July | August 2006 | Arguably, the company financing model is broken. Someone recently quipped that there “is a monsoon of capital, but entrepreneurs are dying of thirst.” Ironically, startups continue to have a very challenging time raising a seed or Series A round of financing, while later stage companies are now faced with a near-dizzying array of financing products.
The private equity markets, both venture capital and growth equity, while characterized by a number of established firms, continue to struggle with how best to finance early-stage, risky bio-IT companies. Industry estimates that there are nearly 700 institutional venture firms in the United States today with upwards of 7,500 practicing venture capitalists. As numerous as that appears, entrepreneurs continue to struggle with raising that first round of equity. Creative sources of early-stage equity capital need to be explored from venture firms, to friends and family, to nondilutive grants.
Increasingly prevalent in today’s market is the strategy of tranching, which is when a group of investors commit to invest, say, $5 million, but will only “release” an initial $500,000. This forces the entrepreneur to very clearly articulate near-term milestones and use only those resources necessary to be successful. But entrepreneurs need to beware that this can simply provide your investors a “free option” on the next $4.5 million tranche.
As constrained as the early-stage equity market now appears is how wide open and evolved the debt market is for these companies. To be clear, to access these other forms of capital, most companies will have achieved some minimum performance milestones and will often need to have respected equity investors. But in many cases, companies are able to access attractive forms of leverage and growth capital even pre-revenue, and occasionally, pre-product.
The most traditional forms of growth capital are provided by commercial banks and similar financial institutions and are collateralized by the assets of the business. Tom Davies at Silicon Valley Bank in Boston, a leading provider of capital to emerging growth companies, observes that “there is a ton of capital chasing transactions” in the current environment. Davies goes on to warn though that “it is leverage on the way up, but it is debt on the way down.”
The relative ease of accessing this capital at times may mask the true costs. Often, these loans are structured to amortize well before the company is generating cash flow, which may put the company in an awkward position and require the entrepreneur to raise additional equity at a very problematic time. Additionally, there is a seduction to put as much cash on the balance sheet; savvy entrepreneurs and investors have painfully learned that too much capital can be as dangerous as too little.
Continuum of Capital
As one moves along the continuum of types of capital a very popular financing instrument is venture debt, which typically is not collateralized by assets and looks very much like equity but must be paid back over a shorter period of time. The institutions providing venture debt are competing aggressively in today’s market and entrepreneurs will find very attractive terms. Typical financings range from $5 million to $15 million in size and often come with modest warrant coverage. Many venture investors are keen to explore this source of financing, as it extends a company’s runway and may be a bridge to either an IPO or a mezzanine round.
Like many of these instruments, the evolution is driven by the advent of hedge funds and the fact that these investors are looking at novel creative ways to finance growth companies to earn higher returns. Consistent with this development is the emergence of “royalty-based financing.” A number of firms are now allowing companies to monetize future royalty or revenue streams in a nondilutive manner.
Royalty-based financings have a cost of capital somewhere between equity and venture debt that translates to the mid-teens cost of capital. Greg Brown of Paul Capital in New York says that “this approach is a novel way for investors to invest in commercialization risk, not development risk.” Typical deal sizes range from $20 million to more than $100 million and are often structured to look like traditional licensing deals.
Entrepreneurs should be conversant in what is available to them over the entire lifecycle of their company as they set out. Quite clearly, many of these instruments are not appropriate (nor available) to early-stage companies, but having a perspective as to how one is going to scale the business and most efficiently access capital is important. As the capital markets gain in sophistication, everyone stands to benefit.
E-mail Michael A. Greeley at firstname.lastname@example.org.