ownership position in your company, they give them the option. If the investor decides to exercise the warrant within the time period, they will own a portion of your company. If you already have VC investment, some lenders may use warrants to gain rights to invest in your future equity round on the same terms, conditions, and pricing offered to investors at that time.
When you’re researching venture debt providers, carefully consider their use of debt warrants as part of their loan conditions. Not all venture debt lenders require them, but those that do will have the ability to take an ownership position at any time up to the warrant expiration. We’ll explore warrants in-depth in a future post this month.
Covenants: A Promise of Performance
Venture debt covenants are loan conditions that set minimum financial and performance requirements as part of the loan agreement. They are designed to mitigate risk for the lender and keep the borrower in check. If you accept venture debt financing with a covenant arrangement, you may be required to maintain a certain level of new subscribers or monthly recurring revenue while also keeping your burn and churn rates down. These metrics might be evaluated on a monthly or quarterly basis.
If you were unable to meet these requirements (called “tripping” a covenant), the lender would have the right to take a number of actions. Typically, the lender would work with you to resolve the problem, but if it continued beyond the initial breach, you may be faced with some difficult circumstances. Your interest rate may be increased, ability to access additional credit revoked, or, as a worst case, declare all debt due. While the latter is an extreme measure, it could mean that a SaaS company in default may not be able to continue running.
Just as with warrants, not all venture debt lenders require covenants as part of a loan agreement. In the event they do, covenants are negotiable and should be discussed at length to find terms that keep both the lender and you as the borrower aligned on goals. Keep in mind that covenants are designed to keep borrowers performing — lenders that require them don’t want to invoke covenant remedies if they don’t have to. But by accepting financing of this type, a covenant can serve as a kind of fence to protect your business from sliding backward — and to keep it moving forward.
Guarantees: Putting Yourself on the Line
This last loan condition is something we wanted to touch on because it may be an instrument you encounter outside of debt financing. It’s a personal guarantee agreement. Whereas bank loans and other forms of financing may require a personal guarantee in the event that the business is unable to repay the debt, venture debt financing companies are more vested in the business, idea, and historical (and projected) performance of the business.
Coupled with the fact that venture debt companies also prefer assets such as intellectual property or a blanket lien on all assets, a personal guarantee agreement often isn’t required. But this isn’t a blanket statement. When researching lenders, you may find one that requires the personal guarantee of you as a founder and owner. And it’s critical that you weigh that risk. Do you want to be personally responsible for the debt your business is taking on?
This is one of the many benefits of debt financing as a funding model. Not only do lenders not take an immediate ownership stake in your business or occupy a board seat (which presents another array of challenges), but the requirements for financing are flexible in that loans can be structured to allow your business to grow — rather than restricting it.
Now that you know these important loan conditions, it’s up to you to find the right lender and evaluate how they use them. Some lenders may have a number of risk-mitigating mechanisms in place, whereas others may be more relaxed. The good news is that you’ve already found one of the latter. At River SaaS Capital, we believe in accelerating the growth you’ve already achieved. To learn more about us and our non-dilutive debt financing options, fill out the form below.