Hercules Capital extends the runway

Hercules Capital: By entrepreneurs, for entrepreneurs. That could be one potential tagline for the business development company which specialises in venture debt as it enters its teenage years.

Chief executive Manuel Henriquez came to the US at a young age from the Dominican Republic and made his way one step at a time, from a young boy to a college student at Northeastern University in Boston.

“I’ve been an entrepreneur since the age of eight years old,” he says. “When I was a little kid, when I first came to America, I didn’t have a lot of money, so I cut lawns. I used to sell mangoes in Florida on a corner to get money to go to school and to buy things.

“That led into high school, and I wanted to buy a car, so I got a job in high school to afford a car. That led into college, and I didn’t have money, so I started two companies and worked three jobs.”

The deal market involving private equity sponsors and alternative lenders has been well documented. Equity firms will often tap debt firms to finance, most commonly, a buyout, add-on acquisition or a recapitalisation. But Hercules often works with a different type of sponsor: venture investors. And Hercules is smack in the middle of the start-up capital of the world: Palo Alto, California. 

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Manuel Henriquez: I've been an entrepreneur since I was eight

Silicon Valley has a well-deserved reputation of being to start-up technology companies what Los Angeles is to the entertainment industry or New York City is to finance; some $181.36 billion of the $333.49 billion of assets under management for that strategy is to be found in California, according to the National Venture Capital Association.

“We are for entrepreneurs,” Henriquez says. “One of the reasons I started this company was for entrepreneurs. I wanted entrepreneurs to have greater access to alternative forms of capital, providing the ability to retain ownership of their companies.”

Hercules, which was founded in December 2003 and began investment operations in September 2004, has been part of the scene for 12 years and closed more than its share of deals. In June 2016, the firm announced it had committed more than $6 billion in capital since inception, a total that might have seemed far-fetched not too long ago.

“What has gone on is that the venture capitalists and entrepreneurs themselves have moved away from the fear of debt and in some cases they also over-embrace debt, which is a bad thing,” Henriquez says.

Naturally, with a different client base than other mid-market lenders, Hercules will finance companies for different reasons – namely, to stretch the timeline between series of equity financing.

“There’s a balance. Debt is not there to displace venture capital dollars,” he continues. “Debt is there to assist companies in extending the runway to allow them to achieve those required milestones and secure that next round of equity capital at a higher valuation. That’s what the right use of debt is.”

Another chief benefit is that the company’s founders keep a larger stake in the company they spent years building; after all, less equity financing means less dilution.

Life sciences and software

Henriquez’s firm has four separate verticals: technology, life sciences, sustainable and renewable energy, and special-opportunity lower mid-market – all areas with plenty of investment activity according to the NVCA statistics.

In 2016, most US venture capital activity was in the life sciences and software sectors, with those areas representing 12.49 percent and 38.1 percent, respectively, of all deals done in 2016.

While life sciences can be a broad term, Hercules focuses on companies involved in medical devices, bio-pharmaceutical, drug discovery, drug delivery, healthcare services and information systems companies.

One example of a company that Hercules has invested in is TransMedics. The financier invested $8.5 million of secured debt into the Andover, Massachusetts-based company. Hercules also holds preferred shares and preferred equity warrants.

TransMedics develops technology preserving extracted organs longer, allowing donor recipients in far-flung locations to have a better chance of receiving their needed organ.

“It gives us a 24-hour window, so we can really go anywhere in the world,” says Michael Hara, senior director of investor relations and corporate communications. “A heart, a living, breathing heart, fully functioning. It is the weirdest thing in the world and the coolest thing to see.”

Other investments include common stock holdings in social media site Pinterest and cloud storage platform Box (not to be confused with Dropbox).

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Michael Hara: TransMedics can go anywhere in the world

As of 31 December, drug discovery and development companies, a life science sub-vertical, made up the largest portion of the firm’s portfolio at 29.7 percent, while software companies took second place at 15.4 percent.

That those two categories take up so much of Hercules’ portfolio is reflective of the amount of money being poured into those areas.

In life sciences, venture capital firms invested $11.65 billion, with drug discovery accounting for $2.33 billion, second only to biotechnology, in which $4.07 billion was invested. For software, of the $69.11 billion of US deal value, $32.98 billion of it came from the software sector, according to the NVCA.

Hara says: “What I think is the strong point of [Hercules] is we are coming from that space – if you’re a software entrepreneur or you started many businesses, things don’t work out all the time – it’s our understanding and mentality of anticipating exactly your company doing the same thing.”

A lacklustre IPO market

Venture capital investment may be strong, but initial public offerings have struggled in recent years.

The number of venture capital-backed companies going public last year and in 2015 were 39 and 77, respectively, down from 122 in 2014, according to NVCA numbers.

“The VCs had a little bit more of a challenge because of [the] Sarbanes Oxley [Act],” Henriquez says, referring to the 2002 law governing financial reporting requirements passed in the wake of several major accounting fraud scandals. “In the old days, if you’re going public in 2.7 years or 3.2 years, you’re typically going to have only three rounds of equity capital and you’re out of the deal, meaning [series] A, B, C and you IPO at the D round. Today, it’s typical to see G, H and I equity rounds of capital because the gestation period is now seven years or longer to go public.”

The timeline has increased post-Sarbanes Oxley as well. In 2004, the average time between a first round of venture capital investment to an IPO was 5.2 years, which increased to 7.61 years in 2016, according to the NVCA.

As the IPO timeline grew for venture capital-backed companies, the 10-year structure for those funds became antiquated – if a fund targets an earlier-stage company toward the end of its life, the pool of capital will dry up.

“Venture funds have migrated upstream, more late stage in nature where they want to see an exit four to six years after the initial investment, which means the company has been around one to two years since their first formation,” Henriquez explains. “Or, conversely, [venture capital firms will] go to their LPs and say the traditional 10-year format doesn’t quite work, but I need at least two or three, one- or two-year extension periods.”

The Jumpstart Our Business Startups (JOBS) Act, enacted in April 2012 by President Barack Obama, tried to ease the burden by allowing companies that qualify as “emerging growth companies” – those with less than $1 billion in revenues – to file IPO registration materials confidentially.

“With the birth of the JOBS Act, you’re now able to file [for an IPO] confidentially, go through the SEC process, get comments,” Henriquez says. “And get your revenue recognition issues cleaned up … bolster your management team, and once you unveil that you’ve gone through the SEC process, you typically go public within 30 days after that.”

The upshot of the new process is it lets start-up companies go through the IPO process without disclosing sensitive financial or customer information that may hurt their competitive edge. Hercules has six companies going through this process, Henriquez said on the firm’s February earnings call.

Not all the capital at once

Hercules also has made a habit of tapping equity markets when it needs the liquidity through its ‘at-the-market’ programme, allowing the firm to close equity issuances quickly.

The firm has used this capability to its advantage over the last year, having issued over $140 million in equity, including a $50 million offering in Q1, selling at 1.45x to book.

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Mark Harris: 'We know when we need the capital and how to raise it efficiently'

“So what we were able to do is look at our pipeline and look at the timing of outflow of capital and overlay that with our ATM programmes and other treasury management tools, as treasury management is a very material part of the operations… here at Hercules,” says chief financial officer Mark Harris. “We know when we need the capital and how to raise it efficiently, to match our fundings.”

Harris explains if Hercules raised all “$140-odd million” at once, it would have caused a “cash drag” and be “absolutely material in terms of the negative impact on our [net investment income] per share”.

“It’s the perfect academic model,” he concludes. “Every time you need a dollar, I raise a dollar the day before and I put it out on our deals.”

The firm also tapped debt markets recently, including an approximately $230 million bond offering completed in January. The offering was initially for $150 million but was oversubscribed.

“We made the decision that it was a great time to take capital off the table again, because we just weren’t sure what was going to happen with the potential uncertainty after [then-President-elect Donald Trump] was sworn in office,” Harris says.

A case for optimism

Venture capital-backed companies’ need for debt may not be decreasing anytime soon, at least based on the amount of sidelined money. Venture investors ended 2016 with record levels of uncalled capital. Dry powder for those firms stood at $94.56 billion, the second highest in at least 12 years. Only 2007 inched out last year, when that figure amounted to $95.26 billion.

Henriquez anticipates that Hercules, which passed a goal of reaching the $1.3 billion to $1.35 billion mark for its investment loan portfolio, will hit its new goal of $1.5 billion-$1.6 billion by the end of the year. He announced those figures on the firm’s year-end earnings call in February.

Henriquez calls these “inflection points” and notes setting such benchmarks are not required.

“[Inflection points are] a signal to the shareholders that at these inflection points, infrastructure investment has to happen,” he says. “Selling, general and administrative expenses will go up. The reason I do that is to be completely transparent in our efforts – and I don’t have to. I think it’s important, it’s their money. I’m a steward of their capital. But I also think it helps set the stage for what we’re doing.”

Henriquez is hopeful about hitting the $1.5 billion figure as the venture capital industry rolls off a stronger-than-expected 2016 in the fundraising realm. Last year, 253 funds raised $41.6 billion, an increase from 2015’s $35.17 billion across 255 vehicles.

“It could be expected that new VC fundraising would experience a downturn similar to that of deal count. But that wasn’t the case; in fact, the opposite happened,” industry-data firm PitchBook wrote in December.

Some of the larger fund closes came from Technology Crossover Ventures, which closed its TCV IX fund on $2.5 billion, and Andreessen Horowitz, which raised $1.5 billion for its Fund V, according to data from PDI sister publication Private Equity International.

This could be set to be a positive year again for venture capital fundraising. New Enterprise Associates is in the market with its 16th vehicle seeking $3 billion, while dozens of other smaller funds have popped up, PEI data show.

“What really surprised me was the resilience of the capital raising that was going on [in venture capital],” Henriquez says. “That gives me a good indication of the health of the business because that means they’ll have enough capital to invest for the next two to three years quite comfortably.”

With the wind at its back, Hercules still holds true to its start-up roots.

“We are entrepreneurs,” Henriquez says. “We understand that journey you’re about to embark on, and that makes it a big difference.”