«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
Venture debt and mezzanine-style finance Uses and targets One of the names most closely involved with venture debt in the US, and increasingly in the UK, is Silicon Valley Bank. It specialises almost exclusively in the technology sector. While Silicon Valley Bank is a full service commercial bank serving all stages of the market, it is active in providing capital in the form of venture debt to businesses from pre-revenue up to turnover of
around £50m and beyond. Director of Commercial Banking, Erin Lockwood, explains:
In earlier stage businesses, the main purpose when using venture debt is ‘runway extension’ – providing additional capital for a couple of quarters to hit a key milestone and drive valuation for the next round of equity. Alternatively, it is to speed up growth.
The advantages are flexibility and the non-dilutive nature of what we offer. We do take warrants ranging from 25 basis points to 2% on a fully diluted basis, depending on the deal; however, this form of finance is substantially cheaper than equity.
While we can also consider venture debt for later stage businesses, we have a full breadth of debt products which can be more appropriate for smoothing out a working capital cycle, for acquisition purposes or building inventory, for example.
Whilst in the corporate world Silicon Valley Bank does get reports from third parties from time to time, and note is taken of investor enquiries and opinions, all the due diligence work is done in-house, with external lawyers being involved sometimes before and always after term sheet
Amongst other things, they check that the IP is unencumbered, and that the technology service or offering is not reliant on another third party’s technology. If it is, we need to have confidence that the supply is rock solid, or that there is an established alternative.
In terms of technology due diligence, Silicon Valley Bank does not “crawl over the code”; the risk it seeks to assess is whether someone is going to buy the service and which companies
have the best chance of commercialisation at scale, rather than whether it is technically brilliant:
There are many examples where there is market pull without impressive technology.
While we like to understand where the investment and development effort will be focused, we also rely on management team experience, competition, and the disruptive nature of the business model. Software as a service, for example, is a fantastic model for a lender.
Stuart Ager now lends to a range of businesses that have realistic, deliverable growth plans (some of which are ‘hi-tech’, but many of which are not). His current activities are in the context of a specialist financier that can lend at interest rates of 10% or more, and can therefore tolerate a higher rate of default (“The problem for a bank is that if one loan goes wrong out of a book it can turn the whole thing bad. Traditionally they work off a 1-2% net write-off rate”). He
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One example where banking and venture debt/mezzanine funding are overlapping is the Breakthrough programme from Santander’s Corporate Banking division, a recently launched initiative, backed by a £200m allocation for lending to high growth potential SMEs. Over 400 companies have already expressed interest in it, many of whom display the typical profile of being IP and intangibles-rich and light on tangible fixed assets. At the time of compiling this report, 14 deals have been done averaging £1m each.
Breakthrough sits above traditional bank finance in terms of price, but at the lower end of existing mezzanine finance solutions. Its launch represents explicit acknowledgement that there is a funding gap for fast-growth businesses.
As with any other debt vehicle its preconditions stress the need for a track record of strong growth and cash generation, but unlike venture debt facilities it does not require businesses to be VC backed (or to bank with Santander beforehand – although bringing banking to Santander
is a precondition for a Breakthrough advance). Midlands Director James Cooksey explained:
How security is obtained and used Silicon Valley Bank always participates alongside venture capital when lending to earlier stage businesses: ‘it is important that venture debt be used as a supplement to equity, not a replacement of equity.’ It acts as a senior lender, and in the UK it takes a charge over all a company’s assets, including all IP. This is due to both legal and commercial protections.
The bank’s deal documentation will typically involve both negative and affirmative covenants, with a key area focused on licensing (‘if for example a biotech company exclusively licenses its IP out – that can be an issue for any lender’) and protecting the business’s IP position. It will also require IP to be updated periodically, and Silicon Valley Bank takes a view on whether something new is core or not to see whether it needs to refine certain documents.
Erin Lockwood feels a bank operating in this space needs to understand the ups and downs of an SME and stresses that Silicon Valley Bank sees itself as a ‘patient lender’, and one that regularly works alongside management teams and the Board to weather challenging situations as a partner.
The importance of this attitude is echoed by Neil Pitcher, founder and director of LGF Partners and former CEO of ETV Capital, who has a wealth of experience in managing venture debt operations across Europe. He provided facilities alongside venture capital companies for two separate providers until his most recent fund’s activities were curtailed by the financial crisis.
Over two cycles from 1999 to 2012, he has seen £300m invested and only £15m provisioned, i.e. 5%. “I suspect the lending book for property over the same period would look an awful
lot worse.” He adds:
We can’t behave like some other lenders and go for a fire sale at the first sign of trouble. I have never seen one company that has hit its business plan – it will always under or over-achieve at certain points. This is expected! So the account management needs to be different, as well as the risk assessment.
Patents are regarded as very important, though Pitcher has also been involved in taking security over brands, drug formulae and software code, which need to have escrow processes in place.
It is particularly important that the company keeps all these assets up to date and notifies the lender of new releases or new patents. These are also important at exit, as it determines the value that will be realised (an observation also made by equity investors in Chapter 4).
By the exit point the debt element may have been paid off, but for the venture debt provider, the warrant portfolio still exists, and because competitive considerations are less intense, a lender can make money even if a VC does not. On occasions, the venture debt facility has even covered the costs of additional protection for the core IP.
In terms of security, the Growth Loan fund under management by Ager will seek the following:
We will take an ‘all assets’ debenture registered at Companies House – possibly including a fixed charge over any identifiable, key asset. The debenture will give you a fixed and floating charge which will catch IP, but it won’t value the IP because you only 82 The role of intellectual property and intangible assets in facilitating business finance
In Neil Pitcher’s view, the venture debt thought process can be translated to banks, if they use the right products (for example, venture debt always has capital repaid from the outset, so there is never a 100% write-off, especially after taking the various fees into consideration). However, while he sees this as a question of education, he believes changing bank lending culture will only
come with case studies and experience. He provides an example:
Pitcher attributes general bank reluctance to get involved with IP as being chiefly down to a fear
of the unknown:
The perception that there is no value in IP is wrong… We only lent to companies that had IP, and it was viewed as the core asset of the company, especially as it’s the asset that will have driven investor behaviour. We took a senior debt position which was always secured on the IP asset, so if the company defaulted, we had a right to go and sell it. If the VC believes that the IP is worth more than the outstanding loan balance, then they will not let this happen.
Where there are difficulties concerning IP, they have generally related to confirming ownership, for example where a core patent used by the business has turned out to be on license from a university.
A clear path of ownership is essential. Sometimes the company itself doesn’t appreciate the importance of having ownership, or obfuscates. These situations can be renegotiated, for example to a revenue share, but they can prove a killer.
Erin Lockwood’s position is simple: “It has to be an innovative business, or we’re not interested.” The further a business is from having core defensible IP, the less aggressive Silicon Valley Bank is likely to be, both on lending terms and facility quantum. Even where the bank gets involved with e-commerce or social media businesses, it is still looking for a defensible USP versus others in the market.
Silicon Valley Bank will still look at innovation that is non-patentable, and the portfolio features some companies in this category. Here, past experience with the VC and/or the management team involved will come into play, especially if the business is pre-revenue.
Whilst the bank does not separately value IP, and does not necessarily quantify the value of the
company as a whole either, Lockwood thinks about enterprise value as a risk mitigant:
If the company continues to grow and is enhancing enterprise value, our assumption is that someone will want to buy it or invest in it further.
Silicon Valley Bank has had an excellent track record in lending to both early and late stage innovation businesses globally. Credit quality has been extremely strong with any losses well below industry averages.
In considering how these approaches might be more widely adopted, the experiences to date of Clydesdale Bank are particularly instructive. Its Growth Finance initiative adopts some of the principles and practices associated with venture debt within mainstream lending.
Head of Growth Finance, Graeme Sands, explains the motivation for looking at this area:
Businesses are changing, from those that use physical assets to service businesses and IP-based businesses. If banks continue to look for physical assets, it follows that the lending opportunity may reduce.
84 The role of intellectual property and intangible assets in facilitating business finance
Whilst there are fixed and variable exit fees, the bank does not use warrants or equity ‘kickers’, so the success of the model is not dependent on exits being achieved. The bank relies on its senior lending charge and covenants, term lending (generally over 3-5 years, with some later amortisation possible) and specialist invoice finance.
In the assessment process, Clydesdale Bank seeks mainly to establish a clear relationship between the IP and the cash flows, rather than lend against a specific IP value. A specialist ‘stretched’ form of invoice finance for growth finance companies is then deployed in order to ensure the bank stays as close as possible to the company’s cash. As Sands explains, “Invoice discounting slows down the burn rate for working capital, and term lending covers the losses.” In building its portfolio, the Clydesdale team has been able to draw on wider experience in managing venture debt across Europe. Sands is confident that technology businesses with
underlying IP make good lending propositions if the company and the package are right:
Sands confirms that whilst the bank takes a charge over the company’s intellectual property, it does not often focus on its value, and does not attribute a value to it within the final terms, so it is technically ‘unsecured’.
We think this is the most prudent position. We are building our own data set, but we are not sure there is a good enough external data set to support the attribution of value. Also, we work in a highly regulated environment, which is precisely why we have a secured senior charge, have covenants and look at a slightly later stage. The discussion around asset categories that attract reduced capital loading is one for the regulators.
Even if a bank does not wish to set up its own operations to specialise in IP in this way, there is no impediment to making investments in other organisations which can offer this focus. One
senior banker who preferred to remain anonymous made the following observations:
I think one of the most sensible strategies is for banks to invest in funds. We can’t otherwise make the returns to satisfy the risk, but we could collectively back a fund that would go out and make the investments. However, I still think the Government would need to stand behind it in some way.
There has been some movement in the past on this front – if you look at the funds like Kreos, Noble, ETV and so on – they’ve got experts, properly trained people and a good track record. They still have a job convincing people, but it’s a much better way of doing it. You’ve got to be able to take security, know what you’re taking, how to take control of it, understand where you can sell it, and do proper due diligence.
FSE CIC and its group subsidiaries, together known as The FSE Group (www.thefsegroup.
com), manages grant, debt and equity funds in the East of England as well as the South East region. It has been operating for over 10 years and has built up a significant body of experience in working with SMEs from very early stage to later growth.