Depending on which sources you consult, life science companies represent between 20 and 25% of the venture capital ecosystem, and many of them increasingly utilize venture debt to limit dilution, extend runway, finance capital equipment or for various other purposes. Venture debt represents a steadily increasing portion of the capital used by venture-backed companies, making it increasingly important that CEOs, CFOs, and investors have a good understanding of how their debt partners approach each potential deal. A few of my colleagues have written insightful pieces to help better understand various aspects of venture debt from basic concepts, to covenants, to the top bad reasons to take venture debt.
In this three part series, I will focus on the nuances of venture debt when applied to life science companies. Up first, the “black box” of life science lending–insight for companies and investors about what happens internally once the typical due diligence package is received. Next, in Part 2, I’ll cover how debt can add value, with a focus on biotech/pharma, medical devices and diagnostics/tools. The last installment, Part 3, will focus on the potential downside(s) to debt, and situations that are best funded by equity.
Part 1: Inside the Black Box of Life Science Lending
As a CEO or CFO of a life science company, when is the right time to seek venture debt? In most cases your company should have the following: a closed or committed Series A, openness by the BOD to look at debt proposals, and an expected ability to repay the debt. Aside from these three items, there are no hard and fast rules or a matrix that determines the amount and structure of debt. Instead, there are a series of questions that help us understand the risk and put together a structure that will hopefully work for all parties. These considerations fall into three categories:
- Outside Forces
Similar to a new investor, one of the first sets of questions a venture debt provider willask may include the following: What is the product/asset? Is it novel? Is it a platform or portfolio play? Does it have strong IP protection/freedom to operate? Is the technology proprietary or in-licensed? With answers to these questions in hand, the venture debt provider will also want to know the regulatory path and plan (i.e., CE Mark first followed by a 510(k), breakthrough therapy designation from the FDA), the company’s current development stage (i.e., pre-clinical, phase 2, commercial), what indication(s) the Company targeting, whether there are other potential uses, along with if there are current treatments for the indication. If yes, what are the pros/cons? If no, are there other treatments in development, what stage are they in and who is sponsoring development?
Equally as important, a venture debt provider must understand who the investors and management team are and their experience in the space (i.e., for a company pursuing HCC treatment, do management/investors have experience in oncology and/or other liver diseases?). It is important that investors, management and the debt partner feel comfortable with each other as they are entering into a long-term relationship which will require all parties to trust and respect each other. Most venture debt has a 3-4 year term, and inevitably– as anyone who has ever worked in science or at a start-up knows– there will be a delay or stumbling block (i.e., reiterations of the formulation required to maximize therapeutic effect, key member of the regulatory panel is on vacation, etc.) that will cause progress to take longer and cost more than originally anticipated. In these discussions, the venture debt provider also likes to understand how much capital has been raised to date, the current syndicate’s reserves, and the total expected capital needed to get to an exit, approval, or the rare case for life science companies: profitability.
These items are less under the control of investors and management, but are an important part of understanding potential exits for the company and repayment sources for the debt: understanding the market size, accessibility, competition and potential partners. Also, for companies that plan to commercialize during the term of the loan, understanding the reimbursement side or partner/customer is also important.
Keep in mind that in most cases there is no right or wrong answer to these questions, and every company is unique. Properly understanding how these questions and considerations apply in each situation is key to finding a debt solution that provides the capital the company needs, mitigates the venture debt provider’s risk and provides a positive outcome for all parties.
At Square 1 Bank we see life science companies from Series A through IPO seeking debt from $1-2 million to upwards of $20 million. The amount of debt typically scales with stage in each given sector and the ways debt can add value varies with sector and stage. In two weeks, I will explore how debt scales by stage and sector, and provide examples of how debt can be used to help build real value in a company while helping to limit dilution.
All capital is not created equal. Debt and equity are not interchangeable and it is important to keep in mind that lenders do not benefit from the full upside potential that investors and management have, and as a result, cannot take the same downside risk. Part 3 of this series will focus on providing examples of situations that are best funded by equity, and how to think about the right amount of leverage for a company in the long term.
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