Venture debt

Over the past several years the practice of using venture debt has increased significantly. For many companies, venture debt is an
attractive option because it stretches equity investment dollars. By leveraging equity with debt, a business can increase its valuation levels.

“Since venture debt provides such a natural and complementary fit to equity capital, it’s used more and more, especially in private, venture-backed deals that are particularly sensitive to the need for conservative use of equity capital,” says Killu Sanborn, senior vice president
and director of life science venture lending at Comerica Bank.

Smart Business spoke with Sanborn about why venture debt has become so popular, what factors lenders consider when granting venture debt and what terms and structures are most commonly used.

How does venture debt work?

Venture debt providers, such as banks, provide a company with a loan, which the company can use to build its business to the next
level. For both private and public equity-backed companies, venture debt provides attractive leverage to the equity capital (and common
shareholders such as management and employees) by increasing the return on equity. Using venture debt increases return on equity,
because value is created by a combination of both equity and debt capital. Naturally, debt needs to be paid back at some point and the
company pays interest to the debt provider, but it is significantly less expensive than equity capital, because it is taking significantly less

Why has it become such an attractive option for companies lately?

Venture debt as a concept has become proven over the recent years as its track record through good and bad times has been established, particularly through the tech boom and bust. Also, in specific capital-intensive sectors such as life sciences, venture debt can provide very meaningful relief from equity dilution and valuation concerns. It may take $100 million or more to develop a drug to the stage where public markets
become open to owning the company’s stock through an IPO. However, IPO valuations remain very low, in the range of $130 million to $150
million. This provides very poor returns for the equity holders that took a lot of risk when investing their $100 million. Imagine now that you
could replace some of that $100 million in equity with debt — not only would it be less dilutive to investors and common shareholders, but it
would likely also help significantly with valuation issues and ultimately, return on equity.

Why is it important for a company to be prudent about the level of debt that they carry?

There are limits to how much venture debt is a reasonable amount to use as leverage for equity, as too much leverage might expose
the company and investors to excessive risk in case the business sours. It is also important to remember that all debt needs to get paid
back before equity investors and common shareholders such as management and employees get paid. At the end of the day, venture debt
providers are in the business of making loans, getting paid for the loan servicing, and getting some upside in the form of warrants to buy
equity at a later date.

What factors do lenders consider when deciding whether to give venture debt to a company?

For private companies, a very important factor for venture debt providers is the quality and makeup of the investors, who are typically VC funds. Deals backed by VC funds (who have experience with using venture debt and are known to protect lenders even if their
company does not work out) are likely to attract very strong terms from lenders. Other factors include the strength and track record of
management teams; the amount of debt sought versus the amount of other capital in the deal (lenders typically lend less debt than the
total equity capital in the deal); uses of capital and quality of the business plan; financial state of the company; and how much capital the
company has in hand when seeking debt.

What terms and structures are most commonly used?

Often, venture debt is structured as a growth capital loan with a term loan structure of monthly amortization of principal plus interest over a specific amount of time, such as 36 months. How expensive the debt is varies considerably between providers and depends
on the size of the deal as well as the level of risk the debt provider is taking.

The cost of the deal typically includes features such as interest rate, closing fees, warrants and any commitment or non-use fees.
Additional deal structures include equipment lines or real estate expansion loans, which make a lot of sense for companies that need
to buy equipment or expand real estate. Last but not least, banks that do venture debt loans often provide generous working capital
loans to companies with revenues and accounts receivable, even if they are not yet profitable, but show a clear path to profitability.

KILLU SANBORN is senior vice president and director of life science venture lending at Comerica Bank. Reach her at (858) 509-2380 or [email protected].