Structuring credit agreement flexibility for venture backed borrower "secondaries"

Secured lenders are seeing increased demand from borrowers to execute secondary transactions in the venture lending space. While these transactions can raise concerns regarding control over leverage, investor support, and protecting collateral value, they can be compatible with prudent credit risk management if the credit agreement architecture anticipates them.

This alert summarizes practical approaches venture lenders are using to mitigate risks when permitting secondary transactions.

A summary of “secondaries”: Their benefits to borrowers and investors, and impact on lenders

In the context of a venture-backed operating company, secondaries typically involve either a direct purchase of shares held by employees, founders, or early investors, or a company-sponsored secondary involving the company using cash on hand or the proceeds of a concurrent equity raise to effectuate the repurchase of existing shares.

As companies remain private for longer, their venture capital (VC) backers increasingly look to secondaries to lock in return on investment (ROI) or otherwise manage liquidity. Similarly, founders and employees look to realize the value of their equity in the company while continuing to work towards an exit. Founders, boards, and VCs may also lose priority alignment over time and wish to bring in better-aligned partners via a secondary. Occasionally lenders may agree with the proposed re-alignment and agree to provide additional credit to facilitate the secondary.

Depending on the size of the secondary, direct purchases implicate credit agreement provisions regarding changes in control and investor support. A lender that underwrote a loan, in part, based on a specific investor syndicate may wish to be prepaid if an investor is replaced with another that has a different vision or with which the lender has historical friction. Company-sponsored transactions implicate provisions governing asset dispositions, distributions and restricted payments, and proceeds application because the borrower is using cash to buy back stock rather than fund growth or de-lever. Lenders to early-stage companies typically expect firm controls on cash expenditure since the companies are cash-burning.

Principal approaches to permissions

Lenders typically choose among three levels of permission for a borrower to sponsor secondaries, each calibrated to the borrower’s risk profile and expected activity.

At one end is a blanket prohibition, absent lender consent on a case-by-case basis. This is the most common approach for early stage borrowers given the expectations regarding cash expenditures discussed above. Lenders are often comfortable discussing a one-off consent to a specific secondary depending on the borrower’s liquidity, loan-to-value ratio (LTV), and other financial performance indicators, so long as they have the final say.

For later-stage companies or those with defined plans for secondaries, lenders may include a “Permitted Secondary” concept with hardwired conditions. In addition to the requirement that no default exists, Permitted Secondaries frequently require that the borrower either (1) closes a concurrent equity raise of a minimum size, and uses no more than a specified percentage of the equity proceeds to facility the secondary, or (2) demonstrates pro forma compliance with liquidity or leverage tests. Either approach may include further restrictions on frequency and overall cash expenditures. The first approach ensures that the secondary must improve the borrower’s balance sheet while offering flexibility if the borrower’s founders, employees, or investors wish to free up liquidity. The second approach provides even more flexibility for cash-rich or low-leverage borrowers, which can meet criteria that satisfies the lender’s concern over cash leaving the balance sheet.

The most permissive structure is an unlimited allowance for secondaries (typically still subject to the requirement that no default exists). This is extremely rare for venture-backed companies, and it is typically only accepted for the strongest credits or when the debt markets are at their most competitive.

Conclusion

Companies and their founders, employees, and investors are considering secondaries more frequently as the life cycle of a venture-backed company lengthens. Venture lenders can support borrowers consummating these transactions while protecting collateral value by establishing clearly defined requirements within credit agreements for Permitted Secondaries. Realistic discussions with respect to the parties’ expectations for secondaries are critical to ensuring credit agreements are drafted precisely so as to meet the needs of all parties.

For more information, please contact the author.