June 1, 2008 (Vol. 28, No. 11)
Barbara S. Schilberg
Strong IP Portfolio and Therapeutic Focus as well as Understanding Potential Backers Are Vital
To build a successful company and attract high-quality investment at every stage of growth, entrepreneurs need to have a command of the microenvironment. This includes knowing the strategic direction of their company and how it fits in the competitive landscape.
These days, successful financing strategies require that entrepreneurs also understand the macroenvironment in which potential investors operate. This can have a significant impact on financing options and exit strategies. Understanding key trends can help entrepreneurs navigate many funding challenges.
VC Investmane Trends Signal a Positive Environment
The good news is that the life science sector—the biotech and medical-device industries together—saw an all-time record for venture capital investing in 2007, with $9.1 billion in 863 deals, according to The MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association.
Nearly $2.4 billion of that total was invested into 366 seed and early-stage deals. Specifically, $497 million went to 116 seed-stage firms, and nearly $1.9 billion to 205 early-stage deals nationally. This represents a 58% increase in dollars invested versus 2006, when $1.5 billion was invested into 323 deals. The medical-device subsector enjoyed a 40% increase in funding—151 deals in 2007 versus 87 in 2006—reflecting renewed interest by investors.
Trends over the last five years also show an overall positive change.
• The size of the average seed-stage deal has increased dramatically since 2003, from $1.5 million to over $4 million in 2007.
• The average size of a Series A investment has also gone up during the same time period although less dramatically, from $5.2 million in 2003 to $7.5 million last year.
• The number of seed and early-stage deals increased by 70% over the last five years.
Investment in the life science sector for the most part is concentrated in established regional hubs. Fully 80% of all seed/start-up financing deals occur in only eight regions of the U.S.—Silicon Valley, Boston, Washington DC, San Diego, Philadelphia, New York City, Los Angeles, and Washington State. In 2007 the top three regions, Silicon Valley, Boston, and San Diego, accounted for 44% of national seed-stage investments. Silicon Valley alone accounted for 36% through 23 deals.
Although capital is theoretically fluid, start-up capital historically stays close to the investor’s home base, reflecting the need for a close working relationship at the early stages of a company’s growth. This factor explains why so much start-up capital gravitates to the regions where venture funds are located. Entrepreneurs located in those regions are well-positioned, at least geographically, to access this capital.
Fortunately, states, cities, and some private investors outside these hubs are beginning to recognize opportunities to mine technology in underserved venture capital markets. To target investment in these regions more effectively, angel investors are coming together as organized funds. Foundations and nonprofits are stepping in to provide capital for companies and researchers working in their disease areas. Biopharmaceutical companies such as Biogen Idec and MedImmune have established funds to complement their internal research efforts, and many large venture funds are now experimenting with accelerator models to generate deal flow.
In addition, states throughout the country are gearing up their efforts to capture the economic benefits of the life science industry. Pennsylvania was among the first, creating the Greenhouse initiative to support preseed and seed-stage firms, coupled with a venture program for follow-on capital. Together, Pennsylvania’s three Greenhouses have invested more than $36 million into more than 133 companies and projects throughout the commonwealth. These companies have gone on to leverage an additional $887 million in capital from other sources.
M&A Is the Primary Exit
Venture investors need to produce returns to their limited partners in three to five years. This is because these partners have their own liquidity requirements and they need a positive track record to raise the next fund. The exit for venture investors has historically occurred through IPOs. The IPO window has unfortunately been erratic at best for several years, with an average of only two dozen companies reaching the public markets each year since 2003.
The diminishing utility of the public markets has been offset in part by merger and acquisition (M&A) activity, particularly by large pharmaceutical companies facing declining revenues as blockbuster drugs go off patent. Although the number of M&A events has been fairly consistent over the last five years, ranging from 40–50 deals, the dollar amounts have increased, particularly in the case of earlier-stage transactions.
Not surprisingly then, investors are especially interested in companies working in areas that make them attractive acquisition targets. Entrepreneurs need to understand the M&A area for their products.
The blockbuster markets that have not been fully tapped, such as Alzheimer’s disease and metabolic disorders like diabetes and obesity, remain priorities for larger pharmaceutical companies in both M&A agreements as well as licensing deals. Emerging companies working in these areas are of particular interest to investors even if the products are at the preclinical stage.
Investors have been less likely to target early-stage firms working in diseases such as oncology where efficacy data in humans is now the threshold for investment given higher product failure rates and a lack of predictive preclinical models.
Every investor looks for great science, a competitive advantage, and a strong management team with relevant experience. With the growing emphasis on acquisitions as the likely exit, several key issues are a priority.
• Has the company identified the first indication for a lead product candidate? If the initial indication taps a niche market that is suitable for a small company, is there a larger potential market opportunity that will interest bigger companies?
• How will the product be reimbursed?
• Is the IP portfolio adequate for larger companies? A bigger pharmaceutical firm wants to see composition patents in key markets around the world.
• Are the clinical endpoints validated? If the company is carving new ground, might investors conclude that this will complicate the regulatory path?
With these elements in place, the opportunities to attract investment can improve dramatically for seed-stage companies. But the effort to identify both available and optimal funding options should also reflect some strategic thinking about potential investors. It is important to review websites including those of portfolio companies to get insights about a fund’s strategy. A few principles are worth noting.
• Investors need to invest their time efficiently. If you don’t have venture funds in your region, target investors who have already made investments in other companies in the sector and in your area. These investors will be better able to accommodate another local investment.
• Venture funds have distinct personalities. Before you knock on any doors, learn about the fund’s investment professionals, including their backgrounds, interests, and existing portfolio, to get a sense of what the team is looking for.
• Understand how much money each fund needs to put to work in a company. Larger funds cannot afford to put only a few million dollars to work. If that’s all you need, look for smaller funds or reposition your development plan to justify an initial investment of $10 million or more.
• Make sure you know a company’s funding cycle. A fund that is about to close is not a good fit for a start-up investment. It’s better to target funds that have had a recent closing.
• Identify the strongest possible industry connections for introductions. A mutual contact that can facilitate an introduction can significantly help to reduce the time to investment.
• Recognize that financing action at this early stage can shape a company’s image for years. The quality of the investor will have a lasting impact on a company’s ability to raise money in the future. Targeting quality investors should be a priority, eclipsing even issues such as valuation.
With more investment dollars trending toward early-stage life science companies and a growing number of specialized funds focused on the sector, it is clear that the climate for entrepreneurs to initiate businesses is better than it has been in the last five years. Understanding how your company fits into the larger financing market is the key to finding the right investor for your business.