Venture debt as an option for start-up companies

Commentary by Joey Mason for Mednous

Multiple events are converging to make drug development a
more attractive risk-bearing activity. These include the use
of artificial intelligence in drug development to the arrival of
a new generation of scientists schooled on discoveries from
the human genome. This has led to the launch of more startup
companies in the life sciences, which in turn need capital
to grow. Typically a young company might be financed by
grants in the early years, and then move on to equity finance,
such as venture capital. But venture capital often comes in
stages, leaving a company’s management in a perilous state
of affairs if the next tranche of financing is delayed.

This is where venture debt can enter the picture. Venture
debt, which is a loan from a bank or other financial
institution, is designed to help a start-up company bridge
the gap between equity financing rounds, or manage other
short-term problems. It first appeared in the US in the
1960s. According to the European Investment Bank (EIB),
the first venture loans were used to help manufacturers buy
machinery to make silicon chips for semiconductors. This
funding practice later spread to the life sciences industry and
to Europe where the EIB, the long-term lending institution
of the European Union, has become a major player. Venture
debt reportedly represents about 3% of the annual venture
capital transactions in Europe – across all sectors – and
about 15% in the US.

Venture debt providers include non-bank lenders such
as institutional investors, banks with venture capital
departments, and public or government owned institutions
like the EIB. While practices differ according to the
institution, the principles are broadly the same. When used
at the right time and in the right quantity venture debt,
also known as growth capital, can be a powerful tool to
supplement equity financing.

Reducing dilution

There has been some negativity around such options in the
past, often caused by its use in companies for whom it wasn’t
the right fit – but using debt should never be about company
survival – it’s about optimising growth. It is most effective in
situations where a business could raise equity, but chooses
not to, or opts to complement part of an equity round with
some less dilutive capital. It can also be a bridge between
equity rounds.

There is also a view that debt can be expensive. In fact,
for most companies, true venture debt offers a lower cost
of capital than most other forms of financing. Not to be
confused with revenue-based lenders or bank loans, venture
debt funds provide secured term loans, with no or low,
covenants whilst charging an interest rate (typically low
double digits) and warrant coverage, giving them the right to
buy shares in the future at a defined price.

Venture debt funds typically have a fixed cost of capital,
so are well insulated from central bank interest rate rises.
The opposite is true of other sources of debt, where they are investing capital provided by a bank or other institution,
and charge a premium over central bank rates for riskier
investments.

Using debt rather than equity to fuel organic growth
and finance M&A can make a big difference to the dilution
suffered by founders and early-stage investors. Ultimately,
it provides access to financing that can help get a business
from one value point in its journey to the next. Companies
can then often raise an equity round 12-24 months later
at a much higher valuation. This is less dilution for the
shareholders than if they had used equity instead of debt.
In fact they may be bridged all the way to profitability, or
even to an exit, thus avoiding raising more expensive capital
at all. Alongside lower dilution and a lower cost of capital
from day one, venture debt can also help companies optimise
the timing of future capital raises, allowing founders and
early shareholders to retain control and governance of the
business.

There are at least three instances where venture debt
can play a role in helping a start-up company. The first is
to extend the life of a milestone period during which an
innovative company has to demonstrate the efficacy of a new
product. If a company’s equity funding is expected to last 12
to 18 months of a milestone period and it needs more time,
venture debt could extend this runway by a further six to 12
months.

The second case is where a company has raised venture
capital at a valuation that is no longer relevant. It can use
venture debt to continue its operations and grow until that
valuation is met. The third case is to defend against dilution
when new shares are issued to raise capital. Venture debt
can supplement the issuance of new shares thereby keeping
existing investors in the company.

There are limitations however. Whatever the category of
lender, the institution providing venture debt will expect to
be repaid. That’s why this type of debt isn’t always the right
tool for companies that have little visibility on revenues or
performance into the 12 months after the loan. But where
the fit is right, venture debt can be a strong propeller of
growth.

Looking ahead, the need for venture debt lending could
increase in the EU if proposed legislation to stimulate
company formation takes effect. The European Commission
outlined a proposal on 18 March that would create a new
legal framework for small, innovative companies across
all sectors to incorporate and have full access to the single
market. If approved by the European Parliament and
Council, the proposal could lead to an abundance of new
companies which will need capital, including growth capital
to succeed.