Venture debt – legal forms and their key features

The world of corporate financing is diverse. Growth companies are constantly looking for innovative ways to strengthen their capital base. In this context, venture debt has emerged as a financing option. Venture debt is a special form of debt financing aimed at start-ups and growth companies. In contrast to conventional bank loans, the focus here is not on the creditworthiness of the company, but rather on the potential of the business model and the expected growth.

I. Loan agreement

With regard to the legal structure of the loan agreement, there are basically several options. It is common to structure it as a risk loan in the first rank with a share subscription right or as a profit-participating loan with a profit subscription right.

Firstly, the structure of the loan is of central importance. As a rule, term loans are agreed with regular interest and amortisation payments over the agreed loan period. Individual modalities with regard to interest and amortisation payments, such as redemption-free periods, can be agreed in individual contracts. In some cases, the loan is also structured as a working capital loan, under which the borrower is granted an overdraft facility.

With regard to the amount of the loan, 25-50% of the last equity financing round is regularly taken as the starting point. This amount is subsequently paid out in one or more instalments. These are either to be called in part or in full and depend on the fulfilment of certain milestones.

Payment conditions

The so-called „Conditions Precedent“ are also of central importance but are often underestimated in practice. These are contractually stipulated conditions that must be fulfilled in order for the loan to be paid out. These include

• the conclusion and notarisation of the share subscription rights agreement and the collateral agreements;
• Presentation of a „Directors Certificate“ (in particular required resolutions of the shareholders‘ meeting, company law documents and confirmations);
• Assurance that the guarantees are correct and that there is no „event of default“.

Repayment

It goes without saying that the loan agreement must include provisions regarding the repayment of the loan. As a rule, repayment is initially deferred for reasons of liquidity and then carried out with the payment of additional interest. It is also possible to defer the interest yourself and pay it in total at the end of the term.

Interest and other fees

Interest is the consideration paid by the borrower for the transfer of the amount of money. In detail, there are a variety of payment options. A fixed interest rate is often chosen, more rarely a variable one. Mixed forms are less common. In addition to interest, there can be a number of different types of fees. These include, for example, the lender’s consultancy costs in the preparatory stage or the costs of concluding the contract. It is also not uncommon for fees to be charged for „prepayment fees“ and at the end of the term („end of loan fee“).

Term and reasons for termination

The term is usually between 24-48 months. If the borrower breaches material contractual obligations (breach of insolvency, no payment when due, etc.), this entitles the lender to terminate the loan. This is referred to as an „event of default“. As a rule, however, contractual „cure periods“ are agreed for such breaches of duty, albeit for a corresponding fee.

Information rights and guarantees

For the lender, the disbursement of the loan to a start-up represents a risky capital investment. The lender therefore has a considerable interest in the commercial success of the company. In order to fulfil this need, the corresponding loan agreements contain a number of information rights and guarantees. The information rights include, for example, the submission of annual financial statements and business analyses as part of the upstream due diligence process. In addition, the information rights regularly extend to all documents that are made available to the VC investors on the advisory board. Any remaining information gaps are then covered by guarantees regarding the effective formation of the company, the authorisation to conclude all contracts, the accuracy of the annual financial statements and the existence of the permits required for business operations.

Behavioural obligations/compliance with financial ratios

Loan agreements usually contain a number of additional behavioural obligations („covenants“). The details of these covenants depend on the purpose of the loan, the stage of development of the start-up and the industry. These obligations include, in particular, the preservation of collateralised assets, the maintenance of the permits required for business operations and the preservation of material assets.

In addition, compliance with certain financial ratios can also be agreed as so-called „financial covenants“. However, these are generally only of limited significance for start-ups. Key figures that are based on the relationship between turnover and debt are therefore widespread.

Relationships with other lenders

If the start-up has already received loans from existing shareholders, the relationship between the lenders and these shareholders must be clarified. A subordination of the lenders is generally agreed for such shareholder loans. In addition, the relationship between the lenders can be regulated in an „inter-creditor agreement“.

II. Subscription rights agreement

Warrant agreements represent an independent option right that exists independently of the continued existence of the loan agreement and can be sold independently. A fundamental distinction can be made here. Genuine warrants represent an option agreement under which the company and its shareholders undertake to grant the lender a share in the company. Virtual warrants, on the other hand, merely establish a claim by the lender to payment of the value that would be arithmetically attributable to a genuine share in the company. This corresponds to the distinction between ESOP and VESOP.

Exercise of the subscription right

In order to be able to fulfil the lender’s share subscription right when exercised, authorised capital must be created. This can only be done by amending the articles of association. Generally the subscription rights of existing shareholders are excluded. The objective reason is the (future) loan agreement to be concluded. Authorization to issue shares is granted to the managing directors. The authorised capital is created when the amendment to the Articles of Association is entered in the commercial register. It is generally exercised by means of a corresponding declaration by the lender. The managing directors are then obliged to create the authorised capital in the amount of the lender’s exercise declaration. The lenders then receive the shares. The lenders‘ takeover declaration must be notarised or certified.

Compensation payments in lieu of shares

In principle, subscription right agreements can also be designed so that the lender receives a claim to a corresponding compensation payment instead of the subscription of shares in the event of an exit. In economic terms, the lender is placed in the same position as if it had exercised its subscription rights immediately prior to the exit and held the corresponding amount of shares in the company. The payment claim in the case of a virtual warrant is calculated in a similar way.

Protection of the share subscription right

The share subscription right must be protected against the background of new shareholders or other capital measures. To this end, a series of hedging measures must be included in the agreement. These are common:

• Obligation to join the subscription rights agreement; existing shareholders must endeavour to ensure that new shareholders join the agreement;
• Maintenance of the authorised capital;
• Hedging in the event of a change of legal form through the obligation to issue new shares or the conclusion of a new subscription rights agreement;
• No changes to the rights of the share class;
• Dilution protection.

Other remuneration elements

In addition to the share subscription right, further remuneration elements can be included in the contractual agreement. Investment rights for future equity financing rounds and bonus payments for achieving certain sales targets are common.

Information rights

The subscription rights agreement is also accompanied by a number of information rights. This is explained by its independence from the loan agreement. The lender and the holder of the subscription right do not necessarily have to be the same person. The information rights usually include the submission of annual, monthly and quarterly reports, timely notification of events that may be relevant to the subscription right and documents for subsequent equity financing rounds and changes of legal form.

Guarantees and behavioural obligations

The guarantees within the framework of a subscription rights agreement usually only include so-called „fundamental guarantees“. These include the existence of the company, the authorisation to conclude the subscription rights agreement, the accuracy of the shareholding structure in the list of shareholders and the absence of grounds for insolvency.

The behavioural obligations serve to protect the share subscription right. They may, for example, be aimed at resolving a capital increase.

Sale to third parties

The independent nature of the share subscription right means that the person of the lender and the subscription right holder may be different. The start-up naturally has an interest in keeping an eye on the subscription right holders. In practice, however, restrictions on disposal are only possible to a limited extent. In any case, a prohibition of sale is often agreed with regard to competitors. Occasionally, the existing shareholders are also granted a pre-acquisition right. Reservations of consent by the shareholders, on the other hand, are rather rare.

III. Other collateral agreements

In addition to the share subscription right, lenders will often endeavour to obtain further collateral. However, it is in the nature of a start-up that its own assets are still being built up. The following assets are therefore particularly important as collateral:

• Bank accounts
  • Pledging of the company’s account balances to contractually agreed accounts
• Receivables
  • Assignment of receivables, e.g. from factoring agreements
• IP rights/know-how
  • Pledging of patents, trademarks, naming rights, copyrights or domains
• Movable fixed assets
  • Transfer of co-ownership or expectant rights

Required documentation

Adequate documentation of the payout conditions deserves special attention. This is essential for lenders. The necessary documents must therefore be compiled and stored with care. These include in particular

• the signed venture debt loan agreement;
• the Warrant Agreement;
• the collateral agreements;
• the Directors Certificate;
• the business plan for the current financial year.

IV. Conclusion

Venture debt enables young companies to raise capital without jeopardising their strategic direction. With the right balance between equity and debt financing, venture debt can play a positive role in promoting innovation and growth of companies in a constantly changing economy.

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Authors: Dr. Andreas Menkel, Constantin Dorschu