Venture Capital for the Pharmacologist

What is Venture Capital?

Venture Capital is a loosely defined term describing the process of making equity investments in private companies, usually companies in emerging technology sectors. These investments are generally high risk, with corresponding high returns if the companies are successful. Venture capital as currently practiced in the U.S. is still a young business, beginning just after World War II and accelerating with the development of microprocessor technology in the 1980s. Venture capital in health care/life sciences is even younger, beginning in earnest with the biotechnology boom of the 1980s. There are approximately 350 venture capital firms in the U.S. Note that venture capital firms, as professional investors, are distinct from “angels,” individuals or groups of high-net-worth investors who use their own capital to fund companies, often at the earliest stages of company development.

How does Venture Capital work?

Most U.S. venture capital firms follow the same model. The firms solicit commitments from investors for a “fund,” a specified amount of capital. These investors are primarily financial institutions or high-net-worth individuals. The venture firms then make investments in companies over several years, drawing on committed capital along the way. When the start-up companies “exit” (i.e., go public or are acquired), venture firms return the profits to their investors, taking a percentage for themselves. After the fund is fully invested, venture firms raise a new fund and the cycle continues. As is the case with most businesses, venture capital is cyclical. Tremendous amounts of venture capital were raised and invested during the Internet boom of the late 1990's. When Internet companies returned to earth, a marked dropoff ensued in venture fundraising and investing, especially in the IT and telecommunications sectors.

Health Care/Life Sciences Venture Capital

There are approximately 100 venture firms in the U.S. investing in health care/life sciences. Of these, about 70% are diversified firms, investing both in health care/life sciences and other technology (e.g., IT and telecommunications). The other 30% invest exclusively in health care/life sciences. Health care/life sciences venture capital has been spared the implosion that followed the Internet boom. Indeed, a record $3.2 billion in capital was raised by venture firms for investments in health care/life sciences during the first half of 2001. As in other venture capital sectors, different venture firms have different specialties, in terms both of company type and stage of development. Some firms specialize in biotech therapeutics, others in medical devices, and a few in health care services. With regard to stage, some firms prefer early-stage companies, whereas others prefer more developed companies. A distinct minority of firms is willing to invest in “seed-stage” companies, often just a promising technology with little or no business infrastructure.

How are investments made?

The process of venture capital financing has three major steps:

1. Contact with the venture capital firm: There is no specified, or efficient, method that brings developing companies into contact with venture firms. Contacts are often made through networking by scientists and entrepreneurs, by university technology licensing offices, or by “cold calls.” Occasionally, companies use placement agents or investment banks to contact venture firms, but this is unusual at the early stage.

2. Due diligence: This is the process whereby the venture capital firm evaluates a company that is in development, makes an investment decision, and considers the terms of the investment. It usually involves reference checks, evaluation of the technology and intellectual property, and review of the business plan. Due diligence is of varying intensity and duration. Companies that wish to be considered by venture capital firms should assemble as much material as possible in advance to facilitate the process.

3. Term sheet: Due diligence, if positive, culminates in the presentation of a “term sheet” offering the terms of a proposed investment. The key issue is usually valuation, that is, how much is the company worth prior to the investment? Again, there are no accepted metrics here. Valuations are roughly based on comparisons with similar companies in the current market environment, and are often negotiated. Other important aspects of the term sheet include amount to be invested, Board of Directors composition, type of security, and effects of subsequent financings.

Most venture investments are made by syndicates, i.e., two or more venture firms sharing the financial burden and the risk. Generally, one firm takes the lead, negotiating the term sheet and helping to attract other investors.

What's next after the investment?

In the event that a term sheet is negotiated successfully and the investment is made, the relationship between venture firm(s) and company is hardly over: the venture firms do not (and should not) go away. A representative from the lead venture firm, and sometimes one from another firm, serves on the Board of Directors. Especially for early-stage companies, venture investors perform critical functions, including:

• Recruiting: Good venture investors help recruit scientists and business people from their networks. If there is no CEO, venture investors will want to have a major say in filling this position.

• Strategy: Experienced venture investors can be instrumental in developing strategy and in identifying and reaching milestones.

• Partnerships: Venture investors should facilitate partnerships with companies in their portfolios as well as outside companies.

• Financing: Venture investors should take the lead in planning and executing subsequent financings.

In summary, a good venture investor becomes a partner in building a successful company, and should not be regarded simply as “the money”.

Should I seek venture financing?

At the earliest stage, when a scientist with a good technology has not yet established any company infrastructure, financing options are limited. Initial financing can sometimes be had from the university or from an SBIR grant, but these sources don’t last long. Banks, needless to say, have little interest in early-stage companies. Beyond their savings, most budding entrepreneurs must choose among some combination of friends and family, angel investors, and venture investors. Venture investors, if interested, are often the best choice. A good venture investor can provide help creating the company infrastructure and recruiting management. The venture investor also participates when the company needs follow-on financing, something that friends and family or angels usually can’t do. The negative, of course, is that venture investors tend to be tougher on valuation than your uncle or cousin, and than most angel investors.

As mentioned above, relatively few venture investors have the stomach for seed-stage investments, so start-up companies often resort to the other alternatives. Once they have survived the start-up phase, there should be more interest in the venture community. At this stage, venture financing is clearly the best alternative. Good venture investors add significanlty to a company's likelihood of success.

How do I find a venture firm?

In the absence of an organized market, networking is often the best way to proceed. Speak with other scientists, and pursue contacts at biotechnology companies. Especially look at biotech companies in similar areas; you can usually determine the venture backers by looking at the Board of Directors, available on most Web sites. As a last-ditch effort, contact venture firms directly using listings such as the National Venture Capital Association or VentureOne.

What should I look for in a venture firm?

Like anything else of value, all venture firms are not equal. Before considering a particular firm, try to find out as much as you can from the venture firm directly, and by speaking with individuals at their portfolio companies. Among the questions you should ask are:

• How many of the portfolio companies have been successful?

• Does the venture firm take a Board seat and an active role?

• Are they patient investors, or are they looking for a quick exit?

• Do they have a history of supporting their companies in follow-on financings?

• Have they worked with similar companies, in terms of sector and stage?

• How experienced are the venture firm personnel?

Summary

Venture capital—not merely the dollars but the expertise brought to bear by the venture capital firm—can be critical in building a successful health care/life sciences company. Despite uncertainties in the overall economy, now is a good time for venture capital in health care/life sciences. A record amount was raised by venture firms in this sector over the last year, so venture firms will be looking for attractive opportunities. Most venture firms prefer to invest in companies with at least some semblance of corporate structure, but some will make “seed-stage” investments, based on a promising technology. The more that scientists and entrepreneurs understand the venture investment process, the more likely they will navigate it successfully and negotiate favorable terms. As with any partnership, each side should understand the other partner's experience and motivations; thus, you must do your own homework when working with a venture firm.

Resources

National Venture Capital Association
1655 N. Fort Myer Dr.
Suite 850
Arlington, VA 22209
703-524-2549
www.nvca.org

VentureOne
201 Spear Street, 4th Floor
San Francisco, CA 94105
800-677-2082
www.ventureone.com

Asset Alternatives
170 Linden Street
Wellesley, MA 02482-7919 U.S.A.
781-304-1400
www.assetnews.com
(Publishers of Venture Capital & Health Care, Genomics Investing)