Roundtable Review

Know Thy Investor
by Guest
Posted 07 January '15

Guest contribution by Ilan Zipkin, Ph.D., Senior Investment Director at Takeda Ventures, Inc. & OneStart mentor.

Takeda Ventures, Inc. is a partner of OneStart, the world’s largest life sciences & health care accelerator, organised by SR One and the Oxbridge Biotech Roundtable. Applications for the 2015 programme have now closed, with submissions from 638 startups representing 50 different countries. Click here to read more about this year’s 70 semi-finalist teams.

Venture (noun):

  1. A risky or daring journey or undertaking.
  2. A business enterprise involving considerable risk.

As in, “nothing ventured, nothing gained.”

The label “venture capital” often evokes images of ruthless financial engineers who take advantage of innovative entrepreneurs, along the same lines as “loan sharks.” In the US this is even codified on TV in the form of the show “Shark Tank,” not to be confused with Shark Week or Sharknado (the British and Canadians are a bit more diplomatic, calling their venture capital show “Dragon’s Den”). The picture of entrepreneurs braving sharks and dragons looking for a couple hundred thousand dollars to get their great business idea off the ground is not a pretty one. And what about business sectors that require millions of dollars just to get going? TV would have entrepreneurs packing their shark repellent and flame proof armor. Reality, of course, is far more complex and nuanced, and entrepreneurs need to peel back the layers of expectation around potential investors just as investors need to conduct due diligence on companies’ and management’s credibility. In fact, “venture capital” only describes the role of private financing in supporting innovative companies, as defined above. What this definition lacks is an understanding of the goals and motivations of those that provide such financing – if something is being ventured, what is hoped to be gained? When the range of different types of investor are considered, in particular corporate venture capital firms or venture debt firms in addition to “traditional” institutional VCs, gaining an appreciation of those goals and motivations can be challenging.

The only real requirement to be a VC (or General Partner, GP) is to have money to invest, whether the source of that money is the GP themselves or a collection of Limited Partners (LPs), which can range from large institutions (state pension funds, university endowments, large insurance companies, etc.) to family offices (think Carnegie and Rockefeller) to pharmaceutical companies (like Takeda, Johnson & Johnson, and GlaxoSmithKline, to name a few). Those LPs are the big fish in the venture ecosystem, and it’s worth keeping in mind that VCs go to them pitching a new venture fund or investment strategy to raise money in the first place. So GPs already have to manage a collection of LPs that may have different interests, goals, and measures of success. Even within the category of financial return (where making money is the only goal), LPs see the venture opportunity differently: while it may be enough for a pension fund to beat the S&P 500 financial return over 10 years, an IRR hurdle of only 8% currently, for a high net worth individual to lock up capital for that long they may want to see a 3x cash return or a >25% IRR. But at least that goal is easily quantified – put some money in, and 10 years later you (pretty much) know how much money you’ve returned.

However, GPs have had Pharma LPs for decades, to a greater or lesser extent depending on market conditions. What would a Pharma company hope to gain by investing money in a venture fund? Purely financial return? Maybe, but even a 3x return over 10 years on a $100 million investment isn’t likely to move the earnings per share needle for Pharma, or these days even for Big Biotech (companies like Amgen, Gilead, Celgene, Biogen-Idec, etc.). So a Pharma LP is probably looking for a less tangible return on that investment, something that helps it achieve its drug development goals along the strategic direction that company has charted. That return can take several forms – information on what startup or early stage biotechnology companies are up to; the chance to get to know those companies ahead of the competition or even collaborate or license products and technologies earlier than they might otherwise or before they hit the general radar; insight into an emerging scientific or clinical area without having to build up an internal research group prematurely; or even just the good PR that comes from supporting the innovation ecosystem.

Thus the makeup of a VC’s LPs will help determine that VC’s own goals and motivations. Of course at the end of the day the GP is looking to make money for themselves, since they have no ulterior business strategy, but they will want to satisfy their LPs strategic interests both to keep the investments coming and to perhaps enhance their ability to exit their portfolio investments through M&A. Just as GPs tell a different story to purely financially oriented LPs as compared to strategics, one can imagine that the experience of a founding CEO pitching their business idea might be quite different with GPs that have some strategic LP relationship compared to those looking only at the financial return forecast. But ultimately, among financial (or “institutional”) VCs, entrepreneurs can count on making money being the primary driver of investor behavior, even if a strategic relationship is operating in the background.

The problem for entrepreneurs becomes more complicated when interacting with corporate VCs – these are GPs whose primary (or sole) LP relationship is with a single Pharma company, whether structured as a separate fund or as a wholly integrated business unit. These funds have names that imply one is engaged directly with a Pharma company – Takeda Ventures, Johnson & Johnson Development Corp., Lilly Ventures, Roche Ventures, Novartis Ventures, etc. But is that really the case? Are these firms all equivalent portals into their parent LP? Not at all, in fact there is a full spectrum of corporate VCs, from those that behave as if their only concern is building a strategic relationship through equity investment that eventually will mature into a licensing deal (and hopefully a drug marketed by the parent Pharma), to those that behave as if they are only interested in the financial return no matter where the product or technology itself ends up (or even if it works). And across the corporate VC spectrum, there are firms that blend both objectives in varying combinations.

So if you are an entrepreneur, and you’ve read this far because they never told you about these things in biochemistry graduate school and you are hoping to raise money for your cool new company, why should you care about financial versus strategic LPs and GPs? The answer is that building a company is not a short term endeavor (in biotech), and you will be in a long-term relationship with your investors for better or for worse. And while blind dates can be fun, and divorces are painful but happen anyway, generally it’s a good idea to understand what your investor wants to get out of the relationship before you commit to getting in it. And at the same time, what do you want to get out of your investors? If you only have one option to finance your company, you may not have the luxury of choice, but to the extent there are multiple suitors at the ball, how do you figure out which one to dance with?

To simplify the problem, one can look at corporate investors as either purely strategic or purely financial and ask what the pros and cons are of each. If purely financial, the investor is really indistinguishable from a traditional institutional VC, where the main differentiation is around the individual partners involved, their background and expertise, and past behavior and success. On the strategic side, the pros and cons depend on the level of involvement of the parent Pharma company. First, investment by a corporate group may imply a strategic interest in the field, mechanism, or specific assets being pursued by the biotech company, which could provide an early view on potential exits through either acquisition or corporate participation in an IPO downstream. While it’s true that acquisitions of a corporate venture group’s portfolio companies by their parent company are relatively few and far between, the presence of a corporate investor does seem to improve exit outcomes. Corporate investment, just like a partnership, can provide validation of a company’s approach that other investors find reassuring.

Corporate venture groups with a strategic focus also generally leverage the R&D resources and expertise of the parent company to support their portfolio companies. This can take the form of frequent meetings and dialog to provide advice and feedback to the smaller company on best practices, study designs, or issues to consider, even without the formalized contractual relationship of a right of first negotiation or option to license the program. Benefiting from the input of hundreds of researchers whom you are not paying can be a real plus. In some cases the portfolio company may even be able to get experiments or manufacturing provided in kind from the Pharma parent, which is even better.

On the other hand, corporate investors with a strategic focus may be limited in ways that institutional VCs are not. On the one hand, partners in those groups may have more Pharma R&D or business experience than venture capital investing experience, which limits the depth of their understanding or help on the corporate finance side of the equation. And while making money seems to be a universal goal, Pharma R&D strategies change, sometimes alarmingly often. If the parent company is no longer strategically focused on a portfolio company’s space or programs, or even if the venture group’s investment budget changes, that could lead to a loss of those strategic benefits and/or a decision to stop putting capital into the company, leading to non-participation in follow on rounds and a misalignment with other investors’ interests.

In reality, each corporate investor will have some blend of strategic and financial motivations. There are a few questions entrepreneurs can ask potential investors to get some clarity around their particular mix. For example, does the investor deploy capital from an independent fund, structured as a traditional limited partnership, and are investment decisions and approvals made at the level of the general partner? Or does the group invest from their parent company’s balance sheet (cash) or even P&L as an annual budget line item, and is there an internal governance process at the company required to approve venture investments? If the former, they are likely to be more financially motivated, and if the latter, perhaps there is more of a strategic focus. To get even nosier, do the investment principals themselves get compensated with a Pharma company salary and bonus only, or do they receive carried interest in their investments, which would significantly incent them to make good financial returns? And if they do invest directly from the company’s balance sheet, do they report to the company’s CFO, implying a financial return metric, or to the head of R&D or business development, implying some strategic oversight?

Finally, the most important question to ask is around what happens after they invest in a company. Is there any ongoing dialog with the R&D groups of the parent company, whether to keep the parent apprised of the portfolio company’s progress or even better to provide advice and input on the portfolio company’s development plans and hurdles as they arise? And what criteria will be used to determine whether the investor participates in any future financing rounds; is there a dependence on continued strategic interest or will they make that decision much as an institutional VC would?

At the end of the day, an entrepreneur wanting to get their biotech company financed will likely take whatever money is on the table. The trick is having a compelling enough opportunity that there are more interested investors than are needed, allowing some selection for those investors whose interests best match the company’s goals. Easier said than done, which is why I’m writing this as an investor rather than as a company founder. Good luck.

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