Something ventured, something gained

Start talking about the mood in venture capital with some venture capitalists (or better still, some LPs with significant exposure to VC) and you're likely soon to be looking at some pretty long faces. If for good measure you dwell on the bubble that was – technology -and what many are increasingly regarding as the bubble that is – life sciences – then you'd not expect the mood to lift much. The venture capital world, both in the US and Europe, is still having to work through some fairly fundamental changes in methodology. Or, as one COO at a leading VC firm active in both of the aforementioned sectors puts it: ?The road's longer, there're more corpses along it and you can all too easily take a wrong turn.? The period of financings closed in weeks, abbreviated A, B and C funding rounds and accelerated IPOs are long gone: instead there's a return to long term investing and hands-on input for portfolio companies. And as another active tech VC puts it: ?Everything takes much, much longer.?

?You get lower capital gain, but the risk is lower too?

So it's in these sober venture times that another ingredient could make a crucial difference to the investment proposition: venture debt. Well-established in the US as a means to help bright young companies survive while they're still burning cash without their equity being cut to shreds, this alternative capital source to equity finance is now beginning to gain traction in Europe. As Simon Acland at UK VC firm Quester says: ?It's not the whole answer but it's certainly something we see as part of the financing solution for our companies.? As evidence, Acland estimates that some 15 per cent of the firm's portfolio are already using venture debt alongside the equity finance they themselves have provided. It is thought that in the US, around a third of VC backed companies are using venture debt.

So what is it?
There are essentially two forms of venture debt: a loan product and a lease product, which are by design orthodox financing tools but are here rendered distinctive by the inclusion of equity warrants. The venture debt provider not only provides loan capital in return for interest payments and the venture lessor not only delivers a lease in return for monthly payments: both also receive warrants for ordinary (or preferred) shares in the client company. This is the upside that helps deliver the kind of returns a capital provider working with high risk, cashflow-negative companies require to make the equation work. But there is also the crucial benefit to the company that, compared to the capital coming from the VCs, existing investors' equity stakes are not being diluted heavily. An oft-used term for venture debt is that it is expensive debt, but very cheap equity.

Two of the leading proponents of venture debt in Europe are GATX European Technology Ventures and European Venture Partners. While the former specialise in delivering venture loans, the latter are focused on venture leases. Both have been growing a close relationship with leading European venture capital firms such as 3i, Atlas Venture, Schroder Ventures Life Sciences, Benchmark and Quester, who are investing in young companies based within the technology and life science sectors. These are investee companies that take more than just a few years to deliver a realisation to their investors and in the meantime can require hefty inputs of capital to not simply operate but also to continue to develop. In these circumstances a venture lease, for instance, can be extremely valuable.

As Piers Morgan, an ex-Close Brothers banker and now CFO at Arrow Therapeutics, which has used a venture lease from EVP, comments: ?We're keen to spend the money on the science, not the hardware.? Thus a firm can take out a 100 per cent lease with no deposit on a range of vital fixed assets: from PCs and servers, through telecommunications hardware and office furniture to test and measurement and other laboratory equipment. ?Capex can be chunky in this sector,? comments Morgan, ?and when you're planning your R&D it's a good thing not to be caught up in buying the kit but rather concentrating on its deployment.? Venture loans are also a valuable part of the financing arsenal open to a life science company, given that one drug can cost up to $800m to get to market.

Working alongside the VCs
Companies that have attracted venture capital backers clearly have reached the stage where the business has the necessary substance to make them attractive targets for investment. Likewise the P&L, albeit immature and still cashflow negative, has reached sufficient robustness to make the investment proposition compelling to the VCs.

It's also the case that in the technology and life science sectors, VCs will have done their homework in terms of projecting subsequent financing rounds to have produced a detailed set of forecasts and benchmarks for the business. This creates an ideal opportunity for the venture debt providers to participate in the funding, combining their own due diligence with the VCs. ?One prerequisite for us is that the company has VC funds in place,? says David Gravano at GATX European Technology Ventures in London. Not only is the VCs' presence a badge of credibility but also gives the venture debt providers additional comfort when reviewing the repayment schedule for their own financing.

The venture debt providers will often see subsequent equity rounds being used in part to pay off the venture debt – although this is something some VCs may balk at if there seems to be little enduring benefit to the portfolio company. But, as Acland at Quester confirms, a VC can often see venture debt providing a vital funding extension beyond the equity capital that will take a portfolio company further down the road – to the point that a subsequent equity-financing round can be made with much greater confidence. ?If a company is well funded with equity capital for two to three years then venture debt is much less relevant. But if the equity capital coverage is shorter then it makes a great deal of sense,? he says. It also makes sense for the company that finds itself lagging behind forecast, raising the prospect of a funding gap as cashflows fail to cover capital requirements. Then, venture debt can be used to ?extend your runway.?

Fred Worth, the CFO at specialist programmable chip designer and software firm Anadigm Limited, takes the pragmatic view that so many financial managers develop as they monitor and sustain their companies' financial health. Anadigm took on a $2.75m venture loan from GATX European Technology Ventures in May this year. Anadigm's VC investors include Quester, 3i and NIF Ventures. ?We weren't running out of money but this financing was put in place to take ourselves beyond certain key value-adding milestones,? says Worth. ?We were able to push ahead with testing and then product launches – crucial stages for the business.? And in Worth's book the cost of the venture loan made sense because the dilution on equity brought about by the warrants was minimal. ?It's not inexpensive debt but the equity cost was not significant,? he comments. ?The equity participation was entirely appropriate because it was a few percentage points [of the company's equity]. So for 10 to 15 per cent more funding this cost is negligible.?

Not cheap but not expensive
It's not as if a venture loan or lease comes in cheap if compared to mainstream financing though. Everyone involved has to accept that the venture debt providers expect to levy a much higher charge than your average bank or lease company. Interest rates for venture loans are not a few hundred basis points above LIBOR but instead are in the teens and similarly the leases are charged at rates markedly in excess of traditional, orthodox terms. The venture debt providers also expect to sit at the top of the heap when it comes to security: the venture loan provider will want to be the senior secured lender and will insist on first call over a company's intellectual property – often one area where the business will have established some significant value. The venture lease provider, in contrast to having a claim over the IP, will want to have a lien over the key fixed assets of the company.

These sort of charges and claims can leave the impression that this is a more than just risky business and that venture debt providers find numerous client companies crashing to earth.

But the percentage doesn't seem high. Although details are hard to establish, Gravano at GATX European Technology Ventures estimates that bad loans in the portfolio are less than 10 per cent. And the equity sweetener in the form of the warrants clearly moves the returns up from the good to the potentially better still. Venture debt providers don't attempt to apply coverage ratios for their financing using the warrants. ?The warrants are not there to provide protection,? says Gravano, ?they're not defensive but rather provide upside potential sufficient to compensate for the risk in providing these loans.?

?2002 will prove to be an important year for making debt investments in quality companies?

At present though, realising value from the warrants is not easy: just like the VCs, the venture debt providers are having to watch and hold whilst the companies they have financed nurse themselves back to health: remember that both the VCs and the venture debt providers who follow them have been heavily involved in the technology and life science sectors. IPOs are remote and trade sales at sensible exit multiples are almost as distant a prospect. ?Our IRRs for 2001 are down compared to previous years,? admits Gravano.

But unlike the VCs, the venture debt providers have repayments flowing back to them from portfolio companies and a finite term to these (typically 36 months) that makes them seem far less subject to the still deep uncertainties of these sectors. Which makes one wonder whether venture debt might not be an interesting way for investors to find their way back to venture-style investment with (almost) venture style returns. As Maurizio PetitBon at European Venture Partners puts it: ?Whereas a VC fund has to wait for exits in order to crystallise returns, venture debt provides a steady cash flow from day one. You get a lower capital gain [than the VCs] but the risk is lower too.?

At present though the takers are few: GATX European Technology Ventures is a joint venture with US-listed GATX Capital Corporation and leverages its own balance sheet to source capital. EVP is backed by three large European banks: The Royal Bank of Scotland, Dresdner Kleinwort Wasserstein and Fortis Bank. Both companies unsurprisingly see venture debt as an increasingly relevant investment destination for those wary of venture capital but yet drawn to the kind of returns VC can deliver. Says Gravano: ?We are confident that 2002 will prove to be an important year for making debt investments in quality companies.?

Venture debt has yet to become more widespread in Europe, but this is something everybody who has used the products (VC as well as entrepreneur) sees simply as a matter of time. And the venture debt providers themselves are bullish too, with both Germany and Scandinavia – where there are both big tech and life science centres – being cited as important markets. There is then the small matter of seeing those warrants deliver the kind of realisations that the venture debt providers hope for and their VC counterparts long for.