Many early stage and emerging growth companies utilize venture lending as a source of funding to compliment equity financing. But what happens to these loans in difficult and uncertain times? Wilson Sonsini has experience in the venture lending markets that goes back more than three decades through multiple economic cycles and we know the active participants in the market well. We have helped both borrowers and lenders through difficult transactions in similar circumstances and we can offer some thoughts on the current situation.
Not All Lenders Are Created Equal
Some of the venture banks and non-bank lenders have weathered multiple downturns calmly and thoughtfully and continued to provide credit, taking a long-term view. The venture banks are generally smaller to mid-sized banks and generally did not have the liquidity issues in 2008-2009 that some of the larger money center banks had. Venture lending has been central to their business and most, but not all, did not deviate from their path because of shorter term circumstances. Borrowers have had more varied experiences with the non-bank lenders. Some proved similarly steady during downturns and have had dedicated sources of funding that are less affected by broad financial market problems. In contrast, some non-bank lenders had their funding sources dry up, which caused them to stop lending or even try to try call in their loans when they had an opportunity. While it is clear that the Federal Reserve and the financial regulators are trying to keep the financial markets liquid, borrowers should keep an eye on the funding sources of their lenders and seek information on how they have behaved in similar circumstances.
Different Types of Loans
Revolvers. Some companies have revolving lines of credit with a borrowing base consisting of accounts receivable and possibly inventory, or the borrowing base may consist of a multiple of recurring revenue. In most cases, to the extent that there is capacity under the borrowing base, the ability to draw on these revolvers will not be directly affected by the financial crisis. Generally, banks will continue to allow borrowing up to the available borrowing base capacity, provided that any reduction in borrowing base capacity could require mandatory prepayments. Some companies have revolvers without a borrowing base and many companies are considering pre-emptively drawing on these revolvers. We have discussed some of the considerations for drawing down revolving lines in a separate Client Alert, Considerations in Accessing Revolving Credit Lines.
Term Loans. Many companies have borrowed term loans from banks or non-bank lenders that are payable on a fixed schedule over time. As long as the company continues to make payments on that schedule, there should be no issue for the borrower. In other cases, it may be necessary or prudent for the company to ask for a modification to a payment schedule. Modifications can take the form of extension of an existing interest-only period or a new deferment of principal payments. These can result in either higher subsequent principal amortization payments or extending the loan period.
Some Salient Points for Companies
Communicate. Companies should talk to their lenders early and often. Even companies which are less impacted should discuss their situations with their lenders. Every frontline lending officer is currently being asked to report internally on the situation and prospects of their portfolio companies. Make that job as easy as possible. It is not necessary to wait until you think you have fully sorted things out. Just discussing how you are thinking about your business and strategy will be helpful to your lender contact.
Focus on People. While lending institutions may set parameters on dealing with their customers, individuals make the decisions on what do and whether to advocate for a borrower internally. Borrowers should attempt to figure out the parameters and pressures that their lender counterparts are operating under and try to create allies internally at their lenders.
Material Adverse Effect Defaults. Much of the time, venture loans do not have financial covenants so there is not a rigid test of when a lender can call a default and require a loan to be repaid. However, many (but not all) venture loans have either a default that occurs when there is a “material adverse effect” on the business or a default that occurs when it becomes clear that the investors are walking away and will not support the company. These defaults are subjective, and some lenders have been very reluctant to exercise remedies based on these defaults. Other lenders, often where management is less institutional and more personality driven, have been quicker to pull the trigger. Borrowers with these defaults in their documents should carefully monitor declines in financial performance and how their covenants or default provisions are likely to be viewed by their specific lenders.
Undrawn Loans. Some companies may have undrawn term loan commitments that they regard as “insurance” in case they need it. In almost all cases, these loans are subject to a condition to drawing, worded in various ways, that there has not have been a material adverse effect on the company’s business. Much has been written recently about larger companies making draws on revolvers and considerations for doing so, but there is generally little real resistance from the lenders to these large companies. Most often, that will not be the case with venture lenders. A company can expect updated diligence and detailed conversations in a financial crisis like this one. The lender may proceed and make the loan, but our observation has been that when faced with circumstances that may amount to a material adverse effect on the business, venture lenders may not call a default on an existing loan, but at the same time they will decline to extend new money in a second term loan that might have been available. However, very often the lender will not just completely decline to fund. Instead, the lender may often suggest that it could be willing to fund (or sometimes fund a lesser amount) if the company’s investors will also fund an amount to make a business plan viable.
Changes to Loan Terms. With an outside shock to the system like the COVID-19 crisis, many otherwise viable companies will need assistance in bringing down their cash burn. We can expect to see many companies and lenders revise amortization schedules to help the companies make it through the crisis and recover so that they can fully repay their loans. The most palatable way of doing this (for a lender), is to provide for a period of interest-only payments (or extend an existing interest-only period). In other cases, principal payments may continue, but at a reduced rate over a longer period. A borrower can expect there to be some cost for this. Often that will be additional warrants in circumstance where the company can be expected to weather the downturn and have equity upside, or a “success fee” where the exit expectations are flatter. Interest rates may also be raised. And, as noted above, investors may be asked to provide additional funding in these circumstances.
New Transactions. Lenders continue to circulate term sheets and document new transactions. A heightened level of diligence and discussions with investors can be expected. However, for borrowers which can show a reasonable path through the crisis, additional credit should continue to be available.
Wilson Sonsini continues to monitor the global impact of COVID-19 on various industries. Wilson Sonsini’s COVID-19 Client Advisory Resource is a collection of alerts, advisories, and programs—all of which are intended to help the management, boards of directors, and in-house counsel of our clients maintain key operational and business functions, despite pressing challenges related to the COVID-19 outbreak. For further information, please contact the Wilson Sonsini attorney who assisted you with your venture loan or ask your Wilson Sonsini contact for a referral to a member of Wilson Sonsini’s corporate finance practice.
Compliments of Wilson Sonsini Goodrich & Rosati – a member of the EACCNY.