Originally Published in Navigating The Capital Crunch - April 15, 2013.
The need for innovation in healthcare has arguably never been greater. A range of factors, from aging world populations to rising standards of living in developing countries, are poised to drive long-run demand for innovative drugs, devices and medical technologies that can improve outcomes and reduce costs.
Ironically, however, funding for healthcare innovation remains in short supply. As industry participants are keenly aware, life science venture capital financing – which has played a critical role in helping translate research ideas into commercially useful medical technologies – is becoming increasingly scarce.
Understanding the Capital Crunch
Results from a recent survey of 2012 life science venture capital (VC) activity by Fenwick & West illustrate the magnitude of the situation. The survey summarizes results from over 350 therapeutic, diagnostic and medical device financings occurring during 2012, and shows that financing valuations continued to trend modestly upward, evidence that companies are continuing to develop promising technologies that justify a step-up in valuation.
However, fundraising by life sciences VCs has continued to decline. While overall VC fundraising rebounded modestly during 2011 and 2012, the percentage of fundraising allocable to life science investments declined from 19% in 2009 to 12.5% in 2012. In absolute dollar terms, we estimate that fundraising by life science VCs was $2.5 billion in 2012, compared to an average of $2.9 billion/year for 2009-11 and an average of $7.8 billion/year for 2007-08.
Given these fundraising statistics, it should come as no surprise that 2012 saw the fewest first time venture financings of life science companies of any year since 1995, according to the MoneyTree Report. Venture capitalists typically spend three or four years making new (first time) investments out of a fund, and then reserve the fund’s remaining capital for follow on investments. So at this point, the 2008 vintage funds have stopped making new investments, and there are fewer new funds to fill the gap.
Navigating the Capital Crunch
In the face of this capital crunch – which appears likely to continue for some time – what is the aspiring life science entrepreneur seeking financing to do? Plenty of smart people are giving thought to this topic, and the early stage financing ecosystem is evolving. In the meantime, however, I think it’s helpful for entrepreneurs pursuing venture financing to bear in mind two simple and related points:
Recognize the timing mismatch: while life science technologies mature slowly, VC investment horizons are limited. Venture capitalists, no matter how enthusiastic they may be about your technology, are constrained by fund structures that require them to return capital to their investors within ten years. And practically speaking, VCs are often making investments several years into a fund’s life, and need to show returns to investors in order to raise their next fund as well. The net result is that VCs are under considerable pressure to seek investments that can exit in five to seven years, ideally sooner.
On the other hand, life science technologies – which invariably must navigate significant R&D and regulatory challenges – can take well longer than five, seven or even ten years to mature and demonstrate their full value.
Adding to the challenge, today’s public markets are less receptive to development-stage life science companies, meaning that investors can no longer count on the possibility of an IPO to provide an exit opportunity. Recent years (2011-12) have seen an average of 10 IPOs of venture-backed life science companies per year, in comparison to 25+ per year for 2004-07. And as noted elsewhere – for example Fenwick’s IPO Survey – more than half of the life science companies that went public in 2011-12 priced below their target range.
Address the timing mismatch: increase your odds of raising venture financing by planning your business for exit from the outset. Every thoughtful entrepreneur recognizes that investors need to see a path to “exit” their investment and realize a return. However, there are key steps that can be taken – from the earliest stages of the business – to enable a quicker exit. And in today’s capital constrained environment, going the extra mile and enabling a quicker exit is helpful, if not essential, to raising scarce venture funds.
There are various ways to enable a quicker exit, for example:
Pursue technologies that can reach key value-inflection points sooner. Resolve Therapeutics did this successfully, pursuing a lupus treatment where proof of mechanism could be established quickly using biomarkers. This helped the company go from research concept to a $255 million partnership and option deal with Takeda in little over two years.
Consider working with a corporate investor earlier. Corporate investors are increasingly willing to work with life science companies from the earliest stages (for example, Novartis’ Option Fund), and can provide validation, invaluable feedback on market potential, and a potential path to exit. As various industry observers have noted, companies with corporate investors involved tend to be more successful. In some cases, a potential sale to a corporate investor can be built in from the get-go, as done for example by Warp Drive Bio.
Adopt a business structure that permits tax-efficient sales of assets, prior to a sale of the entire business. These structures, which typically involve a limited liability company or “brother-sister” corporations under common ownership, have been discussed in the industry for some time. They are particularly well-suited to drug discovery platform companies, but can work with other business models as well, and have the virtue of allowing an earlier return of investor capital, de-risking the investment and improving overall investor IRR. The key point for the entrepreneur to recognize, however, is that in order to avoid a potentially insurmountable tax cost, these structures must be implemented early, ideally at company inception.
As supply and demand factors play out, the early stage financing ecosystem will continue to evolve. Established pharma and device companies, disease foundations and other non-VC investors are playing an increasingly important role. And perhaps in the not too distant future, big data analytics tools and digital health technologies to support better clinical trials will mature that can help shorten the cycle and reduce the cost of life science R&D. But for entrepreneurs operating in the here and now, thoughtful early attention to the path to exit remains critical to raising scarce investor capital.