Market Insight

Growth Debt and Structured Equity Primer

Latham & Watkins
October 29, 2020

Debt facilities account for upward of 30 – 50% of growth companies’ fundraising; debt financings have become ubiquitous.  So it is crucial for the TechGC community to understand the debt market and have a coherent strategy in place for debt financings.

State of the Market

Make sure you understand what debt market you are in – comparing the debt terms a company received when it was a Series A to what it should receive when it is a Series D is not appropriate, but it happens all the time!  

Also, a reminder to not just compare your debt terms to other debt terms.  In the growth tech space – debt often supplements or even replaces equity rounds, so there is no need to compare the cost of debt to equity as well.

Four Key Growth Debt Subgroups

Latham has identified 4 key subgroups in the debt space: venture, structured, lower middle market, and other IP-backed. You should know which market you are in to lead to best results!

We have listed a brief synopsis of each subgroup below:  

Venture: These deals are primarily reserved for early- to mid-stage companies, and the only ones structured with implicit backing. Typical company profile is a private tech company with limited assets and are often time pre-cash flow; however some may already be seeing some revenues.  

Structured: These deals also tend to be reserved for private tech companies, however you will start to see more mid-to-late-stage companies, often close to a liquidity event, and are backed without implicit backing. Some companies we see are pre-cash flow, although most have some significant revenue at this juncture.  

Lower middle market: These companies are mostly growth equity and PE backed with various elements of the above, but with up to US$15m to US$20m in EBITDA.  

Other IP-backed: Burgeoning subgroup that serves as a catch all, this subset derives value from monetizing assets. If you are carrying patents on your books that you are thinking of monetizing, call Latham!

Debt Term Sheet: Top 5 for Tech GCs

  1. Interest Only Period. Always remember that 1) thinking that draw will be available for a “rainy day” may not work out, and 2) if you wait for too long to draw, you would not be maximizing the interest only period!3. Availability / Tranching
  2. Drawdown Period. Always remember that 1) thinking that draw will be available for a “rainy day” may not work out, and 2) if you wait for too long to draw, you would not be maximizing the interest only period!
  3. Availability / Tranching. Tied to above – make sure you are aware of the dynamic between drawing later and the risk of meeting the conditions to tranching.
  4. Non- Financial Covenants. Just remember: financial covenants are NOT the only covenants.  All lenders will have other restrictive covenants that will be just as important.
  5. Warrant Terms. Don’t assume these terms will be plain vanilla.  Anti-dilution, information rights and termination in particular are often hotly negotiated later if not a meeting of the minds at the term sheet stage

Know All Your Options!

Largely due to a combo of wanting to not take on as much debt (leverage risk) and not wanting to have a priced round where valuation is established, structured equity (pre-IPO converts, convertible and non-convertible preferred rounds with or without redemption, holdco notes and similar instruments) have been very popular, especially in Covid times.

Bespoke Securities: Top 5 for Tech GCs

  1. Valuation and Dilution. Know what the impact will be for the current cap table and for future rounds; it’s complicated.
  2. Put / Call Terms. Same as above – know how they will play out and impact not only future equity rounds and optionality, but also debt facilities.
  3. Strength of Covenants. Wide range of outcomes but market is developing here as more and more structured equity deals are closed.
  4. Interplay with Junior and Senior Capital. See above – make sure you understand the chess game.
  5. Tax Tax, Tax! Don’t wing it!
Latham & Watkins
Latham & Watkins combines unparalleled experience and deep industry knowledge in the key business, financial, and innovation capitals around the world. Latham's integrated team of experienced and collaborative lawyers are equipped to handle virtually any issue clients confront, from the Bay Area to Boston to London to Hong Kong, offering innovative solutions for business and legal matters to clients at any stage, in any industry, in any location around the world.

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