As a CEO/CFO or Investor, how much debt is available to your company and how can the debt best be used to help build value in your company? 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. The two graphs below demonstrate how debt scales in biotech/pharma and medical device sectors, respectively. For diagnostics and discovery tool/services companies, there are typically more variables that help determine the amount of debt available to a company at a particular point in their life cycle (i.e., commercial stage, market size, CapEx need, novelty, reimbursement). For example, two diagnostics companies – one that is early-stage (pre- or limited commercialization) with a novel product and clear reimbursement path, and the second that is expansion stage ($5-10MM revenue) in a competitive market without reimbursement, may both receive similar amounts of debt despite the second company being at a later stage. How this debt can be used to help build value is multifold – I’ll provide a few examples to help demonstrate the versatility of debt.
Obvious uses of venture debt similar to more traditional forms of lending include its use in assisting commercial-stage companies with cash flow needs and growth capital, and helping companies of various stages with purchases of capital equipment. For commercial-stage companies (particularly discovery tools/services), a debt facility can be used to help finance the build of inventory, provide liquidity between the shipment of product and collection of associated revenue, and build the sales or service team. For a commercial company that is growing sales, this can often help reduce the size of the growth equity round or delay its raise, allowing the company to build value while limiting dilution. This debt can be structured as a revolving line of credit based on accounts receivable and/or inventory, or as a term loan.
Management and Investors often focus on the size and structure in selecting a debt facility, but the provider with the largest facility and loosest structure is not always the best long term partner. It is important that the selected lender understand the business, including potential bumps in the road. Even great companies will miss a plan – especially when commercializing a novel product or developing a new market. If the company is overleveraged compared to the reduced plan, the company may have less flexibility in addressing the slower sales ramp due to the required debt service. Another cash need that can often be financed through debt is the purchase of capital equipment. Use of equity to purchase manufacturing equipment, or sequencers for a diagnostics company, can often feel like it is not directly adding value to the company, but the cash spend is necessary to allow value-driving milestones to be reached. For larger equipment of significant value (typically ~$100,000+), debt allows the large cash need to be deferred to a point when the company will either have cash flow or proceeds from a new equity round at a higher valuation.
For biotech/pharma companies that have a portfolio or platform approach, venture debt may be used to provide capital to further expand the number of clinical programs. One use is to fund the acquisition of an additional asset that is complimentary to the existing portfolio without requiring a new equity raise. Another, perhaps more common use, is providing capital to advance additional programs into or through the clinic beyond what existing equity would allow. For example, a company may have four solid assets that it would like to move into Phase 2 studies which would typically require a very large equity round. If the company is instead able to split the required capital to advance all four programs between equity and debt, it will significantly limit the required equity raise and associated dilution, as well as allow investors to retain more reserves for future rounds. In addition, due to the diversification of the company’s portfolio there is less potential downside to having debt on the balance sheet, as the likelihood of all assets failing in the clinic is lower. Even if only one program is successful, the company should be able to raise capital to move into Phase 3 trials and service debt (although potentially at a reduced valuation compared to previous rounds). A smaller version of this type of debt can also be used for pre-clinical platform technology biotech/pharma companies to help expand the potential asset pool after proof-of-concept, but prior to entering the clinic. For an early-stage company, the debt can provide additional runway to improve selection of assets and/or the number of assets which will help increase the pre-money valuation. At this stage, even a small increase in pre-money valuation can result in significant reductions of dilution to founders, and help increase the exit economics for early investors.
Medical Device OUS Commercialization and US Trials
In the current regulatory environment, a large number of medical device companies choose to pursue CE Mark prior to FDA approval (particularly if the device is considered Class III and will require a PMA). In addition, in the medical device market it is increasingly important to be capital efficient in order to generate the expected rate of return for investors as the maximum exit price for most medical device companies is lower than their biotech/pharma counterparts. Due to both of these factors, an ideal time to utilize debt for medical device companies is when the company has achieved CE Mark and is initiating the IDE trial. At this point the technology has been somewhat de-risked (as evidenced by CE Mark), but is typically entering a stage that will require substantial capital as the company commercializes in Europe and funds the IDE trial. In this situation the exit window is often close enough that the debt can be repaid by an exit or strategic partnership as opposed to future equity round or cash flow which can help retain returns. As an example, a medical device company at this stage that has raised $50MM in equity, supplemented by $10MM in debt, that is purchased for $250MM will receive a cash-on-cash return of 4.8X as opposed to 4.2X if the full $60MM was from equity.
Bolstering the Balance Sheet
For all life science companies, especially with the open IPO window, venture debt is increasingly being used to bolster the balance sheet in advance of an IPO, strategic partnership or M&A exit. The debt helps serve two goals: enhance negotiating position and limit dilution. More cash on the balance sheet allows the company to enter discussions with the backing of a strong cash position which can help gain an upper hand in negotiations, or at the very least, prevent the counterparty from using a poor cash position to strengthen their hand. It also allows the discussion to play out without raising a new equity round – if the result is an IPO or strategic partnership, this will hopefully increase the valuation of the company. If it is an M&A, it will prevent returns from being diluted immediately before an exit.
A Bridge to Somewhere
Companies often look to debt as bridge financing. In these cases it is especially important that all parties (management, investors and lenders) understand the company, terms of debt, and the key milestones and risk that will occur during the bridge. For a single-asset company (biotech/pharma, medical device) this is particularly important as typically there is a major value-driving milestone that has not yet been reached. If the value event is completion of a clinical trial in which there is a binary event that will determine the success of the trial (i.e. un-blinding the data after completion), it is best that debt proceeds are used to fund the period between positive results and the next financing event, as opposed to being used to fund the binary event. If the trial is open label, or has multiple read-outs that are highly indicative of the ability to meet the primary endpoint (i.e. 24 week data that is highly predictive of 36 week data which is the primary endpoint), debt proceeds can be used earlier. As I will discuss in Part 3 of this series, and Bruce Booth covered in his Forbes article, Venture Debt: Under-Appreciated Tool for Building Biotechs, debt can make the bad times worse. This especially rings true in a bridge situation. If the next financing event fails to materialize as expected or the key milestones are not reached, there is a very small window and limited cash on hand to find alternative scenarios. The key to bridge debt is a true partnership to all parties, supported by open communication and a shared understanding that the bridge is a clear path to somewhere.
While I highlighted some examples of how debt can add value to both management and investors, this list is by no means complete. Like snowflakes, no two companies are alike, leaving endless possibilities of how debt can be used and structured to help in each case.
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