Venture Debt: Considerations for Healthcare Innovation Companies
November 2024 marks 20 months since the venture debt markets were shaken up by a string of notable technology bank struggles (think Silicon Valley Bank, among others), where some expected venture debt financing to disappear.
Fast forward to today, and although the remnants of macroeconomic headwinds remain, the venture debt markets are on the upswing, with $23.5B raised in the U.S. in H1 2024 compared to $27.1B raised in all of 2023, according to J.P. Morgan. The median venture debt deal size was roughly $5 million in H1 2024, more than 2023, and in line with the median deal size in 2020-2022.
With down rounds and unpriced rounds occurring on the equity side, healthcare innovation founders may consider a venture debt credit facility for additional working capital and to shore up their balance sheets. The credit facility can also be used to expand into new markets or patient populations, invest in R&D and clinical studies, scale technology infrastructure, fund acquisitions, and achieve other revenue milestones. From a legal perspective, there are a number of things a borrower should know before taking on venture debt.
What is Venture Debt?
Venture debt is an umbrella term for credit facilities aimed at growth stage and venture-backed companies. This financing typically complements equity funding, providing additional capital to extend the company's runway, support growth initiatives, or bridge gaps between equity funding rounds. In contrast to traditional business loans, venture debt focuses on a company’s strong venture capital backing and prospects, rather than the company’s positive cash flow or asset base.
Although venture debt transactions are context-specific and vary widely, there are a number of common characteristics. As a structural matter, venture debt is generally non-dilutive; that is, it allows companies to raise capital without diluting existing shareholders’ equity, which is a plus for founders and early investors. And unlike traditional bank loans or revenue-based commercial financing, venture debt lenders generally do not require positive cash flow or profitability. In exchange for the increased risk, however, venture debt typically carries higher interest rates and often gives the lender some equity upside, through warrants.
Benefits of Venture Debt for Healthcare Innovation Companies
Non-Dilutive – Venture debt is non-dilutive, meaning that the Company’s existing cap table will not be affected (unless a warrant or equity kicker is exercised, more on this later). This is an attractive options for founders and investors that want to raise additional capital, but are sensitive to the dilutive effects of selling equity.
Board Composition – Venture debt transactions typically do not require that the borrower grant the lender a seat on the Board of Directors. This means that the current board composition remains the same, which benefits existing founder and investor board seats.
Free Cash Flow for Expansion / R&D – Additional capital obtained through venture debt can be deployed in a variety of ways. Funds can be used to expand into new states or patient populations, invest in R&D ahead of an FDA approval, build out an enterprise-wide AI tech stack, or fund payor contracting efforts. Ultimately, venture debt can be leveraged to grow your bottom line.
Bridge Between Equity Rounds – Proceeds from a venture debt deal can also be used to bridge the gap between equity rounds, such as between a company’s Series A and B, for example. In this use case, the venture debt is often paired with a convertible note raise, in which the convertible notes are subordinated to the venture debt.
Interest-Only Payments – Some venture debt terms will include interest-only payments for anywhere from 12-18 months, so that a company’s cash flow will be less constrained by debt payments during the initial period of the loan. This means you can deploy capital without being strained by principal payments from signing date.
Legal and Commercial Terms in Venture Debt
There are a number of considerations that will need to be worked through in connection with a venture debt transaction, including:
Interest Rates and Fees – In the current interest rate environment, borrowers have an increased focus on the applicable interest rates, which may be fixed or floating based on the prime rate. Companies seeking venture debt will also want to understand any facility fees, closing fees and unused line fees.
Equity Kickers – Venture debt lenders typically seek some sort of equity kicker in connection with the credit facility, whether through warrants to purchase common or preferred stock, or success fees that are paid to the lender upon a change of control or exit transaction.
Covenants – Lenders may require financial covenants that the borrowers must meet; the severity of these covenants varies widely, and covenants are often highly negotiated.
Security – Venture debt will generally be secured by the borrower’s assets; one point of negotiation will be whether the borrower’s intellectual property assets are subject to liens by the lender, or whether a negative pledge of IP is sufficient to give the lender comfort.
Call to Action
Venture debt can be an attractive option for healthcare companies, especially those that are venture-backed and in high-growth phases. A knowledgeable legal team is critical in healthcare venture debt deals due to the dual complexities of corporate and healthcare law.
Understanding the legal implications of a venture debt transaction can help startups navigate the venture capital landscape effectively and efficiently. If you’re looking for a strategic partner to support you as you explore venture debt and other forms of capital, our team at Nixon Law Group has the experience and knowledge you need. Contact us today to learn more about how we can partner together.