Case Study In Finding Money: A Reality Check
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
Mary Jones, a biochemist, has stumbled across an interesting piece of science and has been given the opportunity to license the same by the university for which she works, for a nominal up-front fee, an ongoing royalty, plus a gratis equity position in the company. The principal condition of the license is that the science be exploited commercially. The science, if proven to perform as early indications suggest, will greatly reduce the need for insulin injections by patients suffering from juvenile and adult-onset diabetes. Since diabetes is growing at an alarming rate, particularly among adults, Jones is excited and prepared to quit her job. She is intimidated, however, by the fact the development of the drug through FDA animal and clinical trials may, she understands from individuals who have "been there," cost upwards of $30 to $40 million. Indeed, simply to fund testing to get a new drug ready for the FDA will require several hundred thousands of dollars of additional work in the lab.
Jones goes to the Internet and downloads some of the existing literature on early-stage finance; she puts together a business plan seeking to raise the entire amount necessary to get her product on the market. At this point, the case study is interrupted by a supervening fact: Jones is almost certain to fail. With exceptions with which I am not personally familiar (other than a few extraordinary Internet-related examples), it is impossible to raise a multimillion-dollar amount of capital for a start-up in one lump sum. If one sets out to do so, time and money are wasted. The successful examples, accordingly, divide the fund-raising process into small bites. The first amount of capital raised (a "tranche" in VC jargon) is $500,000. There is no magic in that number but it has repeated itself often enough that it has become part of the canon. Five hundred thousand dollars takes the startup to the point where indications of success have become strong. There is, perhaps, even a so-called beta test, meaning a working prototype of the product or technology and, in the biotech arena, successful phase-one trials. The next tranche is, therefore, $3 million. (Again, there is no magic to the number, but it repeats itself so often it has become part of the culture.) The $3 million also may come from high net worth individuals, often those acquainted with the founder (and here the jargon is that the founder is going through his or her "Rolodex offering"), but also may include a venture fund, turning the financing into the "first venture round." Getting ahead of the story, the $3 million does not arrive in one lump sum, ordinarily, but in increments. Recognizing that $3 million is only a fraction of the $30 to $40 million needed, the founder and her advisers, perhaps including a boutique placement agent at this stage, are coincidentally searching for strategic investment, for example, a minority tranche from an ethical drug company in exchange for stock, marketing, and distribution rights to the technology if it clicks. Again, the case study indicates the rules of thumb in the trade. The strategic investor invests at a 25 percent more favorable valuation than the financial partners, a number validated by reliable survey materials. But the bad news is that it takes about twice as long for a strategic investor to make up its mind as a financial partner.
The company is then up and operating, slogging its way through the FDA gauntlet of phase-one, phase-two, and phase-three trials, and burning money at a rate of several hundred thousand dollars a month. As the science arrives at the early stages of FDA scrutiny and trials, the VCs and the founder start talking about a mega-financing by tapping the public equity markets—an initial public offering (IPO).
Again, referencing current fashion, serious investment bankers (and not those firms of questionable pedigrees sometimes known as the "Boca Raton" bankers) express an interest conditional on the company having at least one, and preferably more, applications of its science in phase-three trials. The minimum size of the offering is $30 million for somewhere around one-third of the company, meaning a total post-IPO company valuation of $100 million. A financing takes about six months from start to finish and is fraught with risk, including the possibility of a "fail" on the eve of the effective date if the market turns against biotech stocks, as it does episodically for reasons which can be totally unrelated to Jones and her firm. Assuming a successful public offering, $30 million still may not be enough to get to cash-flow break-even, since the company is taking on other scientific projects, which burn money at a rapid rate, in order to justify the expectations of the market that it is a real company and not just a line of one or two products. The IPO is then followed by another primary offering some six months later, assuming the stock holds up well and the market continues to stay in love with the company's prospects. This time the valuation is advanced to, say, $150 million and the company again puts $30 million in its pocket. The period between the first and the second financing is stressful for Jones because she is not only managing her firm but also, once the company has become public, continually spending time cozying up to stockholders, analysts, and other members of the investment community so that the popularity of her company, as measured by the trading price of her stock, remains strong. Jones has been told that the "road show" (that presentation she made to the investment community and investment bankers immediately prior to the IPO) "never ends." The irony is that at a company valuation anywhere under $300 to $500 million, the company risks a visit to the so-called growing orphanage, meaning that cohort comprising 70 percent of the 12,000 companies currently public which are not followed by the investment analysts, and, therefore, are not liquid in any true economic sense, with a stock price reflecting an efficient market. Jones is advised, accordingly, to pursue a so-called rollup or platform strategy, meaning using her public company as the platform to absorb other public and private companies which have not been able to make it on their own but which house interesting science and have brought their intellectual property to the brink of commercial exploitation. By rolling up those companies into her platform, she is able to increase her market capitalization to one-half billion dollars and finally take a one-week vacation in the Bahamas.
After all the dilution she still owns about 7 percent of her company personally, which translates, on paper at least, into $35 million. She cannot get out at that price because she is contractually obligated to "lock up" (i.e., not sell) for various periods of time so as not to create undue selling pressure. And, she has been living for four or five years on a salary which is somewhat less than half of what she could have earned had she not entered into this enterprise in the first place. However, she beat the odds. She will ultimately have some liquidity, together with the priceless satisfaction of having grown a major public firm and served mankind in the process. She will no longer, incidentally, be chief executive officer. That post was filled shortly after the first venture round, with Jones continuing as chair and chief scientific officer. The first individual hired having not worked out, there have been two CEOs since: the last one a grizzled veteran of the pharmaceutical industry and a long-time favorite of Wall Street. The office of chief financial officer has also changed hands a few times, the law and accounting firms are new, and a major-bracket investment bank long ago replaced the placement agent. Alleged dissident shareholders have sued Jones twice, in fact stimulated by underemployed plaintiffs' counsel for allegedly keeping good news (or bad news, depending on how the stock price performed) under wraps for too long. Was it worth it? The answer, of course, depends on the individual. This game is not for everybody.