Turbocharging Early-Stage Biotech Growth With Venture Debt
By Stefan Spazek
The COVID-19 pandemic, an aging population, and other dynamics have dramatically increased demand for life sciences innovations in 2020 and 2021. And the biopharma industry has responded by raising record amounts of venture capital to fund development of new drugs, drug discovery methods, vaccines, and other therapeutic products and services.
Pitchbook puts the total amount of venture capital raised in the sector at a record $23.2 billion in 2020, a $6 billion increase over the previous year, with more growth predicted in 2021. And with that growth has come increased demand for venture debt to supplement young firms’ equity financing.
As venture capital cash comes in, it often goes out in a torrent, especially when early-stage, precommercial revenue companies double down on R&D and product development investments. According to the 2021 BDO Life Sciences CFO Outlook Survey, 73% of biotech companies have not just one but three to four promising products in their portfolios for development and commercialization. Such rapid acceleration of investment can put young companies under extraordinary financial stress, especially life sciences companies that have not yet realized revenue from commercial products.
Many early-stage growth companies don’t realize they can often supplement their venture capital funding with non-dilutive debt. To meet their growing cash flow requirements, they typically return first to the venture capital well. But venture equity financing is dilutive, and founders may quickly find themselves giving up more ownership than they had planned. That’s why a growing number are making strategic use of venture debt financing to cover short-term cash needs, providing a longer cash runway that helps cover ongoing costs of product development and commercialization without diluting equity. When applied properly, it can help turbocharge growth by providing cash required to accelerate market entry and shorten the time it takes to build sales and achieve positive cash flow.
UNIQUE VENTURE DEBT LOAN CRITERIA
If you’re considering venture debt financing for the first time, it’s important to know that many of the normal business lending rules do not apply. Traditional lenders assess a company’s long-established market position, its cash flow from current and projected sales, and its track record of retaining existing customers and attracting new ones. They also look at the borrower’s pipeline of promising new products as well as balance sheet assets that can be used as collateral. Venture-funded startup companies often possess few if any of those attributes.
Venture debt lenders rely on additional criteria to assess a young growth company’s credit worthiness. These lenders have experience evaluating risk based on the strength of the borrower’s management team and innovations, and on the potential of future revenue and profits, rather than on the usual criteria of current revenue and profitability. The good news is that there is a growing industry of lenders available to bridge young companies between rounds of venture financing by extending debt at reasonable terms.
Therefore, it’s in the interest of entrepreneurs and founders of startups to have credible plans for if, when, and how to use debt financing. It’s also important to understand its potential effects on all stakeholders and to make sure everyone’s incentives are aligned.
IS VENTURE DEBT FOR YOU?
Before seeking debt financing, it is critical to know where your company might qualify on the spectrum of available sources of venture debt and deal structures. It’s important to understand that not all debt financing structures are appropriate for all companies. Answering some basic questions will help determine what type of financing may be available and most appropriate to fulfill your goals.
- How will debt financing benefit your company?
- How much financing will be necessary to achieve your goals/milestones?
- Is the debt to be used for near-term operating expenses, pipeline acceleration, or longer-term runway extension?
- Is your company preclinical, nearing more capital-intensive later clinical phases, or close to an NDA filing or a PDUFA date?
- How much cash is your company burning? (Ask this question early in the process; companies with at least 12 months of cash runway generally secure debt at more reasonable terms than those with less.)
- What is the current valuation of your company?
- How deep is your pipeline? Do you have more than one product in development?
- What regulatory risks, IP issues, or potential legal challenges does your company face?
Once you have answered those questions, you can start to determine what kinds of venture debt financing may be most appropriate for your own capital structure. Then you can identify appropriate lenders and solicit proposals.
A VARIETY OF DEAL STRUCTURES FROM A BROAD SPECTRUM OF LENDERS
An ever-expanding roster of traditional banks, venture banks, specialty finance companies, and nonbank debt funds is willing to lend across the corporate growth spectrum, from early-stage cash-burning companies to later-stage profitable organizations.
- Bank debt is often available at a startup company’s earliest stage. The bank where you deposit the money raised in your first round of venture capital may be able to provide short-term loans. But in return for the risk it assumes, it will often require you to use its other banking services. In the early days, it can be a win-win scenario: the early-stage company with simple needs has a one-stop-shop for loans and banking services, while the bank collects deposits and fees on all services. But as the borrower’s needs become greater and more complex, other providers may be able to step in.
- Venture debt lenders typically provide larger loans for longer terms at slightly higher costs of capital. Historically, venture debt providers offered maximum loans from $30 million to $50 million. However, as equity rounds have increased, so has venture debt. Several life science lenders now will provide loans up to $100 million, or even more in some cases. Nonbank publicly traded funds, venture arms of business development companies (BDCs), and specialty finance companies are active in this space.
- Structured and royalty-based finance may become an option as you move toward late-stage Phase 3 trials, near-term FDA approval, CE (Conformitè Europëenne) mark/European commercial stage, or post-FDA approval. At that point, lenders may seek a share of future revenue streams in addition to regular interest payments. Known as revenue-interest financing or “synthetic royalty” financing, these instruments can be implemented at a crucial stage when a company is moving from clinical to commercial phase. The lenders in this space can be more flexible with longer repayment terms.
These various forms of lending come with an array of potential loan conditions, such as covenants setting minimum financial performance requirements, warrants converting debt-to-equity shares for the lender, prepayment penalties, and final fees or payments.
SHOP FOR THE BEST DEAL
Given the variety of loan structures and sources of funding, potential borrowers must determine which lenders may be most appropriate for their needs. And because there’s competition among lenders, there is room to improve terms and substantially lower costs.
Therefore, it’s in your interest to establish a competitive bidding process by identifying no fewer than six lenders that might be suitable. Interview them, get to know them, and research their reputations. This is going to be a multi-year relationship, after all, and you want a compatible partner. Then, solicit term sheets and negotiate the deals on a comparative basis. Each lender may have slightly different evaluation criteria, which is why the more you can bring to the table, the better. The process can take six to eight weeks or longer.
As a borrower, you can benefit from the growth of competition among venture debt lenders. Terms and conditions have improved over the years. But in this dynamic environment, it’s important to stay on top of ongoing changes in the market. New lenders and new deal structures have made venture debt financing increasingly complex. So, the best advice for any first-time borrower remains “caveat emptor” as the debt financing landscape continues to evolve.