Bloomberg Law
Dec. 5, 2022, 10:00 AM

ANALYSIS: A Shift in Venture Debt Terms May Be on the Horizon

Andrew Miller
Andrew Miller
Legal Analyst

Credit investors are now poised to be more collaborative in negotiations with venture-backed companies. The portion of loans issued without strong covenants intended to protect investors has surged fivefold from 15% in 2008 to 88% in 2022. Though they’ve increasingly forgone contractual protections, credit investors are showing an emerging receptiveness to creative loan structures—even going so far as to lend with no expectation of receiving interest in return. All the while, startups are becoming more reliant on debt to fill funding gaps, meaning that credit investors may have an opportunity to buck the trend and demand more protective terms in their agreements.

The aggregate value of venture debt deployed remained relatively flat from Q3 2020 to Q1 2022 before it increased in Q2 and dropped notably in Q3. While there is a present lull in the aggregate amount of venture debt being loaned out, some anticipate a sharp increase in the use of venture debt in the new year. Current market conditions appear increasingly favorable for lenders who desire stronger covenants, steeper discounts and added perks in loan agreements. Venture-backed companies are likely to find that more investors are interested in lending on customized terms. However, given that investors have been watching contractual protections dwindle over time, that creativity may come at a cost.

Weaker Investor Protections Than Ever

Moody’s and Fitch periodically assesses the strength of loan covenants by evaluating certain provisions in loan agreements across financial markets. In 2019, a Moody’s covenant specialist wrote that they’ve found “weaker protections on a year-over-year basis in nearly every risk category [they] assess. Given the breadth and depth of covenant weakness, existing loans are in uncharted territory.”

Although 2019 has long passed, more recent data reinforces the trend, showing that “covenant-lite” loans accounted for 88% of the S&P/LSTA Leveraged Loan Index in February 2022, compared to 15% in 2008. Among the contractual provisions analyzed are “most-favored-nation provisions, mandatory prepayments from asset sales, exceptions to negative covenant restrictions, restricted payments clauses, and the definition and scope of allowable EBITDA adjustments.”

Bonds That Pay No Interest at All

In a recent phenomenon, companies have begun issuing zero-coupon convertible bonds, and investors are buying. Zero-coupon convertible bonds are a good example of the unique loan types that are increasing in popularity, as they prominently feature no interest and offer a conversion right to investors. In the decade from 2009 and 2019, a total of 18 companies issued convertible notes that paid zero interest. In 2021 alone, 45 companies issued such bonds. Notable companies that have issued zero-coupon convertible bonds during the pandemic era include Peloton Interactive Inc. and Affirm Holdings Inc.

The idea of a loan bearing no interest seems odd at first blush, but investors appreciate that zero-coupon bonds offer a high probability of significant returns by virtue of the benefits added in exchange for that lack of interest. Whereas a lender typically derives a return on investment in the form of interest paid periodically, the lender of a zero-coupon bond benefits from (1) the discount from the face value of the bond, (2) the lack of reinvestment risk, and (3) annual increases to the principal balance owed. By decreasing interest to zero, credit investors open the door for fine-tuning other contractual terms. This benefit goes both ways, as creative borrowers have an opportunity to engage in a productive back-and-forth conversation that hopefully means more pie for everyone at the table.

Covenant-lite loan agreements may now dominate the market, but the tide may turn as investors gain the upper hand in negotiations. The growing prevalence of covenant-lite loans, coupled with startups’ increasing reliance on debt, indicate that investors are poised to seek out more robust contractual protections. Simultaneously, both sides of the table appear eager to customize the terms of loan agreements to account for the dynamic nature of today’s economy. As venture-backed companies are pressed to find liquidity solutions to avoid down rounds, they’ll need to think creatively and proactively weigh alternatives.

Bloomberg Law subscribers can find related content on our M&A Deal Analytics resource.

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