Where Has All of the Early Stage Capital Gone?

Early stage capital for life science companies is tight at the moment.  I believe there are two root causes for the lack of capital: risk aversion among VCs; and the need for VCs to support their portfolio companies longer than expected.

In a number of blog posts over the last year, I noted that while early stage capital hasn’t been exactly abundant, it has also has not dried up.  According to OnBioVC, the aggregate amount of capital raised by life science start-ups in Series A rounds actually increased by 33% from 2010 to 2011.  While 2010 was a low year for Series A rounds, the data from 2011 compared to 2009 was about equal.  

Given the OnBioVC data, there appears to be sufficient Series A capital in play, but it is not necessarily going to early stage start-ups.

Historically, Series A rounds were associated with start-ups that were developing risky, bleeding edge technologies.  Instead of investing in those “early” technologies, VCs are increasingly funding corporate spinouts of later stage assets, which are perceived to be less risky.  Because those corporate spinouts are raising their first institutional capital, they are also defined as “Series A” companies.  Series A capital might be relatively abundant, but it is not necessarily being deployed to traditional early stage start-ups.

Adam Rubenstein of OnBioVC pointed out to me that “for 4Q11 the ~$500M in “first-time” institutional financings was approximately split 1:1 between early-stage “innovative” products and “reconstituted” advanced clinical-stage products.”

That is troubling news for innovative development stage start-ups.

The second challenge hindering VCs from deploying capital into early stage opportunities is that legacy portfolio companies are requiring significant capital infusions.  As the chart below from OnBioVC shows, there has been an explosion in the number of Series E, F, and G rounds over the last year.

Supporting companies for 8-12 years creates significant issues for VCs.  First, most funds do not typically reserve capital beyond 5 to 7 years after an initial investment.  Supporting a company 7+ years after of an investment diverts capital that would otherwise be used to support less mature portfolio companies. Additionally, funds generally have a 10-year term and investors (LPs) expect to receive a return on their investment by that time.  While most funds are allowed to extend the length of their funds by 1-3 years, that is often not a palatable outcome for both VCs and investors. 

Given the fact that LPs currently see a lot of old deals on VCs’ books, there is pressure on VCs to show their investors that they can participate in deals that are likely to return capital in a reasonable amount of time. That pressure results in VCs steering away from early stage companies in favor of corporate spinouts or expansion capital rounds of more mature start-ups. 

Uptick in Late Stage Medtech Financings

Over a billion dollars of capital was deployed in Series E, F, and G rounds last year.  While Medtech accounted for 32% of the aggregate capital raised by the life science sector, it represented 42% of the capital raised in Series E, F, and G rounds.  The uptick in late stage medtech financing activity is not entirely a surprise given regulatory challenges imposed by the FDA and a consolidation of potential acquirers. 

Silver Lining

Osage invests in both early and late stage opportunities from our affiliated universities.  While we are seeing an increase in the number of attractive later stage opportunities, we are also tracking a number of great early stage opportunities.  For a contrarian investor, there has never been a greater time to invest in early stage opportunities.

When States Become VCs

Companies in high growth sectors such as Cleantech, IT, and biotechnology are coveted by states around the country.  To facilitate the establishment of companies in those sectors, many states offer a variety of incentives, including grants and tax abatements.  More recently, states have focused on capital investment in venture capital funds as a way of attracting high-growth companies.  As VCs have historically invested in high-growth sectors, many states have chosen to either align themselves with existing venture funds or start their own state-affiliated funds.  

In 1976, Connecticut started the first state-promoted venture endeavor, the Connecticut Product Development Corporation (CPDC).  Through direct equity investments by the state, the CPDC enabled entrepreneurs with compelling ideas to obtain early stage capital.  This model proved to be quite successful and was eventually copied by a number of other states.  Today, there are approximately 150 state-affiliated venture (including Fund of Funds) funds.

Should States Act as VCs?

As the competition for jobs has ramped up, many states have felt the urge to provide a guiding hand to drive companies to their state.  State assistance is often seen as necessary since few states organically have the tools (abundant capital, cheap real estate, and abundant human capital) necessary to draw companies to their state.

While most states recognize the need to promote start-up creation, few are in a position to effectively deploy the capital and resources necessary to manage a cohesive start-up promotion program. 

Running a cohesive start-up programs requires:

• Consensus building between the legislature, venture community, and the corporate community
• Defined strategy - direct investing, tax incentives, grants, etc.
• Requires the state bureaucracy to make informed business decisions
• Requires the state to take on venture capital-like risk with tax payers’ money
• Requires talented program managers at the state level to run an investment program within a bureaucracy 

These are real challenges that need to be fleshed out before a state decides to allocate significant capital into start-up creation.  

Investment Structures Used by States

Unlike state pension funds which invest from a defined pool of capital, state capital investment programs often borrow money to make their investments.  States are able to obtain low-interest loans from banks by using future tax receipts as collateral.  The loan is then used by  the state to invest in venture funds.  If the state’s investments in venture capital funds return all of the invested capital plus interest, then the state’s investment will be cost neutral.  However, should the venture funds not provide enough return to cover the loan plus interest (excluding other costs to keep things simple), then the state is required to make up the difference by tapping into its tax receipts.    

Below is an example of how state capital investments are structured:

The opportunity cost of capital for the state is quite substantial in this model due to the various management and service fees that have to be paid yearly to the venture funds, fund of funds, banks, lawyers, and auditors.  In aggregate, these fees have an 8-10% cost structure built into the state’s capital investment.  Therefore, the structure I outlined is only cost neutral if the investments provide an IRR greater than 10% - meaning that the state’s pooled venture capital investments must return at least double the capital invested just to break even.  

That being said, setting up investment structures like the one I charted out can be quite effective, even if the venture funds do not perform all that well.  For instance, by requiring venture funds to make investments in local companies, those funds will contribute to local job creation and a larger tax base.  Even if tax payer money is needed to pay off the LOC to the bank, that money will have contributed to job formation in the state.

Pennsylvania

I don’t think any one state has perfected an incentive model for start-up creation, but I do think Pennsylvania does a pretty good job of supporting start-up creation.  

Pennsylvania is fortunate to have numerous top tier research universities within its borders, and can leverage the talent at those universities to spur technology transfer and start-up creation.  Additionally, numerous corporate headquarters are located in the state and provide a large and stable talent base for start-up companies.

Even with great research centers and corporate support, Pennsylvania is in a constant race to attract companies that can generate jobs for the Commonwealth.  Over the last 30 years, Pennsylvania has launched three major initiatives (I refer to them as the “Three Waves”) to promote job creation.

First Wave - Ben Franklin Technology Partners

Started in 1982, Ben Franklin Technology Partners (BFTP) operates four regional non-profit organizations to serve and promote companies across the state.  BFTP’s activities are subsidized by a yearly budget of $20 million to make investments in start-ups that range between $30,000 and $150,000.  The effect of BFTP on start-up creation in the state has been profound and BFTP has become the go-to source of start-up capital for most start-ups.  Since inception, BFTP has invested over $173 million that has been subsequently matched by over $408 million of private investment. 

In 2008, the U.S. Economic Development Administration, an arm of the U.S. Department of Commerce, named Ben Franklin “the most effective regional economic development organization in the nation.”

Second Wave – The Tobacco Settlement

As part of the Master Settlement Agreement of 1998, the major tobacco companies were required to contribute funds to ease states’ burdens in caring for residents with tobacco related illnesses.  With some of the proceeds generated from the tobacco settlement, Pennsylvania approved two one-time appropriations for strategic areas of investment - the Health Venture Investment Account and the establishment of three regional biotechnology research centers known as the Life Science Greenhouse program (LSG).

The Health Venture Investment Account invested $60 million in four life science venture capital funds that pledged to invest that capital in Pennsylvania companies.  Those funds also pledged to match every public $1 with another $3 from private investors, thus turning the state’s $60 million commitment into a $240 million war chest. 

The Life Science Greenhouse program was created to address a lack of valley of death (gap between academic work and early product refinement needed to attract VCs) capital for start-ups.  The three Greenhouses provide not only early stage capital (up to $1.25 million in companies over the life of an investment), but also mentoring and consulting services.

Third Wave – Venture Capital Investment Programs

In 2004, then-Governor Ed Rendell, put forth an ambitious $2 billion stimulus plan to help boost job creation in the state.  Knowing that Pennsylvania lagged its peers in start-up creation, Gov. Rendell carved out $310 million from the stimulus plan to directly fund two new venture programs: PA Venture Guarantee Program and the PA Venture Capital Investment Program.

Launched in 2007, the PA Venture Guarantee Program sought to leverage $250 million of capital to attract VC investors to the state’s start-ups and businesses.  The Guarantee Program was quite novel in that it incentivized VCs to take on more risk in high growth businesses by protecting against the potential loss of investors’ principal.  In return for investors committing at least $15 million of capital to a Pennsylvania start-up, the PA Venture Guarantee Program would cover the first loss of the aggregate amount of principal invested in the company up to 50% of the total principal invested (i.e. $7.5M covered on a $15M investment).  This program essentially encouraged VCs to double down on investments made in Pennsylvania companies. 

To participate in the program, the state created a prerequisite that the recipient (VC fund) would maintain an office in Pennsylvania staffed with at least one senior-level partner for the duration of the guarantee

Philadelphia and Pittsburgh attract the lion’s share of start-up capital, leaving vast regions of the state without funding sources.  Structured as a $60 million Fund of Funds, a second venture program - the PA Venture Capital Investment Program – was launched to promote investment outside of metropolitan areas.  Like the Health Venture Investment Account, the Venture Capital Investment Program has a 3:1 matching component, turning the state’s $60 million investment into $240 million of capital. 

The success of the PA Venture Capital Investment Program has been quite remarkable over the last five years and the program currently has 12 participating venture funds, 5 of which were 1^st time funds.   Those 12 funds have collectively invested over $117 million in 45 Pennsylvania companies.   

Concluding Thoughts

Like entrepreneurs who are looking for their first seed funding, VCs often struggle to find anchor investors.  Given the current economic climate, states might want to consider playing a greater role in spurring venture fund creation and helping maintain the capitalization of existing funds. 

Five first time funds were funded over the last few years through the PA Venture Capital Investment Program.  Without the state stepping up to the plate as an anchor investor, it is hard to believe that those funds would have been raised during the economic downturn.  Yet, it is in such down economies that VC dollars are so impactful – providing needed capital to start-ups as exit windows remain closed and creating jobs through the funding of new companies.  

With the proper incentives and prerequisites in place, capital investment in venture capital funds by states is a proven driver of job formation via the growth of start-up companies.

Early Stage Investing, University Startups Feel the Pinch

I recently spoke at NYC Medical Technology Forum, a regular gathering of medtech folks from the greater New York City area, hosted by the law firm Kaye Scholer.  During the meeting I was asked why Osage had partnered with universities - which have an acute need for early stage funding support – yet had chosen to invest half of our fund’s capital in later stage university companies.  One of the reasons that we have chosen to spread our investment dollars across early and late stage companies is to address capital risk, which is the risk we assume as investors that we might lose a portion, or all, of our investment dollars.  With regards to early stage investing, we are willing to take on more capital risk in some companies because they offer the prospect of a higher return on our investment.  The opposite holds true for late stage companies. 

Investing in early stage companies requires patience and capital.  When making early stage investments, VCs must assume that they will need to support an investment for 6-9 years and across multiple financing rounds.  Because of the length of time and unpredictable future capital needs of a company, it is essential that VCs form healthy and supportive investment syndicates around early stage companies.  However, forming solid early stage investment syndicates has never been harder for most tech and life science investors. 

As you can see by the VC fundraising data above, the number of VC funds and capital raised by those funds has declined significantly over the last few years.

When less capital is in the VC system, VCs generally become more concerned about capital risk and therefore become more risk averse in their investments.  This typically translates into less VCs making early stage investments and more making later stage investments.

Pumping new money into the system is essential to support early stage investing as VC funds are more likely to take long-term investment risks early in their funds’ lives. Without new money in the system, VCs are more inclined to invest in later stage companies, which typically have shorter holding periods and require less capital – thus taking a greater portion of the capital risk off the table. 

With early stage capital scarce, the effect on university startup company financings has been somewhat dramatic.

At Osage, we track almost 1,000 university startups from over 50 different research institutions.  From this group, I selected eight premiere institutions (balanced by geography and research focus) and aggregated their startup company fundraising data from the last few years.

As the Osage data indicates, VC investment in early stage companies has decreased substantially over the last few years while late stage investing has remained somewhat constant. 

Blending early and late stage data together (second chart below), you see a significant decrease in overall university startup financing activity.

How to close the early / late investment divide

As early stage investment dollars have become increasingly scarce, many venture funds have started to negotiate somewhat aggressive valuation terms for university spinouts.  Unfortunately, without a robust early stage investment ecosystem, many tech transfer offices are left with little choice but to give into such demands. 

To avoid being squeezed on valuation, some universities are finding novel ways to fund their startups at reasonable deal terms.

The tech transfer office of one of Osage’s University Partners (I will refrain from naming the institution in this blog post) has developed a novel solution to enhance company value and defend against predatory terms.  Several the university’s startups have successfully formed partnerships with local CROs to exchange services for future equity.  This is an ideal partnership for both parties as the CRO gets a future client with an equity kicker and the startup generates more data to support a higher future company valuation. 

Generating third party data and validating some of the academic work takes a bit of the technology risk off the table for VCs and investors more likely to consider the startup for investment.  Bruce Booth of Atlas Venture recently posited a similar strategy in his March 28 blog post.  I am delighted to report in this post that one of our University Partner’s is ahead of the curve! 

A second idea is for the Small Business Administration to launch an early stage SBIC program focused on tech and life sciences with fund sizes capped at $75-100 million.  Smaller funds are typically more nimble, geographically focused, specialized, and willing to shoulder more risk than larger VC funds.  Also, smaller funds are able to make smaller bets in capital efficient businesses, which can be a challenge for larger VCs (funds >$200 million) that need to put $15-30 million to work in any given deal.  Having a series of targeted SBIC funds could help address some of the early stage company funding issues. 

Early stage tech and life science investing is going through a bit of a funk right now; however, the challenges associated with early stage investing for the venture community opens the door for novel funding strategies to emerge as evidenced by the CRO model of one of our University Partners.  By leveraging novel funding strategies, promising startup companies should be able to advance their technologies to meaningful inflection points that can take enough capital risk off the table to entice venture capital funds to invest in their startups.  

Conflict of Interest Case Could Set Troubling Precedent for VCs

Cadant, a high speed modem company created at the height of the dot-com bubble, fell into financial distress in 2000.  Existing venture investors, Venrock and JP Morgan, submitted a proposal to the board for a bridge loan to the company.  A second investor group also submitted an investment proposal to Cadant’s board, but the company decided to accept the terms from the insiders.  The VCs bridge loan terms were rather aggressive (90 day term), but also indicative of the times as internet companies were imploding all over the place.  After the company spent the original bridge loan, the VCs the made a second bridge loan (this time with a 2x liquidation preference), which provided enough capital to sustain the company until its acquisition by Arris Group for $55 million.  The $55 million sale was just enough to pay off creditors and preferred shareholders.

Shortly thereafter, the common stock shareholders brought suit charging several directors with breaches of their duty of loyalty and also alleging that Venrock and JP Morgan aided and abetted the directors.  The case - CDX Liquidating Trust v. Venrock Associates – was appealed and was recently ruled upon in the 7^th Circuit Court.

It is no surprise that when things do not go as planned, people can turn against one another rather quickly.  I thought I might be helpful to walk through some background info on this case, why it matters for VCs and entrepreneurs, and how the Court’s ruling could impact venture.

Background 

• Cadant had a 7-member board comprised of 4 directors from the VC firms and 3 directors from the company.  The 3 company directors were all engineers, with “no financial experience” according to the defendants.
• Eric Copeland, a Principal at Venrock, negotiated the bridge loans on behalf of the investors, and disclosed a COI to the board before the negotiations began. 
• The sale to Arris was approved by a simple majority of both common and preffered voting together and the preferred voting separately.

Defendant’s arguments 

• The 3 engineers who represented the company did not have the financial acumen necessary to properly analyze and weight their options regarding the bridge loan.
• Mr. Copeland stated his COI, but then negotiated against the company with the help of Venrock and JP Morgan.

Some analysis

• It is hard to believe that the engineers were completely naïve, as bridge loans are fairly straightforward legal documents.  Also, the company representatives had the opportunity to consult with outside counsel, but chose not to do so.  If the engineers failed to act in the best interest of the company, is that really the VCs’ fault?  On the other hand, if the VCs dissuaded the engineers from seeking counsel, then the VCs clearly acted improperly.  Also, with such a large board, why wasn’t there an independent board member there in the first place?
• It is upsetting to see a company seek charges against a specific board member.  This is becoming more common in distressed situations as VCs are increasingly viewed as having deep pockets, while portfolio companies often lack funds to pay indemnification and lack adequate D&O insurance.  Mr. Copeland was most likely chosen to represent the VCs because he was the best they had to offer, and the board acknowledged Mr. Copeland’s COI because they believed that he would continue to serve the corporation loyally.  So, did Mr. Copeland break his fiduciary duty?  Were the engineers naïve to think that stating a COI was enough to prevent Mr. Copeland from negotiating preferred investment terms for the VCs?  Hard to say either way.  What I do know is that in 2000/2001 the internet investing world was in the tank and it was common for VCs, and begrudgingly accepted by startups, that financial terms would be aggressive for challenged companies.
• What I find troubling about the court documents is that while there is a lot of talk about VCs breaking their fiduciary duty, there is no talk about the company itself.  How many milestones did the company hit or miss?  Was it properly managed?  VCs don’t tend to arbitrarily throw aggressive terms around unless there are some fundamental underlying problems and risks that they need to hedge against.  

Court Opinion

• The Court argued that the VCs must prove that they obtained the highest reasonable value and therefore “caused” no loss to the common stock shareholders.
• The Court concluded that there is evidence that the oppressive terms of the bridge loans negotiated by Mr. Copeland contributed to Cadant’s inability to bring fair value.
• The Court rejected the defendant directors’ argument that there could be no breach of loyalty when their conflict of interest was fully disclosed.
• The Court concluded that the evidence of aiding and abetting on the part of Venrock and JP. Morgan was sufficient to get the plaintiffs to a jury.

With the case now going to jury trial, it will undoubtedly have an effect on the way VCs do business and think about their roles as company directors.  Foley & Lardner LLP does a great job of highlighting some practical lessons (shared below) that VCs can apply to avoid another case like CDX Liquidating Trust v. Venrock Associates.

“Address Board-Level Conflicts of Interest. First and foremost is the critical importance of identifying conflict of interest issues at the board level and implementing processes to address them — particularly in distressed situations, where resources and options are, by definition, constrained. An important point in the Court’s analysis was the fact that the non-VC directors did not step forward to act independently for the corporation, in light of the presence of conflicted directors.

Avoid “Sitting on Both Sides” of the Transaction. Of equal importance was the Court’s view that the VC directors used their positions to “act disloyally” — sitting on “both sides of the table” and obtaining terms favorable to them and harmful to Cadant and its common stockholders. These acts included using their knowledge that the disinterested directors would accept smaller bridge loans with shorter terms than the VCs would have expected and obtaining a 2X liquidation preference. In the Court’s view, these terms weakened Cadant’s ability to bargain with potential buyers by keeping Cadant’s runway short and reduced the likelihood that the common stockholders would receive anything.

Mere Disclosure of a Conflict Is Not Enough. An important detail the Court emphasized is that the mere disclosure of a conflict of interest does not absolve a director from liability for a subsequent breach of duty. In this case, the VC directors’ inherent conflict of interest was obvious and well known; the fact that the conflict was disclosed did not mean, however, that the VC directors could proceed to sit on both sides of the bargaining table and be immune from suit.

Prepare for Funds to Be Sued. Increasingly, VC funds are sued as “deep pocket” defendants, especially in distressed situations where portfolio companies often lack funds to pay indemnification and lack adequate (or any) D&O insurance. Here, the VC funds were claimed to have “aided and abetted” the directors’ breach of fiduciary duty. The twist is that the Court treated the funds as third-party lenders, not company insiders, and stated that they could be held liable if they, knowingly, either exploited the directors’ conflicts of interest or extracted terms that required Cadant to prefer their interests at the stockholders’ expense. Funds should consider how they will approach and handle such exposure, including the possibility of obtaining insurance or establishing reserves.

Prepare for Funds to Be Sued. Increasingly, VC funds are sued as “deep pocket” defendants, especially in distressed situations where portfolio companies often lack funds to pay indemnification and lack adequate (or any) D&O insurance. Here, the VC funds were claimed to have “aided and abetted” the directors’ breach of fiduciary duty. The twist is that the Court treated the funds as third-party lenders, not company insiders, and stated that they could be held liable if they, knowingly, either exploited the directors’ conflicts of interest or extracted terms that required Cadant to prefer their interests at the stockholders’ expense. Funds should consider how they will approach and handle such exposure, including the possibility of obtaining insurance or establishing reserves.

Watch Out for “Inside-Out” Economics. A final observation is that the claims in this case are being pursued by a liquidating trust, a creature of bankruptcy formed just for this purpose, without which the claims may not have been pursued at all. These trusts are typically funded by assets transferred from the bankrupt company’s estate — assets the VCs might have thought to be theirs, at least in part. In the absence of insurance coverage or indemnification, VCs may find that they are effectively funding, in whole or in part, both sides of an otherwise non-viable lawsuit against them.”

Q1 2011 Life Science VC Investment Report

It is no secret that early stage (Series A & B) life science investing was way down this past quarter, 50% year-over-year to be exact.  The question is, why? 

Some possible reasons include: 

• VCs are short on money / number of new funds is way down
• Hostile regulatory environment making VCs sit on the sidelines
• Too much capital pumped into companies over last 5 years, VCs waiting for valuations to be adjusted
• Partners sitting on too many boards, need to sell existing companies before making new investments
• Lack of early stage deal flow

Despite the challenging investment environment, a bunch of great therapeutic, device, and diagnostic startups were funded during the last quarter and I compiled those financings into two lists (therapeutics and device / diagnostics) below.   

I should note that the inclusion criteria for my lists were somewhat subjective, as I compiled them from FierceBiotech press releases.  I also did not include Seed rounds because they are not often picked up by major news outlets and can therefore be quite hard to track. 

While my therapeutic financing list is somewhat short (reflective of the overall activity in Q1), some trends can be pulled from the data: 

• The most active VCs (Clarus, SV, Third Rock, etc.) are the funds that most recently raised capital.  Not a shocker, but it is important for startups to know which funds have money before they go out and fundraise.
• Cancer, cancer, cancer.  It is, and will continue to be, a sure thing for investors.
• Omega-3s are hot.  Lots of companies are working on novel Omega-3 formulations or creating agonists that bind to putative Omega-3 receptors.  Also, inflammation is a growing and poorly served market, and pharma is actively looking for inflammation modulators that have improved side effect profiles.
• Cosmetics.  VCs are branching out into consumer, IT, service, and generic plays in an effort to find products that get to market faster, with less risk, than traditional therapeutic plays.  Don’t be surprised if you see a lot more consumer plays over the next year.
• Immunotherapies continue to be hot.  Many startups are leveraging Dendreon’s success to raise capital in a tough financing environment.  Genocea, Gliknik, and Kite Pharma all raised rounds to finance the development of immunostimulatory programs.  Cancer vaccines and infectious disease therapies continue to be the main thrust of immunotherapeutic drug development.  I should also mention that Dendreon did something of incredible value (I actually covered this in my last blog post) to investors, which is to show the investment community that CMS will cover immunotherapies that are used to treat cancer.

Investors hate uncertainty, and by sending mixed signals regarding how it intends to tweak the 510K approval process, the FDA is causing VCs to think hard before making a new medtech investment.  The rumor is that the FDA will provide new guidelines for 510K approvals sometime this summer.

Here is a list of other trends I am seeing:

• VCs are looking for niche products that can be taken to market with less than $20 million of invested capital. 
• Most device startups are now choosing to run their clinical trials in Europe, which has a far more defined regulatory path than in the US.  The new paradigm seems to be, hit CE Mark then come back to the US to go for IDE.
• VCs are looking at a wide array of medtech opportunities, not just orthopedic plays.  Orthopedics used to be the bread-and-butter investment for VCs, due to a simple approval process, high reimbursement rate, and the fact that orthopedic surgeons were likely to buy/try a new product.  All of the reasons why VCs used to love orthopedics are now under regulatory and reimbursement pressure.   Advanced Animal Diagnostics, a diagnostic to rapidly identify disease in farm animals, is a good example of the lengths that VCs are going to find medtech opportunities that have appropriate risk / return profiles.
• European VCs are getting in the game.  While many US-based funds have closed their Europe offices, it would seem to me that now is a prime time for US venture firms to open small European outposts to leverage European medtech talent and clinical trial access.