A Mature Capital Structure Positions Bio-IT Startups For Success

Contributed Commentary by Stefan Spazek

December 6, 2018 | The financial ecosystem for life science startup companies, especially early-stage bio-IT companies, has never been healthier. According to the most recent MoneyTree Report from PwC and CB Insights, venture capital firms poured $2.8 billion into digital health companies in the third quarter of 2018. That’s more than half the $5.4 billion invested in the entire healthcare sector during the same period.

But for early-stage companies navigating the perilous journey from seed financing to commercial revenue and beyond, venture funding is only the start. Even before they are out of the starting gate, they must start planning to raise multiple follow-on rounds of equity just to stay afloat.

At the same time, many startups now are quick to supplement their cash with debt financing as well. By establishing a mature capital structure reflecting a healthy balance of both equity and debt, they can project long-term strength and vision that helps to favorably position them with their stakeholders.

A Mix of Debt With Equity Helps Strengthen the Balance Sheet

With under-capitalization the principal reason most businesses fail, cash burn rates are a concern for any startup. In the life-sciences industry especially, running out of money is an ever-present existential threat.

Large capital requirements, long product-development cycles, and uncertain time-to-market all contribute to spending at unpredictable rates. Too many startups reach the end of their cash runways before they are able to complete follow-on venture and later-stage private equity investment rounds.

To smooth out the process and ensure more reliable cash flow, many startups will strengthen their balance sheets with debt. There are several key reasons to add some debt to the startup equity on the balance sheet:

• First, debt does not typically dilute equity (or if it does, only minimally so). As the loan is repaid, the investors and management maintain their percentage of ownership. In the meantime, it provides needed cash to help sustain operations between equity rounds without lowering the price of new shares.
• Second, adding some debt to the balance sheet provides a cushion against the possibility that cash will run out due to the uncertainties inherent in the product development cycle. It can help the company to reach milestones and higher valuations that otherwise might be just out of reach.
• Third, debt can provide needed cash to help bridge the uncertain time required to position for an IPO, negotiate an acquisition, or work toward some other liquidity event.

Finally, strengthening an early-stage company’s cash position with debt can help attract more equity financing in later rounds. Later-stage private equity funds tend to be larger and slightly more risk averse. Those investors look past initial business plan milestones for a strong balance sheet with a cash cushion reflecting an appropriate mix of equity financing and non-dilutive debt.

Multiple Sources of Financing are Available

Founders are sometimes not aware that an early-stage life sciences company without near-term prospects for revenue can qualify for venture debt financing. But lenders with life sciences industry experience know how to identify early stage companies with strong prospects. They tend to seek out startup companies that are backed by high profile venture capital firms, and they look for a decent cash life of at least 12 months, deep development pipelines, commitments from beta-site customers, and promising early data (if available).

The good news is that multiple sources of financing have emerged in the past decade that may be well-suited to the unique needs of life science and bio IT startups. These lenders fall into three general categories:

1. Venture banks provide venture debt to companies that have a strong intellectual property (IP) portfolio. They often strike a deal with upside potential in the form of warrants. Typical conditions call for borrowers to bring all their deposits and other business banking services over to the bank as well.
2. Non-bank debt funds, or specialty finance companies, also provide venture debt, typically at a higher cost of capital than banks. But they also tend to provide larger loans, sometimes with more flexibility in structure and terms.
3. Structured finance providers cater to companies that are on the cusp of moving from product development or clinical stages to commercial stages. Often the loans are tied to a percentage of the company’s future revenues over an extended period. This type of financing can be more expensive than traditional venture debt, but it may also provide greater flexibility in terms and larger financing rounds.

Evaluating each option requires a careful analysis of the company’s current cash runway and longer-term financing needs. The next step for the borrower is to survey suppliers and line up bids from a small but appropriate group of potential competitive debt investors.

Negotiation over terms might include potential warrants, royalties or other incentives for the lender beyond interest and principal repayments. Fortunately, there are enough sources of financing to create healthy competition among lenders.

The Difference Between Success and Failure

Debt financing should work hand-in-glove with equity to provide optimum balance sheet leverage. When it does, all the stakeholders in the enterprise benefit.

Risk averse investors are reassured that the company has a strong enough financial foundation and management with the financial acumen to direct the company toward an eventual successful liquidity event. Current and prospective customers are confident their supplier will be around for a long time. And management and employees are more secure in the belief that their company, no matter how young, is well-positioned for a successful transition to its rapid growth phase.

In short, a mature capital structure, with a self-reinforcing mix of debt and equity financing, can ultimately make the difference between success and failure for the early-stage bio-IT company.

Stefan Spazek is Director of Debt Placement at Capital Advisors Group. He oversees the company’s debt consulting business and supervises business development in the New England and Central regions. He joined Capital Advisors Group in 2006 as Director of Marketing, leading the company’s brand strategy, product positioning, content development, web strategy, advertising, public relations, and direct marketing. He can be reached at SSpazek@capitaladvisors.com