As growth stage companies rapidly expand there is frequently a need for additional funding to support continued growth notwithstanding that the business is not yet generating (or is only just generating) positive EBITDA. Increasingly such companies are looking to debt as well as equity raises to meet their funding needs. This alert considers the nature and distinctive features of recurring revenue term loans, a product that has emerged to provide funding to such businesses.
There are also a number of recurring revenue loans that have been made available in the market to later stage or public companies. These will tend to be working capital revolving facilities and the debt quantum made available may be based on a borrowing base concept. These revolving facilities are not the focus of this alert, although clearly they share certain features with recurring revenue term loans.
A recurring revenue loan is a loan that is made available and sized on the basis of the revenue stream of a company and the recurring nature of that revenue stream. The borrower of a recurring revenue loan is expected to show a book of expected revenues usually arising from contracts with customers. This has made the product popular in the context of expanding software businesses and other businesses which can show strong committed revenue streams from customer contracts.
For lower debt amounts lenders may consider the nature of the recurring revenue stream and its resilience as part of their credit analysis, and will then make a loan available based on their assessment of the ability of the borrower to service the loan from such revenue stream. In these loans the terms of the documentation varies, but in some cases may not include a specific recurring revenue covenant or a liquidity covenant while others incorporate a borrowing base concept. These loans will often be relatively short term (up to around 3 years), made available in relatively small principal amounts and are made available on the expectation that they will be refinanced in the short term as the underlying business grows.
In relation to higher debt amounts the terms have become more sophisticated. The first sizeable recurring revenue loans originated in the US markets and, more recently, a number of specialist lenders have been willing to make such loans available on these terms to borrowers in the European market.
The target market for recurring revenue loans is companies who have not yet reached the stage at which they have achieved positive EBITDA (or if they have, the EBITDA is insufficient to support a leveraged based facility). Frequently the companies have been in existence for a limited number of years, have been reliant on rounds of shareholder funding to date and show a high rate of cash burn as they are going through a period of rapid growth and development. These characteristics mean that the traditional leveraged unitranche loan metrics cannot be satisfied, at least in the early years of a recurring revenue loan.
As noted above, the terms of recurring revenue loans in the market varies depending both on the quantum of debt being made available and on the stage of development of the borrower; also whether the loan is intended to be a bridge to an EBITDA based facility or a bridge to an IPO or another refinancing or exit.
The terms of the smaller recurring revenue loans vary widely and will not be considered further in this alert. In relation to higher debt amounts, there are a number of features that have been included which differentiate them from leveraged EBITDA based lending. The summary of terms below is based on those features commonly seen and is not intended to provide a comprehensive checklist but is rather intended to flag a number of the features seen in the market. The relative importance of these features in any particular loan agreement will of course depend on the nature of the borrower and the specific business being funded as this is not yet a standardized product.
Recurring revenue loans have been made available for various purposes, including capital expenditure and, on a number of recent deals, the funding of specific acquisitions and refinancing of existing indebtedness.
Recurring revenue loans are frequently provided on the expectation that the business will, at a certain point in the future (commonly up to 3 years after entry into the loan agreement – although there is some variation depending on the specific business plan), start generating EBITDA and, accordingly, be able to borrow on EBITDA based terms. The loan agreements for these recurring revenue loans will be drafted on the basis that the early stage liquidity and recurring revenue covenants will fall away at such point and be replaced by a unitranche-style leverage covenant. Certain loan agreements provide that this flip is at the option of the company (subject to a specified leverage level having been met). This ensures that the company does not have to deal with a forced refinancing at that point in the event it has not yet started generating sufficient EBITDA and equally has the ability to flip earlier if it outperforms the expected business plan.
Provided that the company can comply with the leverage EBITDA based financial covenant, there are a number of key benefits to the company in the flip occurring. In particular:
Funders of recurring revenue loans tend to expect a high level of security coverage, both in terms of the members of the group providing security and in terms of the actual security being provided. In particular there is a focus on the assets of business with value, which for software businesses will usually specifically include the intellectual property assets. Funders may also look to be provided with actual diligence on the intellectual property to determine the scope of security to be taken, rather than relying solely on generic leverage style agreed security principles and a post-acquisition style assessment of the security to be provided.
Given the growth trajectory of the borrowers of recurring revenue loans, funders will tend to require the provision of up-to-date management accounts as part of their credit decision to lend – audited annual accounts which may reflect the position of the group over a year prior to any lending decision are of more limited relevance in the context of these businesses. This enhanced level of diligence also tends to be reflected in the ongoing financial information provision requirements, which are negotiated and may include monthly management accounts, the provision of commentary on performance, comparisons to previous periods and updates on any material developments and key contracts of the group on a quarterly basis.
Funders may be provided with an equity upside as part of their return on lending. This may take the form of a right to co-invest with any equity or the provision of warrants, exercisable on certain events, commonly including a listing, exit, refinancing or at the end of a specified period following the date of the loan. Consideration should be given to whether any warrants are to be stand-alone or are to be tagged to the underlying recurring revenue loan to deal with any potential future transfers. For certain funders it will be important that any warrants include a cash exercise option depending on the terms and requirements of the fund making the financing available and their ability to hold any equity which may be issued.
The debt quantum lent under recurring revenue loans has increased significantly in the past year. Given the continued trajectory of growth stage companies, their relative delay in going public compared to a decade ago and their ongoing need for funding, the availability of debt funding on non-EBITDA based metrics provides significant additional flexibility to enable these companies to continue to grow while limiting the need to raise additional equity. The increasing number of funders able and willing to provide this funding should ensure that this flexibility will continue to be available going forward while, of course, the specific terms of recurring revenue facilities will continue to evolve.