A New Era of Debt Financing: Flexibility Continues to Grow as Hidden Costs Arise

Executive Summary

This paper provides an update, in broad terms, on the state of the debt financing markets. Capital Advisors Group works with companies across industries that are early stage or, for other reasons, may not qualify for large commercial bank debt financing facilities. In this semi-annual review of the market, we will discuss how fierce competition has led to increased flexibility in structure and length of terms as well as the emergence of low-to-no warrant deals. However, while rates on deals remain little changed since the last decade, there is a new wrinkle in pricing that will likely lead to higher cost of capital over time.

Historical Context

Financing projects and growth through debt has long been a staple of modern corporate economics. However, debt for companies which have very little credit history, a relative lack of fungible assets, negative cash flow and little-to-no revenue for the foreseeable future have historically presented an untenable risk for many traditional banks. Therefore, early-stage companies with a need to develop products, continue R&D or build out operations, sought equity investment primarily through venture capital or strategic investors, which resulted in potentially significant dilution to fund their goals.
During the 1980s, typical options for early-stage companies were limited to leasing arrangements for equipment. One of those equipment leasing companies, Equitec, devised the concept of using an “equity kicker” on each deal. Equity kickers increased yield on a portfolio basis to balance the higher risk profile of the borrowers and offset the inevitable increased loss ratio when compared to bankable credit portfolios. In these early equipment leasing deals, the precursor to what we know today as venture debt, the equity components came in the form of success fees or warrants, usually assessed near or at maturity. However, as more lenders came into the space, physical asset-based collateral-driven lending practices loosened, giving way to general liens on all the assets of the firm to collateralize the loan. These liens gave virtual or development-heavy businesses the ability to leverage equity with debt to fund growth capital without the more dilutive properties of investor equity. However, these “venture lenders,” whose funds were dominant in the market between the late 1980s and mid-2000s, were limited in their funding availability. Due to the fund sizes of these debt lenders, companies with significant equity and commercial launch viability tended to be underserved participants in the growth capital market.
The market began a dramatic shift following the credit crisis of 2008-2009. The crunch pinched venture debt lenders into deal sizes that would typically top out at $30 million for only the strongest venture backed companies. So the timing was right for a new group of lenders to step in to provide larger and more flexible terms for later stage commercial or near-commercial stage companies. New lenders and structures began to emerge that often had no equity component, with deals sizes ranging from $20 million to more than $100 million. These new entrants were lending against the commercial viability of the products the borrowers were, or soon would be, offering. And they were presenting longer term structures known as revenue interest financing or structured debt financing that would quickly begin to overlap into the realm once occupied exclusively by the venture debt players.
The current debt space for early-stage and more mature commercial companies has expanded beyond the traditional venture debt lenders and venture banks. Mezzanine and structured lenders, public funds, private specialty funds and arms of large Business Development Companies (BDCs) have dramatically increased the competitive landscape for early stage lending over the past five years. It is this landscape of varying structures, preferences and choices into which a company walks when seeking debt financing. Competition to win good deals is fierce and has forced many traditional lenders to stretch the boundaries of their appetite for risk and compete by expanding the parameters of their structures. Generally, this trend has made borrowing for earlier stage companies far more attractive than it once may have been.
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