Emerging types of finance: Venture Debt and ARR - the basics

Many financing options that we used to consider “alternative” are now commonplace. This article explains in basic terms what some of the alternatives to traditional bank loans are, who they’re used by and why they’ve increased in popularity.

The mid-market is constantly evolving and in recent years we have seen the likes of unitranche and accordion/incremental facilities become commonplace, and the institutions we still call ‘alternative lenders’ and ‘challenger banks’ are now mainstream. Whilst many businesses continue to rely on high street banks for their day to day banking facilities, we’ve seen a steady uptick in the use of alternative financing arrangements alongside capital raises in recent years; details of those are set out below:

Venture Capital (‘VC’)

Like private equity, where a fund purchases equity in an established business, VC involves swapping cash for shares in a less established business.

Individuals and institutions invest in a VC fund, and the fund chooses where to invest that cash.

Typically funding early stage and therefore higher risk businesses, VC funds can usually bring a wealth of experience and expertise to your business to help get you off the ground, and scale up.  The downside is dilution of your ownership, and as a result, your control.

Often businesses require a couple of VC ‘funding rounds’ in order to reach a stage where they’re considered established enough to access debt (venture debt, commercial loans or otherwise).

Venture Debt (‘VD’)

VD, as the name suggests, is a cash loan (rather than cash paid for equity). The key difference being that it needs to be paid back (often with interest). VD is usually provided to more established start-ups which have been through a couple of initial VC funding rounds and have a measurable and projectable EBITDA or ARR (annual recurring revenue).

Recipients of VD often have a higher risk profile than a bank or debt fund would be comfortable with. As a result, the debt is likely to be more expensive and a VD lender will generally take a warrant (an option to buy shares in the company in the future at a fixed price) from the company to allow the debt provider to realise the longer term value of the company and benefit from the ‘flipside’ if the business performs well.

A true VD facility will have no financial covenants, however a VD lender will monitor the company’s “burn rate” (the amount of cash the company is spending each month)  and cash runway (the amount of time, in months, a business has before it runs out of cash).There are usually fewer formal covenants, and VD providers will be used to lending alongside a (potentially controlling) VC fund.

Although banks and alternate lenders have historically required positive cashflows as evidence a business is able to pay back debt, a number of institutions have moved into the VD space over the past 18 months and are willing to take into account both venture capital raised by the business to date, and its future revenue.  Whilst the market was temporarily shaken by the SVB crisis and some predict tighter credit and reduced appetite as a result, many see this is an opportunity in the VD space; more providers are developing growth and VD products, in turn increasing competition and awareness in the market.

For more information and practical advice for borrowers if their bank gets in to trouble, see our article ‘Silicon Valley Bank UK – what happens if my bank fails?

Annual Recurring Revenue (‘ARR’) Financings

ARR financing has seen a rapid increase in popularity over recent months as lenders have shown willingness to fund against credit metrics other than cash-flow / EBITDA. ARR financing is provided predominantly by debt funds to businesses which provide subscription (often apps or software-as-a-service (‘SaaS’)) based products.

ARR varies from business to business and is a particular feature of many in the technology sector, most notably SaaS and enterprise software businesses. In simple terms, “recurring revenue” means contracted and predictable revenues that are customer generated and, well, recur, and in particular excludes any one-off payments. Revenue from service contracts, license subscriptions and/or maintenance fees, often paid annually in advance, provide steady and financeable income. ARR can be tested on a rolling 12-month look back basis or annualised.

ARR is a favourable metric for businesses which are not sufficiently established to have the EBITDA to lend against. An ARR covenant (expressed as a ratio) can be the only covenant in ARR financings, but a liquidity covenant regularly sits alongside to ensure that cash leakage from the business is limited (and there are restrictions on, for example, paying dividends). The businesses which use ARR finance vary in terms of maturity; they need to have an established ARR, but are not yet able to make EBITDA.

ARR financings can be structured in different ways. A level of repayment throughout the term is usually required; sometimes a percentage of ARR is taken alongside that as a yield, and sometimes interest is charged (although this is usually subject to a PIK arrangement at least for an initial period given businesses at this stage are unlikely to be able to service regular interest payments and need any excess cash to be re-invested for growth).

Unlike VD, a key feature of most ARR financings is an eventual ‘flip’ into a more traditional EBITDA leverage covenant lend once the business hits certain milestones. At the point of the ‘flip’, the liquidity covenant will fall away, an excess cash sweep may be introduced and a contemporaneous shake out of some of the tighter cash leakage restrictions is likely.

 

Traditional term loans and revolving facilities provided by banks will always have their place. Not only do those institutions continue to provide day to day banking services that others are not able to offer, they provide a wide range of products and - if you are able to meet their criteria - their products are often cheaper. However, in recent years the market has been innovative in finding ways to lend to businesses which may have otherwise struggled to grow and become EBITDA positive. The Tech sector lends itself to all of them. Tech businesses often have lower investment levels and overheads required to scale up and have been hugely popular (particularly during COVID).As a result, many alternative lenders have dedicated teams to help these businesses on their journey.

Our team has acted on all of these types of financings and would be happy to assist with any queries.

Disclaimer

This information is for educational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given. © Shoosmiths LLP 2023.

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