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Wednesday, February 10, 2016

Beware the Spike


The Real Risk of Venture Debt

A couple of years ago I was with a med-tech CEO who referred to venture debt as being like a super charger for your car.  Strap it on and you get immediate low-end power to accelerate your efforts.  Along with the super charger, he explained, a spike gets placed in the middle of your steering wheel.  Slow down too quickly and you get impaled.

At the time, this seemed like dramatic hyperbole.  A recent experience suggests that if anything, it is indeed dramatically accurate.

I was an investor in a med-tech company that had done a remarkable job of syndicating angel groups in order to raise many millions of dollars to bring their product to the market.  They were able to do this because the technology was clever, addressed large markets and the management team, while young, seemed talented and driven.   In addition to the millions in angel funding, the company had taken in almost $4M in non-dilutive grants.

The company was in an enviable position.  Regulatory approval had been received and the science provided a pipeline of future indications.  All they had to do was get out there and sell.  What’s not to like?

To drive the sales and marketing effort, the company took on approximately $3M in venture debt in the face of protests from several investors.   The company was convinced, that this was a great way to get the company to cash flow breakeven without any additional dilution – no matter how limited.

As in most venture debt structures, there was a fairly long interest only period that seemingly would provide the company the necessary cash-flow runway to get the products launched.  All they had to do was hit their sales projections.  Even if they only achieved their “worst-case” scenario, they would be able to service the debt and eventually get to break even.

Those of us that have been through product launches in this space, however, know how smoothly they typically go, particularly in a capital constrained model.  “Worst case” is rarely truly worst case.  And this situation ran true to form.  Sorting the go-to-market model out took almost 18 months, but they did figure it out.  A re-launch of the product with the proven model brought steady revenue progress and a growing number of satisfied patients and clinical champions.

The challenge, however, was that by this time they had run through the interest only period on the loan and principle payments were coming due which would quickly make the company run out of cash.  More funding would be needed to get to break-even.

The logical step was to pull a bridge round together from the existing investor base to provide this runway.   Unfortunately, the fact that the company missed their initial sales targets made the angel investors wary to provide additional funding even though things seemed to be headed in the right direction.  Perhaps more importantly, the debt overhang meant that the bridge funds would be going to service debt as much as grow the company.  Unsurprisingly, this is not what your typical angels want to do with their investment.   In the end, after weeks of negotiations between all parties, because of these dynamics the bridge round failed to materialize.

The company quickly found itself unable to raise funds of any sort and in violation of their loan covenants.  Consequently, the venture debt group put the company into default.  Within weeks the assets of the company were liquidated at pennies on the dollar under a UCC article 9 sale.  This meant a total loss to the company’s founders, employees, investors, and patients that benefited from the technology.

Should the company have anticipated their cash runway better and started a raise sooner? Perhaps, but they really needed to demonstrate the sales model was working before they had any chance of making a raise a success, so it likely would not have helped.  Could they have negotiated better with the shareholders and debt group?  There was plenty of effort put into achieving this by all parties to no avail.

In the end, the biggest issue was the fact that venture debt was the wrong tool to use given company’s unproven sales model and more importantly, angel investor base.

If debt had been utilized to accelerate the growth after the sales model had been proven and a reliable revenue ramp demonstrated, it might have made sense.  I would argue that even in this case, having a shallow but wide base of investors would make venture debt too risky as there is not the necessary committed investor with deep pockets in place to cover, in the event of a miss on the company’s part.

Having subsequently spoken to a number of CEO’s who have had relatively good experiences with venture debt, my specific take-away from this costly experience is two-fold:

  • Venture debt can be a useful tool if looked at as a vehicle to leverage institutional funding assuming the investors have pockets deep enough and the interest and commitment to bridge or cover in the event of a financial miss. Without this, you risk getting impaled.
  • Getting hung up on dilution and valuation, particularly to the point of utilizing risky strategies to achieve milestones, is simply not worth it. Work hard to get money in early, with reasonable valuations.  Take more than you think you need even at the risk of over capitalizing and even at the risk of more dilution that what in hindsight might have been necessary.  This is much better than having stake driven through your heart.

 

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