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USASBE 2008 Proceedings - Page 1279

SMALL, ENTREPRENEURIAL BIOTECH FIRMS AND COMMERCIAL BANK LENDING: A STUDY David George Vequist IV University of the Incarnate Word 4601 Broadway CPO #460 San Antonio, Texas 78258 (210) 805-5825 [email protected]


ACADEMIC ABSTRACT In a fairly recent article of BusinessWeek, the author states that we may be on a cusp of a new age of innovation (Mandel, 2004). Advances in biotechnologies, nanotechnologies, and information technologies will continue to influence the landscape of modern business for years to come. Spending on research and development (R&D) has increased rapidly in the United States. Leading this growth will be American small businesses which will continue to play a significant role in the overall economy. In this research paper, the interest and attitudes of commercial lending banks towards lending funds to small, biotechnology startups is surveyed. EXECUTIVE SUMMARY In a fairly recent article of BusinessWeek, the author states that we may be on a cusp of a new age of innovation (Mandel, 2004). Advances in biotechnologies, nanotechnologies, and information technologies will continue to influence the landscape of modern business for years to come. U.S. R&D (federal, industry, and other funding sources) grew six percent between 2005 and 2006, buoyed by increases from all funding sources. The National Science Foundation (2007) shows that after stagnating in the early part of the decade, total U.S. R&D grew in 2006 (for the fourth year in a row) to $343 billion (a new high). Leading this growth will be American small businesses which will continue to play a significant role in the overall economy. According to a Federal Reserve Bank of Dallas publication (2003, p. 2) U.S. small businesses “represent more than 99.7 percent of all employers and employ more than half of all private-sector workers. They pay 44.5 percent of the total U.S. payroll and generate 60 to 80 percent of net new jobs annually.” So, it is easy to see that small, startup businesses are on the forefront of this innovation wave. Many of these firms are likely to be the champions for many of the future innovations in biotechnology. It is possible that these biotechnologies will breed a new generation of companies like Pfizer, Merck and Amgen. But, before these companies can become multibillion dollar, multi-nationals they will begin as small businesses that require capital and have small-business lending needs. This research shows that traditional commercial banks realize that funding small biotech businesses requires a new and different lending model. However, most local branches of large national and medium-sized regional banks are reluctant or disinterested in lending to small, biotech startups (one of the fastest growing small business segments). INTRODUCTION In a fairly recent article of BusinessWeek, the author states that we may be on a cusp of a new age of innovation (Mandel, 2004). Advances in biotechnologies, nanotechnologies, and information technologies will continue to influence the landscape of modern business for years to come. Spending on research and development (R&D) has increased in the United States (U.S.) from one point six percent in 1981 to two point six percent in 2006 of the gross domestic product (GDP). U.S. R&D (federal, industry, and other funding sources) grew six percent


between 2005 and 2006, buoyed by increases from all funding sources. The National Science Foundation (2007) shows that after stagnating in the early part of the decade, total U.S. R&D grew in 2006 (for the fourth year in a row) to $343 billion (a new high). Leading this growth will be American small businesses which will continue to play a significant role in the overall economy. According to a Federal Reserve Bank of Dallas publication (2003, p. 2) U.S. small businesses “represent more than 99.7 percent of all employers and employ more than half of all private-sector workers. They pay 44.5 percent of the total U.S. payroll and generate 60 to 80 percent of net new jobs annually.” In addition, according to this article small businesses also: Create more than 50 percent of nonfarm private gross domestic product. Produce 13 to 14 times more patents per employee than large firms. These patents are twice as likely as large-firm patents to be among the 1 percent most cited. Employ 39 percent of biotech workers, such as scientists, engineers and computer operators. (Anonymous, 2003) So, it is easy to see that small, startups are on the forefront of this innovation wave. Many of these firms are likely to be the champions for many of the future innovations in biotechnology. It is possible that these biotechnologies will breed a new generation of companies like Pfizer, Merck and Amgen. But, before these companies can become multi-billion dollar, multinationals they will begin as small businesses that require capital and have small-business lending needs. This research shows that traditional commercial banks realize that funding small biotech businesses requires a new and different lending model. In an article by Asher (1999) in the American Bankers Association’s ABA Banking Journal he states: How times have changed. Ten years ago, a small business owner in need of financing didn't often have choices beyond a few local banks and finance companies. Today, he or she can pick up the phone to dial an 800 number, or hop on the Internet, and in short order an array of lenders who may be located hundreds or even thousands of miles away are willing and often eager to do business. In short, small business banking is starting to change in important ways from a strictly local to something more like a national market (p. 29). Banks have had to have a fundamental change in mindset. Traditional commercial banks, just like everyone else, know about the exciting startups of the late-nineties and early-aughts, which began in garages and before long turned into giant enterprises (Asher, 1999). Most banks are obviously interested in these customers. The difficulty may be convincing entrepreneurs that the banks are interested in being a service to these small businesses. In an article that looks at the role of traditional banks that service small, entrepreneurial businesses in Canada, the author states that “For generations, Canadians have been conditioned to think of bankers as an inherently stingy lot, for whom the essence of innovation is dreaming up new and ever more devious service charges. The idea that a bank might go out of its way to assist cash-starved


entrepreneurs would strike many people (cash-starved entrepreneurs in particular) as highly improbable” (Laver, 1999). The author of this 1999 article says there is some truth to the stereotype, but does believe the situation is slowly changing. The banks have seen the cliché of the digital age that “two kids in a garage with a bright idea can change the world” come true several times and they understandably want a piece of the action (Laver, 1999). In the article, the author describes a traditional commercial bank that has developed a spin-off subsidiary with a mandate to help promising new technologies make the leap to commercial viability. In the U.S., this role is served by venture capital firms, but according to the author “Canadian venture capitalists are generally too risk averse to invest in early-stage companies. They prefer to wait until there's a steady stream of revenues before putting any money on the line. As a result, many new ventures suffocate at birth or are forced to look south (to the U.S.) for financing” (1999). The bank realized that its “traditional criteria for approving business loans and investments were ill suited to the emerging, knowledge-based economy” so they decided to change their image by offering a different suite of services for high-tech startups (Laver, 1999). The author quotes a bank executive in charge of the startup financing, who states that "Companies were coming to us with a track record of losses and we were sending them away, telling them to come back when they had some hard assets on their balance sheets and a track record of profits, …We were either dooming them to failure or ensuring that they'd never come back, because once they were profitable they wouldn't need us" (Laver, 1999, p. 50). Authors Laird and Teckler (2004, p. 51) agree and in an article for Community Banker state that “Small business banking, an area where many community banks (includes commercial banks and savings associations) see potential for growth, is becoming increasingly competitive.” According to the Federal Reserve in the 2nd quarter of 2007 (p. 1) “Loans expanded at a vigorous pace, rising 3.1 percent ($172 billion) for the quarter.” Asher (1999) states that “Lenders have woken up to the fact that, as a class, (small businesses) are desirable customers, generally borrowing at better margins for the banks than larger big corporate borrowers do, and often presenting excellent cross-selling opportunities...” In a recent article from USBanker, de Paula quotes a banking executive that states “Most (small businesses) need retail banking products first, …it (then) generates business for the bank on the consumer side in terms of accounts, and then in the longer term, ultimately getting them to be small-business customers" (de Paula, 2004, p. 54). Therefore, in order to successfully compete, many banks are finding it necessary to offer a complete spread of small business banking products, including traditional products like deposit accounts and finding ways to offer equity funding or loans through a small business investment company, or SBIC (Laird & Teckler, 2004). A SBIC is a professionally managed private equity fund that can be formed by a partnership or consortium of banks that invest in small businesses. “SBICs have long been used by large banks, such as Bank of America and Union Bank of California, to make equity investments in small businesses” (Laird & Teckler, 2004). This type of approach particularly benefits small biotech entrepreneurs whose needs are offer not met at the branch of their local commercial bank. Some of the companies that have received SBIC funding while they were small businesses were Callaway Golf, Apple Computer, Federal Express, Intel, and Outback Steakhouse (Laird & Teckler, 2004).


One of the advantages of this diversification strategy (offering multiple products and services) to a small business is that it can even enhance bank profitability. In fact, according to a study by the Federal Reserve in 2007 bank profits have continued to rise slightly since 1992 (see Figure #1 below). FIGURE 1 Bank Profitability 1990-2006

Feig, in a recent article from Community Banker, quotes a banking analyst who states that “In an effort to increase revenues and improve their bottom lines, a growing number of banks are beginning to increase their investment in small businesses…” (2004). Laird and Teckler (2004) state that SBICs can enhance profitability of community banks in at least two ways: First, SBICs give community banks a valuable banking product-equity funding-for small businesses that may not meet the banks lending standards. This, in turn, allows community banks to build solid banking relationships with small businesses in the early stages, paving the way for more lucrative lending and banking relationships as these businesses mature. SBICs can also enhance business development opportunities for banks, because small businesses that have potential for successful growth are likely to have expanding needs for banking services. Second, the investment in the SBIC itself can also enhance the banks profitability. SBICs, like other private equity investment funds, can generate strong returns, albeit over a period of time while assuming considerable risks. (pp. 52)


Other products that traditional banks may offer to small businesses include tax-deductible grants (which qualify for Community Reinvestment Act credits) to poor or disadvantaged entrepreneurs (de Paula, 2004) and other services (typically offered by non-traditional financial institutions) such as revolving lines of credit, equipment finance, advice on small business plans, and tax advice (Asher, 1999). In designing an overall set of small business banking products/services, traditional commercial banks should consider including the equity financing needs of the small business community. Laird and Teckler believe that “The ability to offer equity financing to small businesses may be a factor that can differentiate them(selves)” (2004). SMALL, ENTRPRENEURIAL BIOTECH FIRMS In a recent U.S. Small Business Administration (SBA) news release, the SBA announced that it has approved a little over six thousand loans worth over one billion dollars for the period between October 1st and October 22nd, this compares with the previous year when the SBA only approved a little over four thousand loans for a little over six hundred and forty million dollars (SBA, 2004). A recent search on the SBA’s Tech-Net search engine (http://technet.sba.gov/tech-net/search.html- which lists small startup businesses that have received contracts with federal government agencies) returns over thirty-six hundred over the last two years. In the third quarter of 2004, VentureOne and Ernst & Young reported that venture capital investments were four and a half billion dollars to four hundred and sixty-seven companies in the U.S. (2004). Thirty-two percent of all this money went to seed-funding or first-round funding (up from twenty eight percent last year) and twenty five percent of the funding alone went to biopharmaceutical firms. PricewaterhouseCoopers in a more recent study (2007) found that the Life Sciences sector (Biotechnology and Medical Devices combined) had a strong 3rd quarter in 2007 with $1.9 billion going into 175 deals (Biotechnology alone had $1.1 billion going into 99 deals). In Texas, where this research takes place the trends have followed the national norms. The majority of venture capital funds have been focused on high-tech businesses. Specifically, the Federal Reserve Bank of Dallas stated in 2007 that “The biotechnology, medical devices and equipment industries are also making strides, with this life sciences sector identified as one of the drivers for innovation and economic growth” (see Figure 2 below).


FIGURE 2 Distribution of Venture Capital in Texas

All this data leads us to believe that BusinessWeek may be right when they predict that “the economy may be on a cusp of an age of innovation equal to that of the past 75 years” driven by new, small, technology-based startups (Mandel, 2004). These businesses, that will potentially be leading that charge into the future, will have an insatiable need for capital so that they can grow and thrive. TRADITIONAL COMMERICIAL BANK LENDING One of the important questions that will need to be answered in the near future will be the role of the traditional commercial bank (either a community-based bank or a local branch of a national/international bank) in this innovation revolution. Will they become the partners that are needed for these biotech startups or will this role continue to be filled by private equity firms (for example, venture capital and angel investors). According to Cowan, Featherston, and Nail (2004) this role may already be changing. Traditionally, customers of commercial banks use to concentrate on “relationships and bank reputation (which) were considered the primary factors in bank competition for small-business loans” (Cowan, Featherston, and Nail, 2004). They suggest that now, the small-business credit scoring (SBCS) system (implemented in 1995), is leading towards a paradigm shift in smallbusiness lending by banks. The authors describe how banks now “originate small-business loans based on both transactional and relational elements” which is supposed to enable bankers to “quantify the risks inherent in these loans” (Cowan, Featherston, & Nail, 2004). The expected outcome would be more banks entering the small-business loan market (or a measure could be greater percentage of the total bank assets invested in small-business loans).


In 2001, a study by Payne and Franck found that small business lending was relatively higher and growing (particularly among smaller banks) as a percentage of assets. This supports the findings of Cowan, Featherston, and Nail (2004) who found that “despite the very sluggish economy during late 2001 and 2002, small-business lending increased in large banks in both numbers and amounts.” However, they also found that “banks with assets of between $250 million and $1 billion showed the greatest increases in small-business lending, increasing the number of loans originated by an average of approximately 42 percent annually from 1996 through 2002” and that “this same trend is not evidenced in the small banks primarily with assets less than $250 million” (Cowan, Featherston, & Nail, 2004). Meaning that although there is an increase in the amount of small business lending it is increasing being generated by large banks at the expense of smaller banks (as predicted by the authors). This is pictured by Figure 3 from Cowan, Featherston and Nail’s article (2004, p. 29).


FIGURE 3 Number of Small Business Loans

Because this study takes place in Texas, the loan growth in Texas-based banks was analyzed as well (Robinson, 2007). The Texas banks also rebounded from the lows of 2000-2001 but seem to have stalled in 2005 (see Figure 4 below). Overall, the loan growth in Texas was recently described as ‘erratic’ by the Federal Reserve of Dallas (2007) FIGURE 4 Small Business Lending at Texas Banks


The good news for small businesses is that escalating interbank competition should result in a greater supply of loans with lower costs of funds for entrepreneurs. As Cowan, Featherston, and Nail point out, often times for small businesses “the line between success and failure is access to capital” (2004). The result according to these authors is that “both banks and small businesses will continue to benefit from the enhanced ability of banks” to conduct engage in small business lending (Cowan, Featherston, & Nail, 2004). Banks typically borrow or take in deposits at lower short-term rates and then lend out that money longer term at higher rates. The difference between those two rates is what they pocket and can affect their profitability. The challenge for banks in recent years has been the narrowing gap between these two rates, putting pressure on their profit margins. However, the longer this environment persists, the more banks have to worry about struggling to sustain their earnings. The squeezed profit margins may lead to too much cost cutting in such areas as internal controls, compliance, loan review and personnel. If this continues then on top of that, the banks may have a hard time in the future attracting the right talent to their management ranks. DATA COLLECTION In order to assess the interest, loan process, and attitudes around biotech startup lending in the local community, a study was undertaken to interview local small business bankers at traditional commercial banks. This study was performed in a large metropolitan city located in the southwest region of the U.S. Banks were chosen from a list of lending institutions that was published as a yearly supplement by the city’s weekly business journal. Seven banks were chosen from the supplement that had total assets over one hundred million and had a small business loan specialty department or officers. Two of the banks that was chosen did not have total assets listed but both were large domestic banks with well over a half a billion dollars in total assets (Bank A and E). Many of the banks were local branches of regional/national/international banking intuitions. The data from the banks are found in Table 1. TABLE 1 Description of Banks Interviewed Bank Total Assets Legal Lending Limit (U.S.) Currently Lending?

Bank A

Bank B

Bank C

Bank D

Bank E

Bank F

Bank G

NA

$1.3 billion

$9.6 billion

$100 million

NA

$332 million

$1 trillion

$8.4 billion

NA

NA

$1.4 million

NA

$7 million

NA

Yes

Yes

Yes

Yes

Yes

Yes

Yes


The small business loan contact was interviewed over the phone at each of the seven banks. In all but one case (Bank G), a local/regional branch contact person was listed as the small business loan contact. For this branch a toll-free eight hundred number listed connected the interviewer to a national small business lending contact. Each contact was asked the same questions from a standardized interview and all contacts were interviewed by the same interviewer within a week of each other. The standardized interview questions were as follows: 1. 2. 3. 4.

Would you consider offering funding to a biotech startup? What information would you use to evaluate the loan application? Do you have someone on staff that understands biotech business? Who would evaluate the business plan of a biotech startup? RESULTS

The interview data was collected and entered into Table 2 below: TABLE 2 Data from Banks Interviewed Bank Would you consider offering funding to a biotech startup? What information would you use to evaluate the loan application? Do you have someone on staff that understands biotech business? Who would evaluate the business plan of a biotech startup?

Bank A

Bank B

Bank C

Bank D

Bank E

Bank F

Bank G

Pure startupNo; One year operating history (financial statements)maybe 1. Financial statement 2. Business plan

Possibly, if not through the bank then definitely through SBA

Possibly, would consider under $500K

Yes, if SBA would guarantee

No, but can offer a personal (secured or unsecured loan)

Definitely not interestedmore comfortable with real estate lending

Yes, if SBA would guarantee

Business plan

Comfort level with the background/ credit of the parties involved

NA

Individual credit

NA

1. Business plan 2. 2 year tax returns

No

No

No

No

Not sure

No

May have some experience

Credit Analyst

Loan Officer

NA

NA

Underwriters

1. Credit Analyst 2. Senior Lender

Underwriters


When these primarily regional, commercial banks were asked about funding to a biotech startup the majority of the responses were that they would attempt to find the right financial vehicle for the startup. Surprisingly, only one small local banking institution said they would have no interest at all. Most of the small business loan officers that were interviewed had no experience in funding small, biotech startups but didn’t shy away from the challenge of trying to meet the entrepreneur’s needs (several through guaranteed SBA loans). Business plans were one of the most important ingredients to getting funding along with a good individual credit rating. LIMITATIONS The major limitation of this study was its generalizability. This study interviewed personnel at branches of the banks that were located in a city in the southwestern U.S. that has a lower percentage of biotech companies than other major cities. The major focus of the economy of this city is the service and hospitality industries so therefore the banking personnel may not be as familiar with biotech startups as a banker in Boston, Mass. for example. CONCLUSIONS The findings support the literature that the traditional commercial banks were becoming more interested in lending to small technology startups. Several of the authors researched suggested that banking institutions were changing or undertaking a “paradigm shift” and the results showed that these changes may have influenced the policies and/or behaviors of the banks in the region in which this study took place. There does appear to be less reluctance on the part of these financial institutions than was expected. Some of this may be the influence of greater competition and higher profit margin potential for these types of financial products. In defense of the banking institutions in this study that were not interested, they are attempting to keep the deposits of their customers secure and thus they engage in very conservative lending behaviors. In support of the diversity strategy as mentioned earlier, all the bankers interviewed were interested in serving biotech startups with traditional banking services (savings, checking, real estate loans, etc.) but not all were prepared to meet their capital needs. The interesting Catch-22 is that these same banking institutions would be willing (in many cases) to fund a restaurant which according to the SBA data is probably as equally risky as a technology startup. With great risk there is the possibility of great reward and according to the Federal Reserve Bank of Dallas (2007) “Biotechnology is risky business.” They state the statistic that for every start-up that succeeds, between 15 and 20 fail. In a fascinating interview with Nancy Chang (a successful biotech entrepreneur) in the 2007 March/April Federal Reserve Bank of Dallas’ Southwest Economy report, she is quoted as saying (p. 9): The good thing is that the U.S. is still the one place where people value creativity. There are savvy investors and hard-driving entrepreneurs in the U.S. who are willing to invest their money, time and expertise on innovative ideas in new drug development. This is one of the competitive advantages that will keep the U.S. at the forefront of pharmaceutical development.


REFERENCES Anonymous (2007a). “A Conversation with Nancy Chang: Taking the Pulse of Biotech” Southwest Economy: Federal Reserve Bank of Dallas, Issue 2, March/April 2007, 8-9 Anonymous (2007b). “On the Record: A Conversation with Bob Hankins - Taking Stock of the District Banking Industry” Southwest Economy: Federal Reserve Bank of Dallas, Issue 5, September/October 2007, 8-9 Anonymous (2007c). “Money Tree Report” PricewaterhouseCoopers and National Venture Capital Association, Q3 2007 US results Anonymous (2007d). “Report on the Condition of the U.S. Banking Industry: Second Quarter, 2006” Federal Reserve Bulletin, June 2007 Anonymous (2007e). “SpotLight: Texas Venture Capital - Revived Spending Ends Prolonged Lull” Southwest Economy: Federal Reserve Bank of Dallas, Issue 1, January/February 2007, 11 Anonymous (2004a). “Record Demand Continues for Government-backed Small Business Loans” SBA News Release, October 29th Anonymous, (2004b). “A Boom in Business Startups” CA Magazine, 137, 7, 12 Anonymous, (2003). “The SBA at 50: Q&A with Hector V. Barreto” Perspectives, Federal Reserve Bank of Dallas, 1, 2-4 Asher, J. (1999). “Small business: Suddenly everyone wants a piece of it” American Bankers Association: ABA Banking Journal, 91 (4), 28-31 Carlson, M. and Weinbach, G. C. (2007). “Profits and Balance Sheet Developments at U.S. Commercial Banks in 2006” Federal Reserve Bulletin, July 2007 Cowan, A., Fetherston, T., and Nail, L. (2004). “A Paradigm Shift in Small-Business Lending” Commercial Lending Review, 19 (4), 28 de Paula, M. (2004). “Grants to Poor Entrepreneurs Nurture Future Business” USBanker, 114 (9), 54-55 Feig, N. (2004). “Ahead of the Curve: Women-Owned Businesses to Outnumber Men-Owned Businesses by 2007” Community Banker, 13 (9), 82 Laird, R. H. and Teckler, M. D. (2004). “Small Business Investment Companies Offer Big Benefits” Community Banker, 13 (8), 50-51 Laver, R. (1999). “Millionaires in the making” Maclean's, 112 (24), 51


Mandel, M. (2004). “This way to the future” BusinessWeek, Oct. 11th Payne, T. H. and Franck, D. (2001). “Small-business lending trends and commercial bank performance” Commercial Lending Review, 16 (3), 42-47 Robinson, K. (2007). “Regional Lending in a World of Interstate Banking” Southwest Economy: Federal Reserve Bank of Dallas, Issue 2, March/April 2007, 11-13