For decades, venture-backed life science companies in the U.S. have used debt as a cost efficient way to minimize dilution on the way to their next meaningful clinical milestone. RBCx is the first Canadian bank with a dedicated life science credit team able to provide venture debt to pre-revenue venture-backed companies.
While equity is the primary source of funding for startups, venture debt can be a complement to equity due to its unique attributes which are designed to help early stage companies scale. But how do you know if, and when, venture debt is right for your business? This article covers the basics on venture debt financing and offers insights unique to companies in the life science sector, for both clinical (pre-revenue) stage and commercial stage.
What is venture debt?
Perhaps the best place to start is to define what venture debt is not. It isn’t a substitute for equity and shouldn’t saddle a business with a disproportionate amount of interest or a repayment structure that inhibits their ability to grow. It doesn’t have revenue or liquidity covenants that scaling companies might struggle to meet.
Venture debt is a type of loan that provides an additional capital injection to a VC-backed startup to reduce the overall cost of capital, reduce dilution for founders, and extend runway. It’s structured as a term loan with a long interest-only period during which the company can choose when to draw the loan (if at all), followed by interest and amortization payments that must be paid within a specific time frame.
In other words, venture debt can be a way to supplement an equity round without materially impacting the cap table. However, keep in mind venture debt includes a nominal warrant position which aligns the interest of the lender with the interest of the company.
How is the life science sector unique?
From clinical stage biotech, to medtech, to diagnostics and research tools, the life science sector is capital intensive, requiring significant investment to meet clinical and regulatory milestones. It is fraught with uncertainty with companies dealing with everything from clinical trial delays to supply chain challenges. Investing in this sector requires experience and subject matter expertise, and companies shouldn’t expect any less from their venture debt provider. Debt can be a powerful tool to accelerate R&D, invest in laboratory buildouts or extend runway, and strengthen the balance sheet. It can also act as an insurance policy in case of unexpected expenses, delays in clinical development, or slowdowns in the equity markets. The right structure and terms ensures that the capital raised from venture investors is invested in value creation activities.
How venture debt differs from traditional loans
Traditional term debt is typically risk-averse, and best reserved for stable enterprises with positive cash flow. Traditional term loans are often backed by tangible assets and come with covenants which compel companies to meet predefined revenue targets or maintain a certain number of months of cash on hand.
Life science startups are IP-driven, often pre-revenue, and cash-burning—meaning they clearly don’t meet the prerequisites for a traditional loan. Venture debt offers an alternate option specifically designed to support early stage companies’ unique needs. Instead of underwriting to cash flows or tangible assets, venture debt is dependent on the company’s ability to increase their enterprise value and the VC firms who back them. An experienced lender will customize the terms to each situation, which could include:
● Extended draw periods,
● Interest-only periods, and
● The ability to unlock additional capital upon the achievement of business or clinical milestones.
A startup can choose to treat venture debt as insurance and refrain from using it unless it’s absolutely necessary. Interest is only charged on the principal once the loan is drawn, and terms will typically include an interest-only period to preserve cash in the near term. If the venture debt is never drawn, the cost to the company is negligible.
Imagine a biotech company waiting for clinical trial results: they know if the results are good, an exit may be on the horizon. They also know that when those trial results are released, their cash position will impact their ability to negotiate with potential acquirers. If the company secures venture debt alongside its previous equity raise, it will have a strong balance sheet and the insurance needed to make the right decision for both the company and its investors.
What do venture debt lenders look for?
While venture debt can be an impactful tool for some life science companies, it isn’t a solution for all companies. Finance teams should look to partner with experienced life science lenders that perform a thorough review of a company before issuing a term sheet. A lender that extends too much debt on the wrong terms for a company may be putting short-term interests ahead of long-term risk. The best lenders will be your guide on the side, and ensure debt never becomes an anchor that inhibits your ability to scale.
Much like venture capital investors, venture lenders look for companies with the right profile. Similarly, life science startups should look for a lender that has experience supporting life science companies. These are some of the questions a lender should ask a life science company:
- Is the company developing an asset or technology that is highly differentiated, disruptive, a significant improvement to health economics, and/or the current standard of care?
- Is there a well-thought-out clinical, regulatory, and/or commercialization strategy? Is there a defined pathway to reimbursement?
- Has the company raised venture capital from institutional investors who have experience investing in similar technologies?
- Will current investors make sequential investments?
- Is a quality management team and scientific advisory board in place?
- Metrics and performance
- Lenders analyze the company to fully understand its performance. Some questions they may ask are:
- Does the company have a cash runway of more than 12 months?
- Does the cash-burn indicate that venture debt will meaningfully help the company? Will it extend runway by at least a quarter or two?
- Does the company have enough capital to reach the next clinical, regulatory, or commercial milestone/value inflection point?
The best time to qualify for venture debt is shortly after an equity raise. In other words, the best time to secure venture debt is well before you may need it.
How venture debt is structured
Life science companies should ensure that their lender develops a solution that fits their unique needs. When determining how to structure a company’s venture debt, these are the main considerations:
Loan size relates to equity raise
The loan size is usually a function of the business’s equity raise—around 20 to 40 per cent of the latest equity round or cash on hand. The reasoning is to bolster the equity round by an amount that’s meaningful enough to provide the company more time to hit specific milestones, but not so much time that it hinders the ability to raise equity at the next round.
Flexibility on drawing the loan
Venture debt is underwritten to the strength of the investors and the company’s ability to increase their enterprise value, so an experienced lender typically doesn’t require covenants. The purpose of venture debt is to preserve optionality, which provides the company flexibility to draw on their loan whenever they need it. Founders seeking to borrow funds should carefully consider any covenants in term sheets from financial institutions or private lenders to ensure they fully comprehend how that could affect their business, particularly if things don’t go perfectly to plan.
Term length is relatively short
Lenders want to provide enough time before the loan matures that companies aren’t burdened with an accelerated repayment schedule while at the same time minimizing their own risk exposure. It’s difficult to predict a startup company’s trajectory 10 years ahead, therefore lenders tend to keep the loan term relatively short. In the broader venture debt market, the average term for a facility is around three to four years.
Pricing has two components
Pricing is a major consideration of venture debt, and has two components: interest rate and the warrant position. The interest rate is usually a margin above the prime rate but is only applied to the amount the company draws upon.
What is a warrant?
In venture debt, the warrant is a nominal equity option that the company gives to the lender. A warrant gives the investor the right to buy company shares in the future at a pre-established price. Because the lender has the potential to share in the company’s future success, it helps create alignment between the lender and startup on its success. These warrant positions are much smaller than the facilities themselves (in the realm of basis points.)
What to know when considering venture debt for your life science startup
It’s important to carefully consider all your options because not all venture debt providers are the same. This is a partnership and, ideally, you’ll want to work with a lender that can refinance and upsize your loan as you grow, and continue to support the company through to maturity. Here are some factors to consider:
- How much experience does the lender have with life science companies?
- Are they willing to provide you with an extended draw period?
- How long are they willing to extend the interest-only period?
- Is the lender able to scale with you?
- Is the lender able to provide additional products and services that can help your company grow over the long term?
Ask enough questions to familiarize yourself with the lender’s approval process and understand how they structure deals. Consider asking how often they’ll communicate with you and how they might respond should the company not perform to plan. Some providers may label their solutions as venture debt, but have minimal diligence, an unreasonably high interest rate, and no warrant position to incentivize them to support you during tough times. Working with a law firm experienced in venture debt is recommended given the complexity of this debt instrument.
RBCx now offers venture debt financing designed for venture-backed life science startups in every growth stage, from pre-clinical to commercial stage. We work with Canada’s most innovative life science companies and idea generators, turning our experience, networks, and capital into your competitive advantage to help drive lasting change. Speak with a RBCx Life Science Advisor to learn more about how we can help your business grow.
