The life sciences venture capital industry is undergoing rapid change. Although many innovative ideas have been taken from the bench to scientific discovery to treating patients, funding today to develop new products and services is getting more difficult to attain. Getting a product to market involves not only a long scientific process, but a carefully orchestrated financial process. This article attempts to explain how a typical VC fund operates and makes investment decisions.
Although many management teams readily approach us for possible funding, more than a handful are not knowledgeable about the inner workings of a venture capital firm, specifically the process by which we decide whom we will ultimately fund. I believe an understanding of the entire funding mechanism will better help entrepreneurs understand what to expect, the types of information the venture capital fund will request, and how long the process will take.
When a VC fund is formed, the general partners’ primary responsibility is to provide positive returns to its limited partners. The limited partners may range from family offices and wealthy individuals to the large investment arms of endowments, municipalities, cities, states, and universities. For example, the California Public Employees Retirement System (CALPERS) manages almost $250 billion of retirement savings. Major universities such as Harvard or Yale manage $20 billion or more of endowment assets. These institutions will allocate a certain percentage, typically 4 percent to 7 percent of their total assets, to alternative investments with funds generally having a ten-year term. The goal for these large institutions is to find fund managers that will outperform other, traditionally safer, asset classes (e.g. publicly traded equity stocks and bonds).
In an attempt to capture a higher return, limited partners understand that time frames to liquidity must be longer. In today’s environment, this poses an inherent conflict, as recent pressure to maintain the endowments’ value has reduced their willingness to hold an investment as long as they did in the past. At the same time, many investments made in life sciences companies, depending on the stage of development, have a much longer time frame to a liquidity event.
Once a fund has received commitments from its limited partners, the VC team begins looking for investment opportunities. The fund needs to determine how many investments it plans to make during the course of the fund, how to diversify those investments and what the expected returns should be. Some VCs attempt to take more risk in the hope of achieving a 5x to 10x return on their investment, while others take less risk and target a 2x to 3x return on investment.
There is a growing trend in the investing community to attempt to de-risk the investment in a company in order to resume capital from losses. Sources of deal flow come in a number of ways. Often a company will make cold calls to the VC community to seek any interest in their company. We may get a referral from other professionals in our network. Our own investment professionals also work proactively to identify opportunities in our certain focus areas (e.g., obesity or cancer) or when we see interesting data or intriguing journal articles. Lastly, placement agents, such as investment banking firms, are often hired by companies to access the private market. Generally, companies and management teams we know are more likely to get a full hearing at a typical VC fund.
To the extent time permits, we are very willing to meet and learn more about a prospective opportunity in a company. We do so by asking the company to provide us with a brief (two or three page) explanation of the investment opportunity, including contemplated financial goals. We might receive anywhere from 500 to 700 such summaries per year. A majority of these do not fit with the mandate of the fund for such reasons as the therapeutic area being developed, the maturity of the company, or its financing needs.
If the opportunity does fit into our investment strategy, we invite the management team to present to us in more detail on a non-confidential basis either at our office or an investment conference. We then assemble as many members of our investment team as possible and meet in person with the presenting company for an hour-long session.
During this hour, we look for the presenters to explain the benefits and risks of the potential transaction. This should include details about the management team, the investment proposition, the clinical trial plan, the FDA and reimbursement risk of the product, as well as what the competitive landscape and relevant commercial strategies might be. We may have 150 of these meetings a year.
Many management teams ask how their interactions with the venture community can be optimized. We suggest that companies come and visit even when they are not actively raising capital, so we can assess the progress of the company and strategic vision in a more relaxed atmosphere. We would also suggest that companies understand the nature and investment philosophy of our firm, what other types of investments we have made and our backgrounds.
We view a successful meeting as one where we come away from the initial meeting with the answers to three basic questions: Do we understand the value proposition of the investment and the appropriateness of the timing? Has the management team developed and do they have a clear vision of strategy and goals? Do we understand not only the potential upside of the investment, but all the risks and concerns surrounding the deal?
Based on this meeting, we will then make our preliminary determination: either the investment does not fit and we will pass on the opportunity; the investment does not fit currently and we will follow the progress of the company over a period of time; or the investment may fit and we will begin to perform more advanced due diligence. These decisions are discussed and arrived at during our weekly meetings, which involve all investment professionals, even those not present at the initial meeting with the company. We attempt to relay these results to the management team in a timely basis.
Once we decide to perform additional due diligence on the company (approximately 40 to 50 per year), two or three investment professionals from our team will be assigned to do extensive analysis of the opportunity. This process further analyzes the scientific and business proposition of the company, and includes detailed conversations with third parties, such as scientific and clinical advisors, lawyers and reimbursement and regulatory experts, other potential investors, as well as further dialogue with the management team and board of directors. If a management team is wondering how the diligence is progressing, they can often look to signs such as whether they have been asked to make additional presentations to a broader group of the VC team and whether the VC firm is reaching out to other interested parties, such as Board members of the company. We try to keep the management team appraised of how the due diligence process is progressing.
VC funds also perform due diligence in different ways. Some put more emphasis on outside consultants, some focus more on the financial terms, and some put emphasis on a comprehensive memo which serves as the guidepost for the investment going forward.
Once the due diligence is complete, the transaction team distributes an internal investment memorandum, which summarizes their findings. After review by the entire VC team, a vote is taken to determine if a non-binding term sheet should be submitted to the company. If the vote is in favor, the deal team will put together a term sheet, which outlines the relevant terms and conditions by which we would be willing to invest. This will include valuation, liquidation preferences, anti-dilution rights, composition of the board (generally there is one board seat for each VC firm), and other customary governance terms.
It is important to note here that some transactions do not get consummated even after the term sheet is signed. Occasionally, this is the result of a material adverse event in the company’s operations, general negative findings during the final diligence process or an inability to reach common ground on the detailed terms of the investment.
If all parties do agree to the term sheet, we will finalize our due diligence to include detailed intellectual property and manufacturing examination. We then wait to receive the necessary approvals to consummate the transaction, and begin to build a syndicate of other venture investors.
Building a syndicate is one of the most important parts of the process. The VCs, the management team and the Board of Directors must be aligned on the strategy going forward. Do the other potential investors have experience in the particular therapeutic areas of interest? Will they be a value-added investor? Do they share the vision of the future, and that of the board and management team? Will they be constructive when we inevitably hit a “bump in the road?” Do they have enough capital available for follow-on investments? Have we had a positive experience with them as co-investors on previous transactions?
Finally, as the closing process begins, we set a timetable for the actual consummation of the transaction, and begin to involve legal representation from both parties to the transaction. They work to put together a comprehensive stock purchase agreement which is the binding document for “closing the deal.” Once the closing process begins, it takes approximately two weeks to complete the transaction.
Investing in a company is a serious commitment of our limited partners’ capital and only the first step in the process. We must now help to insure that our investment brings the company through a critical stage of development and leads to a profitable exit and ultimate positive returns to our limited partners. As such, we must now carefully assess the ways in which we can be a value-added investor with the goal of helping the company achieve its strategic objectives.
A key issue for the management team is what to expect from the venture capitalist after the initial investment is made. The management team needs to understand how involved the VC plans to be in the operation of the company. Depending on the size of the investors’ commitment, a member of the investing VC fund will generally either hold a board seat or become an observer on the board. The VC aim is not to micromanage the management team, but rather to insure the proper management team is in place, set goals for the team, help resolve strategic issues, and use their experience and contacts to bring appropriate additional expertise to the table.
An increasingly important part of our business is determining how much to keep in reserve for our investments. Given the recent lackluster IPO market, we are often required to fund our companies for a longer period of time. Investors who are either unwilling or unable to participate in further rounds of funding are often subject to draconian forms of dilution, such as being converted into common stock.
As venture capital investors, our primary responsibility is to provide a positive return on investment to our limited partners. So at some point, we need to become focused on exiting our positions. We try to do this while at the same time positioning our companies and their technologies to continue to evolve after we are no longer involved. After all, we are all motivated by the innovations and cures provided by the companies of this industry that lead to improving health.
Our exits generally come in three forms: an IPO, a merger or acquisition, or a capital-raising that’s large enough to independently sustain a company over a longer period of time until an acquisition or IPO. The IPO of a venture capital-backed company used to be the end of venture involvement, but now is only a further step in the evolution of a company. Likewise, in the past, most acquisitions were cash-based deals with the larger company taking control of the ongoing activities. Today, most transactions are tranched based on milestones that are predetermined so that risk is shared going forward. Lastly, because of increasing financial and regulatory requirements, the ability to become a stand-alone self sustaining entity has become much harder to achieve.
In conclusion, working in the life sciences industry and developing successful companies and therapies to make a difference in human health is both challenging and fulfilling. There are many different aspects involved in building a successful company. In addition to the scientific underpinnings, the ability of managements and boards to navigate a difficult path, including financing their endeavors, will hopefully lead to better outcomes for patients.
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