Capitalizing your climate business with term loans
One common form of non-dilutive financing, the term loan, can be a powerful tool for funding your growth at a much lower cost than venture capital. With this financial instrument, you’ll borrow money on a fixed term with a predetermined set of payments, with lenders ranging from banks and alternative finance firms to venture debt providers. But the speed and flexibility of term loans doesn’t come without a price or a certain amount of risk.
Jennifer McFarlane is a veteran CFO who’s advised countless climate entrepreneurs. We chatted with her for insights into making an informed decision on whether to take a term loan, common conditions to look out for, and how to navigate negotiations with your lender.
If/when to take on a term loan
You’ll typically want to raise additional capital if you’re (a) struggling with cash flow or (b) have a specific growth opportunity you’d like to pursue. In order to effectively plan to take on financing like a term loan, you need to carefully forecast both your revenue and the associated burn. This can be incredibly hard in the earliest stages, as you don’t have enough data or insights on your customers, so be conservative in this process.
Once you’ve completed your forecast, you need to decide if a term loan is the right product for this specific need. If you want funding to further develop your IP, it's probably best to raise some form of equity or convertible debt as you aren’t going to see any financial returns in the near-term that will enable you to repay investors. However, if you need working capital to buy equipment or inventory that quickly generates revenue, or to achieve a major milestone that will significantly help with an equity raise, then taking on a term loan will make more sense.
The second big question is timing. The easiest time to borrow is when you have a strong cash balance; but then you will be making interest payments on cash you may not need for another 6-12 months. The hardest time is when you actually need additional cash as you may then be perceived as ‘too risky’ by lenders. It's a careful balance and is best to start talking with lenders early to understand their criteria
If you are considering a term loan but will still need additional equity down the road, always look at the ‘net cash benefit’, i.e. how much net cash (after paying principal and interest) is left to truly extend your runway beyond your current position? Sometimes this will be smaller than you would like.
Common terms and conditions
Most lenders will require some form of security to protect themselves in the event that you fail to repay the loan. This could mean putting your business’s physical assets up as collateral, but this may not be an option if your equipment or inventory is very bespoke and will be hard to resell. In other cases, lenders might require personal guarantees or liens on IP as security, which you should try to avoid as much as possible. One compromise can be a negative pledge on IP, i.e. you will not pledge the IP to any other lender.
You’ll need to decide whether you want the full sum of the loan up front, or funding that’s drawable over time. Typically you should be able to negotiate a draw period that will run for nine months up to a year, but it can vary across lenders. Flexibility of drawdown is always good but, in the current market environment, it may be best to draw sooner than later, in case there is an unexpected ‘issue’ that reduces your ability to draw down the remaining balance.
As well as the date you need to start paying the loan back, considerations around the repayment term include whether there’s an interest-only period, how you’ll repay the principal, and if there’s a no-payment (or grace) period.
Common repayment schedules include (a) interest-only with a balloon principal payment at the end, which is mostly available from alternative credit providers; (b) interest and principal on a level amortization schedule after the interest only period; or (c) an increasing amortization schedule across both interest and principal, where you’ll pay less at the beginning and more at the end.
Covenants, or running requirements during the life of the loan, will vary widely lender to lender. One common covenant in a term loan is liquidity, i.e. a minimum amount of cash in the bank. Because you can’t touch this cash, the value of the loan is effectively reduced - but you’ll still be paying interest on the full amount increasing the effective cost.
Another covenant, common in alternative credit, involves lenders having first right of approval (or refusal) on any other debt you take on or equity you raise. If you don’t talk to them first, it could be considered a breach, and the loan will immediately be due in full.
Other covenants, more frequently sought by banks, may include a material adverse change or event clause (‘MAC or MAE’). Unless you have highly predictable cash flows, it's best to avoid these.
Getting the best deal on a term loan
1. Look at milestones, not months
Don’t just look at how much ‘true’ runway the loan will give you. The real value of the loan arises from whether it will enable you to hit milestones you wouldn’t otherwise be able to, boosting your valuation, helping you get to breakeven faster, etc. And, by allowing you to generate revenue - for instance by unlocking inventory - the loan could significantly extend your runway beyond your initial calculations.
2. Remember there’s always a tradeoff
There may well be room for negotiation on the terms of your loan, but keep in mind that there’s always a give and take. This is typically between the amount and term of the loan to the amount of security, the all-in-cost and the nature of covenants
For example, if you want to avoid putting up security, this will likely reduce the size of your loan or increase the cost of capital.
Another tradeoff might involve borrowing a larger amount, but at a higher interest rate and/or with a precondition to meet a specific milestone before the full amount can be drawn. If you can translate that additional cash into higher revenues, the higher rate can be justified by a higher valuation down the line. You’ll need to weigh up the pros and cons in the context of your business to decide what’s right for you.
3. Be alert to the need for warrants
Many term loans for early stage companies also require warrants being issued to the lender, giving them the right to buy shares in your company at a fixed price within a certain period of time. This effectively increases your borrowing cost and should be taken into account.
For venture backed companies, in normal lending markets the amount of warrants tends to range between 0.15-2% of the principal amount - so with a $10m loan, the lender has the right to purchase $15,000-$200,000 worth of equity typically on the terms of the latest capital raising.
For non venture backed companies borrowing from alternative credit providers, the amount of warrants can be much higher, even up to 10% in challenging market conditions, especially if the equity is common stock rather than preferred stock.
While they shouldn’t create a problem for your cap table, assuming they’re the average size, you can typically pay a higher interest rate to have less warrants and should speak to your advisors to get a better sense of what they will actually be worth.
Jennifer is a Partner with Asterra Partners which advises early stage climate tech companies on strategy and fundraising. In addition, she is an independent board member at four venture backed companies (Emrgy Inc. Blue Planet Systems, TruTag Technologies and Betteries GmbH), and a private company (Cascade Energy Services). Prior to Asterra Partners, Jennifer had a career as C-level executive at both public and venture-backed companies and as an international investment banker. Her experience spans multiple industries including climate tech (NEXTracker), synbio (LanzTech), medtech (Zyomyx) and energy (SPP). Ms. McFarlane is also a C3E Ambassador (an appointment by the U.S. DoE) and serves on MCE Social Capital’s Loan Committee. She holds an MBA from Stanford Business School and LLB / BSc from the University of NSW, Australia.