Venture Debt: Under-Appreciated Tool for Building Biotechs

Posted July 11th, 2012 in Biotech financing, Biotech investment themes, Biotech startup advice

Cash-burning R&D-stage biotechs have big appetites for cash, which is typically addressed with an equity-based diet.  It’s also supported through corporate partnerships and other less dilutive means such as grants and foundation funding.  But another important and often under-appreciated source of capital are the debt markets – taking a loan out to provide working capital for further R&D.

One might ask why and how a company that won’t have profits for a decade can raise any money through the issuance of debt, but it happens frequently, and the “venture lending” business is actually very robust.  Players like Silicon Valley Bank (SVB), Oxford Finance, Hercules Technology Growth Capital, and Horizon Technology Finance (and many others) are all very active supporters of emerging life science companies.

But venture debt is also a very opaque business, with little public information out there around the overall market size, the typical returns to venture debt providers (or its flipside: the cost-of-capital to those who access it), and what are the “market rate terms” and conditions of the debt.  This is yet another area where we as a sector would benefit from greater transparency.  And entrepreneurs seeking to build their companies with alternative forms of capital should certainly spend the time to learn more about it.

Here’s a quick Q&A with some data points on venture debt in biotech.

How big is the venture debt market in the life sciences?  It’s bigger than most people think.  Industry insiders have suggested to me that the debt market in the life sciences is about 10% of the equity market: since $7.7B was raised for Life Sciences (Biotech plus Med Tech) in the US alone in 2011, according to PWC Moneytree, that implies the venture debt market is about $800M per year in life sciences alone. 

It’s hard to know the exact number of companies that raise debt but it’s presumably at least 200 per year (US only).  SVB is the market leader by volume, and has done approximately 150 venture loans since January 2011.  Oxford Finance has done nearly 50 deals since then according to its website, though my understanding is these are probably at slightly higher average deal size than SVB.  Hercules, a pure-play specialty finance company, does a handful of deals per year, and has some 50 LS portfolio companies on its website (though many were done prior to 2011).  A similar specialty finance player, Horizon, has 34.  There are another dozen or so venture debt providers for life science companies, so it’s clear that a lot of firms raise some of their capital this way.

To give a more specific example, in our maturing Fund VII portfolio of early stage life science companies (all started between 2005-2007), >40% of them have taken on debt of some type over the past five years.  For example, Avila and Miragen both have had a $2M line from SVB, and put them in place when their lead programs were in Phase 1 and drug discovery, respectively.  It’s worth noting that Miragen only had $4M in equity at the time, so it provided a material extension of our early stage runway.

Why would a biotech want to take on debt?  There are lots of reasons, but the single most important is that a company wants a longer cash runway and chooses debt financing because raising additional equity financing is more costly and more dilutive in the near term.  Companies use this debt financing for a variety of things: extend visibility to reach key value inflection (e.g., completion of a clinical study); purchase expense capital equipment; strengthen their balance sheet prior to deal negotiations or IPO; or, expand the pipeline by purchasing new assets or advancing secondary programs, among other things.

What are the typical financials and terms?  For an individual company, the size of a debt issuance varies widely and caters to the needs of the issuer: only $1-2M for equipment or capital expenditure loans, and up to $15-30M for later stage growth or working capital.  It obviously depends on the needs and balance sheet of the company.  Typically they are done in concert with and to augment an existing equity financing.  As SVB likes to say, venture debt requires a symbiotic relationship between the debt provider and equity-provider (venture capital).

The “market rate” for terms also varies greatly across these different types of loans, but typically has three important financial components: interest rate, warrant coverage, and fees.  In the US market, fully loaded interest rates range today 10-13% (far higher than in 2007-2008 when it was half that rate).  Warrant coverage is typically 2-8% of the offering in the recent preferred stock security.  Fees are 40-100 basis points of the loan.  Other important terms to consider include whether there are liens on the IP (a negative), Material Adverse Change clauses, cash-collateral elements (where a bank can sweep the account), and other particular covenants.  When all of these are considered, the cost-of-capital is probably in the 15% range.  This is in general much less dilutive than the cost of capital of venture equity.

These deals can generate good returns for the debt providers.  Two specific examples, pulled from Hercules’ public disclosures: Aegerion Pharmaceuticals’ debt yielded them a fully realized IRR of 17%; Sirtris provided a 21% IRR.  These both obviously benefited from the run-up in equity value from the warrants in those deals.  On the flip side, their $25M debt offering with Anthera is now close to the latter’s entire market cap.  Obviously there are winners and losers in any portfolio.

Comparing terms is often a complicated analysis and the practical cost-of-capital of a given debt term sheet is sometimes hard to calculate.  Firms like the Capital Advisors Group specialize in helping biotechs frame up their options and seek competitive offers.  As a general rule, having multiple debt term sheets (much like equity) is critical to understanding what the true “market rate” is for any given company’s debt.

What are the downsides to venture debt?  As they say, debt makes the good times better but the bad times worse.  When lead programs fail or stall, debt can kill a company – force an ugly sale or liquidation, limit future financings, impair the intellectual property, etc…  This isn’t theoretical, it happens.  At Dynogen, having $5M in venture debt when the clinical programs didn’t work as planned significantly hampered our strategic options.  I won’t list additional companies in order to protect the innocent, but across the industry it’s not a short list where debt has become a bugbear in the boardroom.

Fortunately, good venture debt providers often work with the equity holders to come up with a solution that works for rescuing the most value in these scenarios.  But it’s certainly the case that having debt on the balance sheet significantly changes the dialogue during tough times.  Boards and management teams should think through scenarios before raising venture debt to ensure the covenants aren’t likely to become onerous, the core IP isn’t pledged, the Material Adverse Change clauses aren’t easily triggered, etc…

Does debt hurt or help BD or IPO prospects?  If it can meaningfully impact a balance sheet and provided for an extended corporate development runway, than its probably helpful on the margin.  But should the BD process drag on, or S1 get pulled, debt can adversely impact an outcome.

Its worth noting though that it can however be used creatively in deals.  For example, last fall Myriad did a strategic debt investment into Crescendo Bioscience (here), where the former loaned the biotech $25M for 6 years at 6% interest in exchange for an option-to-acquire the whole business at pre-defined revenue multiples.  I don’t know the specifics of this deal, but it appears a creative way to provide P&L-sparing access for Myriad to an interesting platform, while sufficiently funding Crescendo to build an interesting business.

I’ve not heard of Big Pharma doing these types of deals, but given the perceived dearth of equity capital supporting innovative early stage biotechs, it seems to me that they could use their massive balance sheets to offer venture loans to complement their corporate venture capital businesses.

What are some further examples of biotechs that have done debt deals?  Here’s a list of publicly disclosed transactions from SVB, Hercules, and Oxford.  Interesting to see Aegerion, Vitae, Ceptaris, Pacira with multiple listings from different venture debt providers: often these debt providers work together and syndicate their loans much like VCs work together on equity rounds.

  • SVB: Aegerion Pharmaceuticals, Affymax Inc, Alimera Sciences, Avila Therapeutics, CardioFocus Inc, Ceptaris Therapeutics Inc, CodeRyte Inc, Enobia Pharma, Furiex Pharmaceuticals Inc, NuPathe Inc, Ocular Therapeutix Inc, Sunesis Pharmaceutucals Inc, TearScience Inc, Tetraphase Pharmaceuticals Inc, TRIA Beauty Inc, Vitae Pharmaceuticals Inc
  • Hercules: Aveo Pharmaceuticals, Portola Pharmaceuticals, Anthera Pharmaceuticals, Sirtris Pharmaceuticals, Acceleron Pharma, BarRx, Novasys Medical, Dicerna Pharma, Adiana, Aegerion Pharma, Pacira Pharmaceuticals, and Cempra Pharmaceuticals.
  • Oxford: Avanir Pharmaceuticals, Pacira Pharmaceuticals, Affymax, Ligand, Transzyme Pharma, Cadence Pharma, Protox Therapeutics, Anacor, Synta, Supernus Pharmaceuticals, Zalicus, Zogenix, Nanostring, Cerus, Ceptaris, Vitae Pharmaceuticals, and Achoaogen.

While not back to its free-flowing pre-2008-crisis form, the venture debt markets are open for business in biotech.  It should be considered strategically by entrepreneurs, management teams, and boards as a useful financing tool to build biotechs in our capital-constrained world.

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