Equity vs. Debt Risk
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. This can be seen in comparing the returns of $10 million in venture debt compared to the same amount in equity. If we assume the venture debt deal is 12 months of interest followed by 3 years of amortization with an interest rate of 10% (approximate average rate for venture debt when including banks which will typically be less than 10% and debt funds which will typically be more than 10%), the total cash return for the lender will be $2.6 million. Comparatively, the average return over the past 3 years for a VC Fund is about 2.1x, which would result in the same $10 million investment generating $11 million in cash. Keeping the difference in these returns in mind when pursuing venture debt, the VC firm should be and is rewarded for taking additional risk by receiving higher returns. Conversely, the lending partner is giving up return in exchange for a safer investment. It is important to consider this when determining if the capital need is best funded by equity, debt, or a combination of the two. High risk events or milestones should be funded by equity, not debt. For example, when the next key milestone is a binary event – the result of which will determine the success of the company (i.e. clinical trial with a single primary endpoint and no ability to look at interim data), equity should fund through the read-out of the data, and there is potential to add debt to fund the company after the positive results to provide additional runway.
Cost of Overleveraging
When deciding to go with debt an important item to think about that can sometimes be overlooked, is an understanding of how the debt will be repaid. For many life science companies, debt will be repaid not by cash flow, but by future equity rounds or partnerships. Keep the size of the next influx of capital in mind when deciding on the amount of debt to pursue. Investors, especially new investors, are providing equity to help a company grow and achieve the next milestone(s). If they see that a substantial portion of the equity round will be used to re-pay debt it can create concerns for the investor(s) and may make it more difficult to raise the round, or get the pre-money valuation expected. This is especially true when there is a bump in the road that causes a delay in achieving a milestone, or growth is slower than expected. In these cases, overleveraging of the company can make bad times worse by limiting options for the company, investors, and the lender.
Building a Strong Partnership
The most important way to avoid potential pitfalls of debt is to build a solid partnership between the company, investors, and the lender. The first step is selecting a lending partner that understands the potential risks the company will face during the term of the loan. A good understanding of the company and associated risks will enable the lender to differentiate between a delay in progress that can/will be solved given more time/capital, and an event that is a true failure for the company. The next step is to maintain open lines of communication between all parties, the more the lender knows about progress (and setbacks), the more reasonable and rational they can be when any changes to the terms of the debt facility need to be made. The quickest way to make bad times worse is to withhold information from a lender, or surprise them at the last minute with bad news that the company and investors knew was coming. If the lender feels they can’t trust the company and its investors, they will be forced to behave in a more conservative manner to ensure they protect the principal of their loan.
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