Venture debt offers an alternative capital source alongside traditional equity investments, enabling startups to secure additional funding for growth without further diluting equity. It is particularly favoured by companies between equity financing rounds, as it allows founders to retain control of their businesses while offering investors steady fixed returns. Unlike traditional loans from banks or financial institutions, venture debt is underwritten based on the venture capital raised and the growth potential of the borrower, rather than on asset value or cash flow.
For the purpose of this article, we assume that the venture debt investor is organised in the form of an alternative investment fund, typically structuring venture debt funding through subscription of non-convertible debentures issued by the borrower company.
A venture debt transaction is structured in the form of a mix of (a) loan component which is a substantial part of the total amounts to be provided to the borrower company and is usually undertaken via the issuance of non-convertible debentures with a fixed tenor, agreed interest or coupon payments and is secured by a charge on the fixed and current assets of the borrower company (including any IP, receivables etc.); and (b) equity component which is a small percentage of total debt amounts and is typically in form of convertible instrument, like partly paid up compulsorily convertible preference shares (CCPS), which converts into equity at a pre-agreed ratio in future or at a discount to the price of next qualifying round. The proceeds of the debentures are to be repaid in agreed equal monthly instalments payable by the borrower company in terms of the redemption schedule agreed between the parties.
As to the documentation process, it follows a similar transaction process when compared to equity investments: (i) execution of a term sheet; (ii) conducting legal, financial and any commercial due diligence; and (ii) execution of transaction documents i.e. investment/subscription agreement, debenture trust deed, debenture trustee appointment agreement, deed of hypothecation and other ancillary documents like demand promissory note, NACH mandate forms up to the investment amount, undated cheques, etc.
The composite investment agreement contains terms, rights, and processes involved in relation to both the loan and the equity component. Following are the broad typical terms that are covered in the relevant investment agreement:
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Objects, tenor coupon and covenants under the issue
The agreement should mention the purpose for which the amounts infused will be utilised i.e. capital expenditure or working capital purposes or for any general corporate purposes of the borrower company. Additionally, the period of the debt facility and repayment thereof and the applicable coupon rate are to be specified upfront within the terms of issue of the debentures. With respect to the equity component, the terms of issue of CCPS are specified which, inter alia, include terms like anti-dilution, liquidation preference, conversion terms, etc. Certain affirmative covenants such as obtaining insurance, maintaining books of accounts, paying taxes when due, providing end-use certificates, etc. are also enshrined till the time debenture proceeds are fully repaid.
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Creation of charge and minimum security and financial covenants
The nature of the charge created on the hypothecated assets (whether a first charge or a first pari passu charge) and the assets over which such charges are created should be set out. In case the borrower company has subsidiaries, the agreement should describe whether the charge is to be created on assets of such subsidiaries and contain other covenants for investor protection in this regard, e.g. maintenance of a debt servicing reserve account, maintenance of agreed amounts of cash burn equivalents in the form of cash or bank balances, etc.
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Representations and warranties
These are required from the borrower company on its business, contracts, compliance with laws, financial statements or accounts, issuance of securities, legal proceedings, hypothecated properties, etc. From the company and the founders’ perspective, relevant carve-outs such as knowledge qualifiers, the construct of ordinary course of business, the requisite look-back period of the warranties, and monetary thresholds shall be factored in depending on the nature of the warranties.
Until the time debenture proceeds are repaid, the investment agreement includes a broad list of negative covenants (i.e. actions which the borrower company cannot undertake during the term of the debt without the consent of the investor, e.g. obtaining further borrowings, creation of charge in hypothecation assets, change in shareholding of the founders or change in founders; change in business or legal status of the borrower company, enter into transactions relating to sale of assets, provide guarantees, undertake changes in board, etc.). From the founders’ perspective, it is relevant to have carve-outs to the negative covenants in the form of monetary thresholds, ability to conduct business in the ordinary course, etc.
A wide range of default events are applicable till the time debenture proceeds are repaid (i.e. scenarios wherein early redemption of debentures and the invocation of hypothecated property can be triggered). This construct includes, in addition to the standard payment default events, events such as a material adverse change occurring in relation to the borrower company, material breach of identified covenants of the transaction documents, utilisation of the proceeds other than for agreed purposes, criminal conviction of the founders, and cross defaults in other lending documents. From the founders’ perspective, it is relevant to have materiality thresholds, carve-outs in the form of monetary thresholds, material adverse effects vis-à-vis these applicable events, and an adequate cure period to cure the default involved.
Indemnity obligations arising out of the material breach of the warranties and material covenants have to be specified. The indemnity points to be considered include – (i) whether only the borrower company has to provide indemnity, (ii) losses being limited to actual and direct losses, (iii) other limitations of liability constructs, inter-alia, de-minimis, tipping basket, aggregate cap, sunset periods or time limitations, no double recovery, and due process of establishment of losses.
These operate between the execution date and the closing date and include matters that cannot be passed without the consent of the investor. If the standstill duration is higher, from the founders’ perspective it is relevant to have monetary thresholds and carve-outs of the ordinary course of business and consent shall not be unreasonably withheld by the investor.
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Right to invest or subscribe
Usually, investors negotiate for a right to further invest a specific amount (which is either specified upfront or extends up to the principal amount of debenture subscribed by the investor) in favour of the investor in any future round of capital raise on the same pricing, rights and terms as the equity securities being issued to the new investor at a specific future round. From the founders’ perspective, it is pertinent to note that in many instances this right to further invest goes beyond the pro-rata participation right of the investors (based on a fully diluted capital structure) and amounts to a superior pre-emptive right protection which may not be viewed favourably by an incoming new investor. The company can instead consider providing this right subject to best efforts by the company based on the discussions with the new incoming investor(s) at that point in time.
The other covenants include – debenture holders having a right to appoint an observer to the board, penal interest applicable on the prepayment, information rights of the investor (timing of providing relevant information to be agreed), default interest on amounts due (over and above the coupon rate), bearing of costs and expenses by the parties, break fee (in case the issuer does not avail facility), liquidation preference on the equity portion (priority in case of liquidity events), tag along rights in relation to the equity instruments, assignment by debenture holders, transfer by the investor (competitors are excluded other than in cases of an event of default), etc.
The other transaction documents usually contain standard provisions as to the security created and its invocation, rights of the debenture trustee (along with the scope of powers and obligations of the debenture trustee specified in Section 71 of the Companies Act, 2013 and the rules made thereunder) including in case of a breach, the fee payable to the debenture trustee, etc.
Usually in India, the venture debt deal is structured as a domestic transaction given that in the event the debt is an external commercial borrowing, there will be certain restrictions or compliances in terms of extant foreign exchange laws, for instance, the conditions as to the recognised lender, eligible borrower, limitations on the end-use of funds by the borrowing company such as meeting working capital requirements and general corporate purposes (other than in certain cases), all-in-cost ceiling and minimum maturity constructs also become applicable. Further, if any partly paid instruments are subscribed to by non-resident investors, such instruments need to be fully paid up within 12 months, along with the requirement of compliance with the pricing guidelines for the issuance of securities to the non-resident.