Capacity is one of the five C’s of credit which refers to a borrower’s ability to repay a loan’s principal and interest. For early-stage companies, the capacity to repay is markedly more uncertain than for larger, more established businesses. The presence of institutional investors, either venture capital or private equity, provides the venture lender with an implicit promise to repay a loan should the company be unable to do so from cash flows generated by the business.1 Venture lenders are theoretically swapping the borrower’s capacity to repay the loan with their institutional investors’ capacity and willingness to repay. Hence, the traditional venture lending business model relies heavily on borrowers having institutional equity sponsors.
Venture lenders can be loosely categorized into two primary buckets: venture banks and non-bank direct lenders. While both banks and non-banks prefer extending credit to venture capital backed companies, institutional investor presence is generally a necessary condition for accessing venture bank loans. Non-banks, typically structured as Business Development Companies (BDC’s) or private funds, may be more forgiving concerning this criteria, but also generally shun lending to companies that do not have institutional backing.
Like any lender, SWK generally underwrites to the five C’s of credit, with the capacity to repay playing a starring role. One way that SWK differentiates itself from other venture lenders is in how we think about the capacity to repay within the context of the other four C’s of credit. Perhaps we employ what may be considered a more traditional approach to lending, but we decidedly prefer to underwrite to a company’s ability to repay as opposed to their investors’ implicit promise to repay. This requires the companies that SWK partners with to have a sufficient liquidity runway and a realistic path towards repaying their note by executing on their business plan.
Early-stage companies, particularly in the life sciences, often require several rounds of capital investment prior to turning cash flow positive and being able to self-fund the business through operations. In light of this need for frequent fundraising, many venture loans have short maturities which enable the lender to be repaid prior to, or in conjunction with, the next round of expected financing. The truncated tenors of traditional venture loans mean they function primarily as bridge loans to the next round of financing. Despite relatively short maturities, venture debt plays a valuable role in the venture ecosystem by extending the runway between financing rounds, which has meaningful impacts on equity dilution and returns to equity investors. Because SWK is underwriting to the borrower’s ability to repay the loan through operations, we rely less on the need for future funding rounds, which allows us to offer maturities twice the length of the industry standard.
Venture lenders expect equity investors to continue to support their portfolio companies through subsequent rounds of investment, particularly early on in a company’s development. Follow-on investments not only allow venture capitalists to maintain their ownership percentage in the company, but they also protect the VC’s reputation. Equity investors would like to be known for being supportive of their portfolio companies by providing them with enough runway to have a legitimate chance at success. In a world where dollars are to a certain degree commoditized, failing to provide follow-on investments in early rounds would negatively impact a VC’s reputation and consequently their ability to source and win the most highly coveted investment opportunities.
Venture lenders also expect equity investors to protect their equity positions from losses that could result from a distressed exit precipitated by a foreclosure or fire sale. When a venture loan matures, or the borrower runs low on cash, venture lenders presume that the loan will either be repaid through an M&A exit, a refinance, or that equity owners will inject the capital necessary to repay the loan to head off any possibility of a foreclosure. Historical loss rates in the 2% range2 suggest that repayment through one of those methods is highly likely. Nevertheless, SWK prefers not to find itself in the position to learn whether an equity investor will indeed step in to repay a loan.
To reach commercial stage, the vast majority of life science companies require a quantum of capital that makes raising institutional equity all but certain. However, great companies do exist that have been able to bootstrap themselves and create substantial equity value with minimal investment. Other small but innovative companies have raised capital, but from sources that are less highly regarded by venture lenders: namely, angel investors, doctors, customers/suppliers/distributors, high net worth individuals, or retail-oriented investors. Unfortunately, many of these businesses will find it challenging to raise debt capital simply due to the nature of their investors.
At SWK, we pride ourselves on seeing value where others don’t. While we frequently partner with businesses that have institutional investors on the cap table, we are also willing to underwrite great businesses with non-traditional funding histories. Where other lenders see institutional investors as a gating item, SWK views the presence of institutional venture capital as a single, but important, data point in our holistic approach to underwriting.
Put simply, SWK underwrites great businesses with great products run by great management teams, regardless of the form or amount of equity that has historically funded the business. There is something to be said about great founders who have been able to create considerable value through bootstrapping their operations and managing the business as true owner-operators. SWK endeavors to understand the various components that contribute to the value of an enterprise while not placing an inordinate amount of weight on the presence of institutional equity investors. We encourage entrepreneurs with great businesses that are changing patients’ lives and disrupting industries to contact us about partnership opportunities, whether or not they believe they fit the traditional venture lending profile.
- Ibrahim, D. 2010. “Debt as venture capital.” University of Illinois Law Review, 2010, 1169–1210.
- González-Uribe, J. & Mann, W. 2017. “New evidence on venture loans*” LBS PE Symposium. https://www.dropbox.com/s/5l9xntjdzrs1xbg/LBS_PE_symposium.pdf