Term sheets are a common part of the financing process for tech companies, whether they are raising equity or taking on debt. Many tech startups are familiar with the vocabulary used on an equity term sheet (from a VC or Angel) but debt term sheets will have some terms that may not be familiar.
In this post, I’ll go over some of the basic terms in a debt term sheet that you likely won’t see on an equity term sheet. Before deciding on financing with debt, I would also recommend considering all of the Pros and Cons of Debt, Equity and Bootstrapping to ensure that debt financing is the right fit for the company.
Why Term Sheets?
In Venture Deals by Brad Feld and Jason Mendelson, they point out that Term sheets are not actually a legal requirement. They are more or less a tool for negotiations, to focus discussions and to outline an offer. From Venture Deals: “Nothing requires a term sheet to be used. Our favourite negotiations with entrepreneurs have been ones where we’ve literally shaken hands and agreed on valuation, board structure, and option pool size verbally or over email“. Even with this in mind, term sheets provide value by aligning borrowers and lenders/investors early in the process. They point out later that “Usually, the term sheet will be the first real negotiated document in a relationship”.1
Term sheets have, at times, been used to simply get a company’s attention and both investors and lenders develop a reputation on whether on not they close their term sheets. Siri Srinivas’s tweet mocks this practice beautifully. 2
Term Sheets are simply a tool for outlining in writing the terms and conditions being discussed. I have personally worked on deals with and without term sheets, but when using debt financing (rather than equity) it is extremely common to use a term sheet. This is because a term sheet can clearly outline to a borrower the general terms and conditions of an offer before being presented to a credit department or committee for approval.
With this in mind it’s important to understand where in the lending process the term sheet fits in.
Term Sheets vs Letters of Offer
Although term sheets are technically non-binding offers (sometimes even called “Discussion Papers” or “Letters of Intent“) they still form a great outline of what will be offered and are generally not presented unless the lender has a strong opinion that they would like to finance the company. Once a term sheet is presented, a lender will then underwrite the file and present it for review by a credit department (or committee), to be followed up by a binding Letter of Offer.
First Things First
Some of the vocabulary used in a debt term sheet is different from what many founders are familiar with on an equity term sheet. Here are some examples.
Amortization
- Amortization is a concept that will be different from an equity term sheet along with the interest rate. The loan will have to be payed back. The amortization is the length of the term that the loan can be payed back over. Amortizations may be as short as a few months (ei: Bridge Financing) or as long as 30 years (ei: for Real Estate Financing). Most amortizations for term loans will be 1-7 years.
Interest Rate
A major difference from an equity Term Sheet is that the financing will have an interest rate and requires repayment. The interest rate may be a Fixed Rate or a Floating Rate.
- Fixed-Rate: A fixed-rate will have a set interest and principal repayment amount each month. The downside is that it often comes with additional breakage fees, less flexibility, and if the banks prime rate drops the borrower does not benefit from this adjustment.
- Floating Rate: A floating rate will have a “Base Rate” that follows either the Bank of Canada’s Prime Rate, LIBOR (London Inter-Bank Offered Rate), or the lender’s own internal base rate. It will also have a “variance” which represents the lender’s spread (mark-up). It is important to understand which rate you are tracking too if you are on a floating rate. For floating rates, the principle is charged based on the amortization amount and the interest amount varies month to month.
Security
- When raising equity a portion of the company’s ownership is exchanged for the funds. Loans take no ownership but need to be secured.
- Types of security can include General Security Agreements (GSAs), registrations against specific Intellectual Property, Postponements of Claim, and Personal Guarantees. (I’ll go over the different types of security that can be offered or requested for debt term sheets in another post and what they each mean.)
Conditions Precedent
- These are conditions that will need to be met prior to the loan advancing. Examples may be a specific request additional due diligence – for example, an accountant prepared year-end financial statement or execution of a legal agreement (like an offer to purchase) that would have to precede the loan advancing.
- Another common condition precedent may be that a certain amount of equity is raised prior to the loan advancing. This condition might require the funds to either be deposited into the companies bank account first or proof that the funds are committed by the investor.
Covenants
- Covenants are one way a lender tracks a company’s performance. Some covenants can scare companies away if they are too restrictive. The goal of a well-determined covenant is that the borrower and the lender agree that it is both attainable enough to be met consistently and flexible enough to exist without impeding growth. It’s important to understand the covenants on any agreement and borrowers should feel free to ask a lender why they have chosen a specific covenant.
- There are three types of covenants, Positive, Negative, and Financial Covenants.
- Positive Covenants (or Affirmative covenant) is a promise to do or maintain. An example would be to maintain a certain level of working capital in the company.
- Negative Covenants are covenants to prevent a certain activity. An example of this might be a No Dividends or Withdrawals covenant for the term of the loan. This could be put in place to clarify that all of a loans funds are to stay in the company. There are many different types of covenants and they vary substantially.
- Financial Covenants reference maintaining a performance ratio like a Debt to Equity Ratio or a Debt Servicing Ratio (less common in tech) and is set to be met to help maintain the financial health of a company.
Reporting Requirements
- Loans are reviewed regularly with financial information provided by the company. This can be done annually, quarterly, or even on a monthly basis depending on the size of the loan and the complexity of the agreement.
- These reporting requirements would be listed on the Term Sheet or on the final Letter of Offer.
Prepayment Indemnity
A Prepayment Indemnity is a penalty for paying back the loan before the end of the amortization term.
It can show up in different ways but common types are:
- Months of Interest: in this method, a prepayment may carry a fee that is equal to a certain number of months interest on either the remaining balance or the drawn amount. These can vary from 3 months to 12 months or even higher.
- IRR Calculation: Lenders may have a set IRR (Internal Rate of Return) on their loans. If a loan is paid back early there may be a required return that is paid out calculated from the date of the loan’s advance to the date of the repayment. An example of this would be a 15% IRR requirement.
Participating in the Upside
There is a saying that goes “Equity owns the upside of a Deal and Debt owns the downside.”
What this means is that equity investing is highly focused on the success and growth of a company while lenders are highly focused on mitigating the downside risk – simply put, avoiding default situations. There are a few tools that can change this for a lender. These tools are Royalties, Warrants and Bonus/Kickers.
- Royalties: Royalties are a payment that is paid as a percentage of sales. They can be collected monthly, quarterly or annually. Sales growth is aligned between the lender and the company.
- Warrants: Warrants give the lender the option to buy shares at an agreed price on or before a specified date. The company and the lender are aligned in increasing valuation. 5
- Bonus (or Kicker): This is a one-time payment that is made at the end of the term. It is often used when the lender has taken a longer interest-only period. The company and lender are aligned for the full term of the loan for the bonus to be paid at maturity.
Using any of these tools, means that a lender is not just underwriting and trying to mitigate the risk of default, but is also lending to the company on the basis that they believe strongly in the companies success. These options can really align both the lender and the founder’s motivations to have the company succeed.
Summary
- There are different terms and meanings used on a debt financing term sheet vs. an equity financing term sheet.
- Ask your lender for clarifications and check if there are definitions in an appendix to the contract.4
- Understand terms that help lenders participate in the “upside” of a deal (Royalties, Warrants and Bonus/Kickers).
- Considering the Pros and Cons of Debt and Equity when looking at financing options.
Footnotes
(1) Venture Deals by Brad Feld and Jason Mendelson – Page 253. Its also one of the First 5 books I recommend for learning about Tech Finance.
(2) Siri Srinivas is an early stage investor at @drapervc
(3) Graph from Credit Genius Article
(4) I will elaborate on these specific options in a future post. In the meantime, here is a great article on Warrants by K. Reilly of Fuse Capital
(5) Also please keep in mind that this is a guide and the specific terms may be defined in an appendix to your offer
(6) Here is another great guide to some of the more complex terms that will show up on a Debt term sheet. A guide to important terms in a debt term sheet by Rohit Mittal
