Amid all the challenges facing high-growth businesses right now – whether in life sciences, software or otherwise – the surging success of venture debt stands out as a beneficiary. Responding to a crunch on valuations and management teams being forced to rethink fundraising plans, venture debt providers are seeing booming demand.
Ed Testerman, partner and head of the growth lending platform at credit firm King Street Capital Management, says: “Dealflow and activity has picked up fairly substantially in 2022 and our expectation is that will continue into 2023. A big reason for that is most of these companies are continuing to burn cash due to their business models and require additional capital to fund that burn. Meanwhile, the public markets are closed and companies are not as willing to do an equity down round that is highly dilutive to existing shareholders.
“Because of that, and because growth companies still need to raise capital, venture debt has become a more appealing option relative to preferred equity.”
The growth lending space is maturing at the same time, with venture debt deal structures evolving in response to company needs. Where traditional venture debt was amortising loans plus warrants, there are now hybrid financing solutions available in the market, including convertible bonds. Testerman says that a one-size-fits-all venture debt structure can be less appealing, while demand is growing for flexible structures that provide a lower cost of capital, less upfront cash burn, act as an accelerant for growth initiatives and maximise valuations.
Venture debt convertible bonds used to be structured such that conversion took place at a discount to the IPO price and conversion was mandatory, so if a company went public the lender automatically converted to equity at a 25-30 percent discount. Now, says Testerman: “As more credit-focused players come into the market, there has been some evolution to a structure more akin to public market converts where the conversion price may be struck up 20-30 percent rather than down, but the lender is given the option whether to convert at IPO. They can keep their consideration in the form of debt if they choose.”
He explains: “That is more appealing to the company, because they preserve the potential option to not experience a dilution and the strike price is much higher, and to the lender because it gives them more optionality as well to lock in a debt return and not necessarily have to take an equity-type risk if the trajectory doesn’t play out as they would expect.”
Noah Shipman is a partner at Vistara Growth, a provider of flexible growth debt and equity solutions to technology companies. He says: “We can do term debt, convertible debt and equity, as well as creative combinations of those solutions. Both companies and the market have realised that is a more powerful solution than just providing a very narrow single product solution to companies.
“We see a lot more language around being a provider of solutions rather than just being a lender, and that matches the maturity of how technology companies are starting to think about and utilise various forms of venture debt to build their companies.”
Part of the long-term plans
Shipman argues that growth-stage technology companies used to use venture debt tactically, accessing the lowest cost debt for a short amount of time to bridge between equity rounds. “Now,” he says, “those companies see debt as part of the longer-term capital structure, and they are thinking much more intelligently about the application of debt. The venture debt industry needed to step up to match that with better solutions.”
Lenders to high-growth businesses are at the forefront of a wave of innovation. Another example is Finitive, which offers IP-based lending as an alternative to typical venture debt. Co-founder and president Caroline Hayes says: “Traditional venture debt is often secured by companies simultaneously with raising an equity round. Typically, the amount of venture debt obtainable is about 10 percent to 30 percent of the most recent equity capital raise.
“The venture debt lenders are essentially betting on the brand name and reputation of the equity sponsor. This approach assumes that such investors will not let the company fail or default. Thus, the accessibility of venture debt in this model moves in tandem with the availability of venture equity financing.”
In contrast, Finitive believes that intellectual property-rich companies are being overlooked by banks, credit funds and other traditional investors. Hayes says: “These types of investors are unable to analyse the realisable sale or licensing value of the IP, and thus either give a very low or no value to the IP. These IP-rich companies are falling into a gap in the capital markets, based on investors’ inability to underwrite IP.
“Our view is that if the IP value of these companies was clear, this funding opportunity would not exist. Our programme helps companies unlock IP value via our specialised partners and underwriting process. Broadly speaking, these companies are overlooked by equity and debt investors that are not able to assess IP value, which is often a hidden asset.”
With traditional funding markets currently inaccessible, Finitive is enjoying increased demand for its flexible financing solutions, as are others.
Management teams and company boards are getting smarter about what is available and how to work with debt. Louis Lehot, partner at Foley & Lardner, argues there is a right and wrong way for life sciences companies to work with debt. The right way is to borrow the right amount, not so little as to miss out on maximising equity value by using less expensive debt capital, and not so much that debt becomes a burden.
“The main wrong way,” says Lehot, “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.”
But market players are convinced that the new entrants coming into the venture debt market are here to stay. Testerman says: “We think this space is a really attractive place to deploy capital and we think more lenders are coming to that conclusion as well. As there are more players in the space deploying capital creatively, both supply and demand look pretty favourable going forward.”
More than just a flash in the pan
Will demand drop off when equity markets eventually rebound? Noah Shipman, partner at Vistara Growth, thinks not.
“The conversations I’m having are much more strategic in nature now, where companies are looking to secure a long-term partner in their selection of a lender,” he says.
Shipman says the penetration of debt as a part of the overall capital structure for technology companies was very low “compared to basically every other industry on the planet”. But that has changed: “Over time, as more people have positive interactions with venture debt providers, we are going to see venture debt as a percentage of overall funding into technology companies mirroring how many other industries have increased their usage of debt over time as well.”