Easing the Path to Profitability
Stefan Spazek outlines the steps for biopharma startups in tapping non-dilutive financing options.
Management teams of early-stage life science and biotech companies must constantly monitor the financial health of their organizations—especially their cash flow. Longer-than-expected product development schedules can substantially lengthen time-to-market and cash runways, which can mean a higher-than-expected cash burn rate.
Running out of cash will quickly derail a new venture at any stage of its development, no matter how promising the business plan or how strong the initial proof of concept. Therefore, emerging life sciences companies tend to be in perpetual fundraising mode. Most rely on multiple rounds of equity financing from venture capital (VC) funds with sector expertise in health, biotech, and life sciences. But they often find that a private equity war chest, no matter how large, is only the beginning of their financing journey.
As firms progress toward a rollout of products and strive for initial revenue, they nearly always find it advantageous to evolve to a more robust and mature capital structure. That often means additional financing from later-stage private equity investors or large pharma partners that can support the companies beyond the initial VC equity capacity. And, sometimes equally important, it can mean one or more forms of debt financing as well.
Some of the most successful early-stage companies will establish a balance sheet with a capital structure fed by multiple forms of both debt and equity financing. Their stronger balance sheets can help position them to survive the long march to regulatory and market acceptance as well as positive cash flow. And pursuing the right financing options early in the game can make all the difference when it comes time for a liquidity event that delivers returns to early investors. A company with a strong cash position negotiates from a position of strength when either seeking an acquirer or pursuing an initial public offering.
Most startups progress through a familiar, time-tested funding process. But that slog through approvals to actual commercial revenue can be arduous and expensive. Clinical trials can take months or years to complete, and regulatory approvals can be a time-consuming process shot through with uncertainty. Running out of cash, in spite of strong prospects for success, is an ever-present danger.
Venture equity investors with life sciences sector expertise understand those dynamics. However, even the most patient venture investors need reassurance that the company has a strong enough financial foundation and management with the financial acumen to direct it toward an eventual successful liquidity event. That’s where debt comes into play.
Mix debt with equity
Why debt? First, it does not typically dilute equity (or if it does, only minimally so). As the loan is repaid, the investors and management maintain their percentage of ownership. In the meantime, it provides needed cash to help sustain operations between equity rounds without lowering the price of new shares. Adding some debt to the balance sheet also provides a cushion against the possibility that cash will run out due to the uncertainties inherent in the life sciences product development cycle. It can help extend a company’s cash runway and allow it to reach milestones and higher valuations that otherwise might be just out of reach. And it can expand and extend product pipeline development.
Also, debt can provide needed cash to help bridge the uncertain time required to position for an IPO or negotiate an acquisition.
Finally, debt that strengthens an early-stage company’s cash position can help attract more equity financing in later rounds. Those later-stage equity providers tend to be slightly more risk averse than the intrepid venture capitalists who assume the biggest up-front risk in return for huge potential returns. They tend to want to see not only successful progress against clinical milestones, but also a strong financial foundation for future growth. A capital structure with a strong balance sheet and cash cushion reflecting an appropriate mix of debt and equity financing sends a signal to those risk-averse investors that the early-stage firm is well-positioned to transition to its rapid-growth stage.
In short, debt is not a replacement for equity. Rather, it works hand-in-glove with equity to provide optimum balance sheet leverage. When used appropriately and strategically, it helps management to more effectively manage cash flow and hedge against risk while growing the business.
Multiple sources of financing
Many might assume a company must wait until it has substantial assets and multiple quarters of positive cash flow before it qualifies for a bank line of credit or standard business loan. But early-stage life sciences firms without near-term prospects for revenue can also qualify for loans. Debt finance providers with life sciences industry experience know how to identify early-stage companies with strong prospects. They tend to seek out startup companies that are backed by high-profile VC firms, have a decent cash life of at least 12 months, deep development pipelines, and promising early data, if available.
For managers of emerging growth companies in the life sciences sector, several specialized suppliers of non-dilutive financing have emerged to help ease the path to profitability:
• Venture banks provide venture debt to companies that are funded by top-tier VC firms and that have a strong IP portfolio. They often strike a deal with upside potential in the form of warrants, and they secure the loan with a senior lien on all assets other than the IP. Typical conditions of bank loans are that the borrower must bring all of their business baking services over to the bank from which they borrowed the funds.
• Non-bank debt funds, or specialty finance firms, also provide venture debt, but usually at a higher cost of capital than banks. They’re not able to lend using relatively inexpensive deposits, and they can’t offset a lower cost of capital with other services. However, these lenders also tend to be able to provide larger loans, sometimes with more flexibility in structure and terms.
• Structured finance providers cater to life sciences companies that are on the cusp of moving from clinical to commercial stages. They extend large loans sometimes in exchange for a percentage of the company’s future revenues over an extended period of time until the loan is repaid. This type of financing can be more expensive than traditional venture debt financing, but it can also provide much greater flexibility in terms and far larger financing rounds than standard venture debt.
Evaluating each option requires a careful analysis of the current cash runway and longer-term financing needs. The next step is to survey suppliers and line up bids from a small but appropriate group of potential competitive debt investors. Negotiation over terms might include potential warrants, royalties, or other incentives for the lender beyond interest and principal repayments. Fortunately, there are enough sources of financing to create healthy competition among lenders, which helps establish fair market prices. And because such investors pursue long-term relationships that will generate repeat business, they have an incentive to negotiate with borrowers.
Align stakeholder incentives
As entrepreneurs, founders, and their teams begin their journey with a new company, it’s important to get all stakeholders on board. The more clearly a company identifies and articulates its specific financing needs, the better the result. Having credible short-, medium-, and long-range plans for capitalization of the company helps get all stakeholders on the same page.
An appropriate mix of both equity and debt financing can help play an important role in aligning stakeholder incentives:
• Company management will proceed on its growth plan with confidence that the necessary cash will be available to fund each stage of growth.
• Investors will be assured that if the firm continues to perform well at each equity funding and meets its milestones, the non-to-minimally dilutive debt financing should return more total value to the founders’ stock.
• Lenders will be confident they will receive their expected return while looking forward to partnering on future financing as the company grows.
Under-capitalization is one of the top reasons new businesses fail. Life sciences companies, with large capital requirements and exceedingly long time-to-market, are especially prone to cash shortfalls and, therefore, need to constantly monitor and manage their capital requirements. A mature capital structure, with a self-reinforcing mix of debt and equity financing, can ultimately help make the difference between success and failure.
Stefan Spazek is Executive Vice President, Director of Debt Placement, Capital Advisors Group.