BioVentures Investors Rules of the Game
Private equity consists of financial professionals investing in non-quoted companies with high grow potential in exchange of equity capital. The majority of private equity financial investors commit large amount of investment over medium or long-term periods. This holding time is necessary before the equity can be converted into liquidity after an IPO or the acquisition by a public company. Private equity generally includes different stage of financing, from early stage that requires venture capital, medium stage reallocation of capital from stakeholder through a buyout and larger investment for growth and expansion.
According to the European Private Equity and venture Capital Association, 80% of the entrepreneurs who approached private investors benefited directly from an improvement of their business and a better management of their finance. Externalities were also observed in term of networking and mentoring as well as a gain in credibility and recognition to external partners and customers.
Private equity can be considered by traditional investors as an alternative investment complementary to the stock and bond portfolio. When looking at return rates average within a ten years period in the US, the bonds return rates are 3–5% where the stock market is 7.4% for S&P500 index as compared to 17.4% return rate for private equity. The internal rate of return (IRR) is the net difference between capital invested and money returned to fund investors, taking into account the holding period. In addition of long term capital, private equity firm contribute to business performance buy helping in the adoption of better management practice, financial control and reporting. They will also help with their network of investors and strategy with private banking for capital consolidation and IPO preparation.
A private equity investment fund collects capital from primary general investors called limited partners (LPs). Those general investors are usually banks, pension funds and insurance company looking at private equity as one of the tools for diversification of their investments.
Sometimes funds are created by rich individuals, usually defined as family offices, in this case strategy and exposure can be different with investment criteria with higher risk and expected returns or dedicated field such as healthcare specific diseases or industry niche. A third category of funds, called corporate, is usually created by large corporation and has also some specifics in investment priorities and expected returns. Subscription to an investment fund is usually for a period of five to ten years according to the field of operation and the duration it takes from growth to exit. This gives stability to entrepreneurs who need time to grow their business before they repay their shareholders. Those investors are professionals who have a clear understanding of the financial risks inherent to their investment operations. The consolidation of an investment fund of general investors takes up to one year to build. After ten years, the fund must be closed and all portfolio projects must be divested.
The private equity company manage the fund with a team of managers called General partners (GPs). The GPs role is to use the fund capital to buy equity of high potential companies. Private equity company are usually specialized in one industry field (ie healthcare, digital, telecommunication, …) or in one geographical location (London , Geneva in Europe, San-Francisco or Boston area in USA, …). GPs create usually small portfolio of companies by fields and investment stage with a pipeline of project to enter and exit. Before conducting the investment, the role of GPs is to select wisely high potential business to invest, usually helping promising entrepreneurs to better define their business model and strategy in an iterative process and through the evaluation process (due diligence). After completing the investment, the role of the GPs is to advise wisely the entrepreneur to help their business to create value. The governance role of VCs include the “rights of first refusal”, the “Liquidation Preferences”, the “Participation” ensuring in the term sheet the reward for investors.
Venture capital are private equity instruments that focus on the early stage of the company development. Venture capital financing concerns mainly seed, start-up, post creation and expansion stages of the company development. In the particular field of life science, the strong regulation constraint the companies development who will need five to ten years to generate revenues through licensing its technology or accessing their first market. Considering the high risk/reward ratio at early stage and the needs of VCs to generate high profits for their limited partners. The only selected projects are those combining the most performing organization with the greatest growth potential.
In a 2013 HBR paper, Lerner ( 2013) evaluate the positive impact of corporate venture capital in the pharmaceutical industry : “A corporate VC fund like Lilly Ventures can move faster, more flexibly, and more cheaply than traditional R&D to help a firm respond to changes in technologies and business models. In some cases, such a fund can even help stimulate demand for a company’s own products. At the same time, of course, its investments may earn attractive returns — an added benefit for a tool that helps capture ideas that may ultimately shape an organization’s destiny.” While independent VCs have strong financial focus to return money for the limited partners the corporate venture funds invest for gaining strategic advantage.
Seed financing usually comes at the early stage with the first patents following research and initial proof of concept. Institutional actors such as government agencies usually provide seed financing. The following stage, at the start-up, helps in developing the product and validating the market with the definition of its business model, often at the time of entering the Phase 1 of the biomedical product development in patients. The business strategy takes place in the business plan. At this stage a core team join the project on operations and innovation. The risk and rewards are both high at this stage which explains the high attrition rate of VCs with 5% of financing decision.
Post creation and expansion stages come later with matured technology and market validation. In particular moving from phase 2 to phase 3, capital is required to industrialize the product and market it through licensing to industry partners, allowing the company to break-even. The investments are here to increase the working capital of the business and reinforce the management team. This period of growth for the company and amounts already invested usually reassure the confidence of new investors with reduced risk/rewards.
The independent venture capital funds rely on limited partners invested capital. Their particularity of is that none of the shareholders of the fund holds a majority stake. Among the whole venture capital industry players, only fifty players focus in early stage life science companies, other life science players preferring less risky companies with advanced development stages or start-up already interconnected with mature partners (in bioclusters and hubs for instance). VCs often take a significant share of early stage companies who have few options for raising capital from traditional actors like banks or stock market. Their negotiation options are limited due to the lack of demonstration of their product technology and shorten maturity in operating the business. For early stage, knowing that only one quarter of funded projects will exit successfully, the best project should return 5 to 10 times their initial investment in order to generate an IRR of 25% for VCs.
On the other hand, the corporate venture capital funds are captive with one shareholder contributing to most of the capital, usually internal resources from the parent pharmaceutical company. Biomedical companies looking to invest in sectors relevant to their core business launch corporate funds either to secure innovation or to explore new scientific domains. Investment could concern a technology that could complement an existing one with the firm such as a companion diagnostic platform for an existing portfolio of therapeutic. Investment can help to mitigate risk in a disruptive discipline, such as in such as nanomedicine or regenerative medicine, help them to reach faster a maturity level and gain therefore first mover advantage.
Corporate venture capital have contributed to reshape the VC ecosystems and compensate from traditional Life science VCs investment shift to later stage of companies development. In 30% of the new venture round-tables, several venture capital investment funds team up to form a “financial syndicate” to make an investment. This usually happens to share initial risks and also to ensure investors will still have financial resource to invest during later rounds when risks are decreased and amount become particularly substantial. Biomedical new venture usually need a first round where individual VC investment vary between 0.5–1M€ and can go to 5–10M€ for second round.
Raising capital from VC takes time for preparing, approaching, negotiating and finalizing an investment campaign. And often, as soon as a successful campaign is closed, entrepreneurs need to prepare for the next one. At the early stage of the company development, entrepreneurs will dedicate one third of their time in raising money. The investment process can be divided in two main steps, the partnership settlement and then the collaboration.
The role of professional adviser is key in the process. Professional advisers such as bankers, accountants, legal and law experts can either consolidate the business proposition of the entrepreneur with their certification. They have specialized network and will bring accurate attention to asset and liabilities valuation all along the time of the collaboration agreement. The venture association between the entrepreneur and the investor happen in the context of a complex ecosystem. In term of preparation, entrepreneur should identify a list of VC funds that match their investment stage, industry and geographical focus. For early phase life science companies in Europe there are around fifty potential VC funds. It is also important to remember that for the best projects, VC funds are in competition and will emphasize their experience, strategic value, open up alliances within their network. VCs funds will provide information on request on their organization, investment portfolio and performance.
Usually initial contacts take place on business convention during elevator pitch sessions or through third party quick introduction after provision of the Business plan executive summary. If first impression is positive, VC fund general partners will invite the entrepreneur to send a detailed BP and to pitch its venture project and capital needed during 20–30 minutes with additional time for questions. In return VCs could provide results and performance of their investment portfolio. It is possible to put in place confidentiality and non-disclosure agreement. At this stage both VCs and Entrepreneur evaluate partnership opportunity with regard to their respective goals.
If both parties are happy to proceed after the first meeting, then the negotiation starts on the deal with a letter of intent. This provides a framework for boundaries and memorandum of understandings. The VCs will start to revise the BP and suggest some changes in the business model and the strategy. The legal and financial structure, capital partition will be discussed in term of risks and return and in line with the valuation of the business. The valuation of the company takes into account the future potential of intangible assets. Valuation methods usually benchmark similar companies at the same stage as well as opportunity cost comparison and discounted cash flow. An offer letter is thus written between parties to define the deal agreement terms and the acceptance to comply to the “due diligence” process before closing the deal.
The “due diligence” consist in involving external consultants, scientists, IP, lawyers, accountants, market opinion leaders to analyse deeply every assets and achievements, contracts the company is basing is valuation on. All necessary information, data, suppliers and employee contracts should be accessible through a secured database called data room. The agreement can finally take place after successful completion of the in-depth analysis, revision of the business model and proposition of a new shared strategy through a amended business plan.
The importance of the VC contribution to the board is key after the investment is conducted. Strong boards contribute to the venture success, in particular by providing useful reporting tools and scorecard to reflect on the science, in particular in regard to clear cash burn indicators. The importance of what are the ten most important expenses sources and lever on amount and time is key.
The shareholders agreement between parties defines the right and obligations regarding the representation for decision, the dividends allocation, the composition of the Board of Directors, the business roadmap and financial reporting, employment contracts for the management team and arbitration procedures. Involvement of the investors may happen for the following company decisions: recruiting a new management team member, establishing the reporting tools and performance indicators, negotiating with banks, supplier, partners, consolidating offer proposition in front of customers. In addition, investors are mainly involved in organizing subsequent rounds of investment, in particular when dilution clauses were considered to limit the participation in equity of potential new investors. First round investors will also look carefully at any stock-split operations between existing shareholders as well as partners stock vesting on a specific period of time.
The objective of the exit is to achieve the best possible exit for the fund investors as well as other company shareholders including the entrepreneur and its team. The mergers and acquisitions (M&A) consist in the trade sale of company shares to industrial investors such as a large pharmaceutical company. This often happen for a larger corporations willing to pay a premium to secure a strategic advantage or complete its own business activities. The exits through financial markets are cyclic and no one can predict in five/seven years if the period will be favorable for investors to conduct IPO deals.
The large demand following the stock market recovery has had two positives consequences since the past years. The first one is that venture capital investors have generate profits after a large number of biomedical start-up have successfully exited in IPO. The second consequence is that venture capital investors have fresh new capital to re-invest in growing start-up companies with high potential.