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rather than in the 35-40 percent range. While the underlying risks of commercializing life science technologies continue to climb, it is possible that angels will adopt a higher-volume, lower-return strategy, thereby maximizing the portfolio effect of addressing risk. If so, the market for “solid doubles” will increase—which will likely favor medtech deals over biotech deals.
Venture capital participation
Additionally, angels may return to the days of actively seeking investments which will attract rather than avoid follow-on investment from venture capital firms who, at later stage valuations, will absorb the capital requirements and risk of life science companies. Many angels have become nearly pathological in their fear of deals which require venture capital. Some fear the dilution, and others the loss of control that often comes with reconstituting the board in the wake of such venture investment. Some fear that VCs want to stay in deals longer because, unlike angels, they cannot recycle capital and thus need to maximize total returns at the expense of IRR which is adjusted for time.
Most of this thinking misses the mark in today’s venture investing environment. First, percentage dilution has never been that important for minority stake investors. Only value dilution is relevant. Which of us would prefer 100 percent of a startup to 1 percent of Facebook? Second, the loss of control is natural and often appropriate. Investors should always seek control provisions that permit them to drive the company towards the goals stated during the investment process. If a company early on indicates that the strategy will be capital intensive and will seek angel and venture involvement, then angel investors should be satisfied with swapping out their appointed directors for those selected by later-stage venture capital. Such capital should be brought in by the company with the clear participation of the angels to execute such a strategy. If the angels believe that such investors and their directors will opt for deals that do not support returns for all investors, then they have made the same kind of mistakes that occur in angel deals that pay angels but not founders.
On the issue of exit timing, views among the angels differ. IRR was invented as a metric to compare multiple investments with differing capital requirements and timelines. Because quality deals are harder to find, exiting quality deals early is likely to decrease total portfolio returns. The next use of the recycled cash is likely to be a lower risk-adjusted return than the existing business. However, if the existing deal is likely to stay illiquid for long stretches of time, it is hard to know, in advance, what the “optimum exit valuation” looks like for planning purposes.
Additionally, it will be important for angels to properly appreciate the relative value of new cash versus the existing asset base (consisting of human, financial, and intellectual capital). It would be inconsistent to demand very low values at the angel investing phase and then high values for the venture capital phase. One hallmark of biotech life science investing is that the efficacy and regulatory risks are the biggest risks and they exist through the clinical trial phase. Market risk, on the other hand, is often relatively easy to assess. This is very different from software or engineering type companies where “does it work” is a question that gets answered much earlier in the process, but market adoption and sales risk remains the dominant risk as the business progresses. Life science companies, and their angel investors, should expect modest but not radical step-ups in valuations as angel cash, during the proof of concept phase, is converted into intellectual capital and human capital.
One interesting outgrowth of this expectation is that angel investors might return to using a convertible debt format for such companies, with the expectation that the negotiated discount to the next round will be the sole step-up in valuation from their original investment. By aligning expectations in such a fashion, it is possible to satisfy investor expectations while providing some increased protections of debt to the angels during the proof of concept phase. Founders, however, should assume in such a deal not that they are getting the angels to invest effectively at later-stage venture capital valuations. Rather, both the angels and the venture capital investors will be investing at the more modest POC pre-money valuation (which means angels should also prepare for the dilution impact). The upside is that the companies and angels can accelerate the investment process by not wasting time negotiating valuations, and the investment can properly be understood to be a bridge to the next phase of company evolution.
But why do companies need to fund this phase with equity? In most cases, after consuming all of the angel cash, life science ventures will continue to require significant capital to achieve regulatory approval. This capital is well aligned with venture capital for two reasons. First, the green-light/red-light nature of such risk means that the risks are very high and therefore the market will likely price the cost of capital very highly. Second, and related, unlike their digital brethren who may be generating revenue and aggressively adding full-time employees (both of which may attract lower cost financial investors), life science companies will continue to lack meaningful collateral and will therefore be poor candidates for debt financing. While, as noted above, strategic, grant, or PRI-type capital may be attractive, there exists a far larger pool of equity financing.
While deal structures, return profiles, financing terms, etc. remain unknown, it is probably safe to say that angels will continue to be a cornerstone of early stage support for life science ventures. Angels’ industry and entrepreneurship experience is too valuable, their instincts and rigor in evaluating quality opportunities is too strong, and their desire to participate in the next wave of life-saving and enhancing technologies is too resilient to allow investment market conditions to remove them from the playing field.
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