As life science equity markets have soured, management teams and boards are rethinking fundraising plans, asking how to optimize capital resources when progress does not command high equity valuations.
Interestingly, there has not been a comparable market reset for venture loans. Comparing loan terms from a year ago to now, you would not see much change – spreads between interest rate and loan rate haven’t moved against borrowers even as interest rates have gone up; interest-only periods and loan durations are longer than ever, and fees and warrants are reminiscent of years past. Many loans have no covenants or are covenant-light.
We are living in a dislocated market where debt and equity markets are out of step, providing an opportunity for companies to borrow at more favorable loan terms than one would expect. Perhaps this dislocation is also due to recent lean years for the lenders, as fewer loans were closed, leaving lenders hungry and willing to embrace new business, despite changing financing markets.
This market dislocation is likely to resolve over time. There is already a shift underway, but it mainly relates to quality of companies able to secure venture debt rather than to specific loan terms.
Since so many public borrowers saw their market capitalization drop, many became unable to secure comparable loan sizes to a year or two ago. Lenders evaluate refinancing risk and health of the enterprise, and with precipitous drops in market capitalization, both have moved in the wrong direction.
Some public companies that were able to secure loan proposals but ended up not acting on them, are now learning that they are offered either much smaller loans or none at all, depending on what has happened to their equity value.
On the other hand, companies with market capitalization in hundreds of millions to billions, are enjoying larger venture loans than ever. It used to be unusual to see venture loans at $100 million to $250 million range. Not anymore! It pays to be more mature in markets like today. Financial teams and boards of more highly valued companies understand that well, optimizing their capital structures by layering on less dilutive venture debt instead of closing dilutive equity rounds.
There is a right and a wrong way to work with debt. The right way is to borrow the right amount – not so little as to miss out on maximizing equity value by using less expensive debt capital, and not so much that debt becomes a burden. The main wrong way is to work with debt partners who have not been tested in downturns, or who have a reputation of having a quick trigger in difficult situations, just when a debt partner’s patient support is needed the most, to support developing alternative plans. In life sciences, uncertainty is a given, and plans change all the time. Experienced, high-quality lenders know that and work in ways that make it easier for borrowers, rather than responding rashly. Experienced lenders are also slower to offer loans so large that they might put the growing enterprise at risk.
Debt is not equity – it needs to be paid back. However, it is very powerful in its ability to support driving equity value. Many companies discovered this when they reached an IPO or sale in the last several years, as those that used debt, often retained more equity for the management team and existing investors than companies who fueled growth with selling equity alone. The latter had transferred valuable equity value growth potential to their new equity investors, instead of keeping it in the company.
No rule of thumb
How to know what is the right amount of debt? There is no rule of thumb, but often, venture loans can provide an extra quarter of runway, or more. This is especially helpful when approaching the next fund-raising period, as equity dollars fund companies to reach a milestone, but without a cash cushion, their negotiating position can get impaired by the prospect of running out of cash.
When debt is used to purchase or to in-license additional assets, then the right amount depends on what the full enterprise, including the additions, can command. Revenue generating, cash flowing acquisitions can command a different level of debt than cash burning R&D or clinical stage pipelines. When in doubt, call a lender – they are always happy to provide quick feedback, or run the analysis to support scenario planning by the executive team and the board.
Additional typical uses of venture debt include supporting commercialization, accelerating underfunded pipeline projects, building manufacturing facilities, and supporting strategic collaboration or acquisition negotiations.
Often, there is tension between the desire to bring in a larger loan and the potential risk of doing so. Such tension can be easily resolved by tranching the loan to operating milestones, making additional capital available only when it is needed. For example, tranching to a clinical milestone secures the availability of capital once it is clear it makes sense to proceed with spending for the next stage of development. Meeting the clinical milestone secures an increase in the company’s equity value, which in turn increases the amount of debt that is prudent for the company to carry. Additionally, tranching also saves borrower from needing to make interest payments until the tranche is drawn.
Another feature of venture loans that seems to be here to stay, is interest-only period extension, often offered upon reaching a predetermined milestone. Borrowers won’t need to amortize the loan until they are stronger, as evidenced by reaching a milestone, and lenders extend interest-only periods only upon seeing good progress, thereby reducing their risk.
What to expect when lending terms finally reset to reflect the increased risk in the current financing markets? Judging by past downturns, fewer companies will qualify for venture loans, especially if financing risks continue to increase in deteriorating financial markets. Loan terms will become less generous. Current loan interest rates already leave little room for lenders to profit, because in the competitive lending markets, lenders absorbed some of the pain from fast federal interest rate increases, instead of passing it on to borrowers. That is not sustainable. In addition, loan durations will likely shorten, along with shortening of interest-only periods, giving lenders more comfort when going into uncertainty. Covenants will likely make a come-back, as they enable lenders to keep lending and borrowers to keep borrowing even in shakier markets, versus just turning off the spigot completely.
We are not there yet. This is good news to financial teams, investors and boards contemplating future financing scenarios, because there has never been as much capital available for venture loans as there is now.
Killu Sanborn is a managing director for Oxford Finance, which provides debt to life sciences and healthcare services companies worldwide.
Louis Lehot is a partner and business lawyer with Foley & Lardner LLP, where he is a member of the Private Equity & Venture Capital, M&A and Transactions Practices.