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Financial reporting for life science start-ups (part 1)

By  Stefano Picone in May 21st 2013   1 Comment »
Filed Under All posts, Financing, Founders, Lean Startup, Startup Models, Uncategorized     Tags: , , , , , , , , , , ,      

Seeing as I am an accountant by trade, I figured it was about time that I write an article about financial (and non-financial) reporting for life science start-ups.  As most visitors to this site come from a science background, this article (part 1) will introduce the high-level concepts of reporting, and the next article (part 2) will explore some of the details.  I will note that no previous accounting training is required to understand either article, so, if you do not know a debit from a credit, no need to worry.

Most series A funded life science start-ups will have a full or part-time finance director or VP whose responsibility it will be to manage the reporting process.  However, in the case of a seed stage start-up, particularly a lean start-up, this will be the responsibility of the founder.  Although this may seem like an intimidating task, it is certainly doable.

“Reporting” is the process by which an organization communicates information to stakeholders for the purpose of making decisions. This can be both internal, between an organization and its management, as well as external, between an organization and its investors, creditors, bank, government, general public, etc.  Reporting can also be financial or non-financial.  Most people are familiar with general purpose financial statements, namely those consisting of a balance sheet, income statement, and cash flow statement, which are commonly audited by an independent entity to provide some assurance that they are free from misstatement.  However, much reporting is non-financial, such as the case of a pharmaceutical company releasing the results of a clinical trial.

When it comes to reporting, every organization needs to be aware of three questions:

(i) Who are the stakeholders?

(ii) What decisions do these stakeholders need to make?

(iii) What information is required to make these decisions?

In the case of a seed stage start-up, the major stakeholders are likely to be the founding management team, investors and Board of Directors, academic or government contributors (i.e. providers of non-dilutive capital), and scientific or clinical advisory board.  Below, I discuss steps (ii) & (iii) for each of these.  Note that I have included investors and the Board together as the Board will likely consist exclusively of investors (except for perhaps one independent director), so, they are one-in-the-same.

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Management Team

The management team is responsible for the day-to-day operations of the business, and therefore, needs to have its pulse on operations in order to make frequent and effective decisions.  The best system of “reporting” to one another is simply via open and honest conversations, however, there are two critical reports that should be kept and updated on a biweekly or monthly basis.  First, the company should have a rolling budget to monitor spending, track variances, and calculate runway.  This may seem complicated, but in the next article, I demonstrate how this can be easily done with a spreadsheet and some free accounting software.  Second, there should be a project plan with documented milestones and outcomes.  Whereas lab books maintain detailed notes about experiments and results, project plans are meant to provide a high level view and consolidate information for multiple sources.

Board of Directors

Reporting requirements vary by Board, and can only be ascertained by a having a conversation with the Board.  Some Boards prefer regular e-mails with information updates from management, and then meet on an ad hoc basis to discuss issues as they arise.  Others prefer to meet on a regularly scheduled monthly or quarterly basis so issues can be addressed in concert.  In either case, the Board will require some combination of financial and non-financial (i.e. project or scientific) information.  One of the principal benefits of maintaining a rolling budget and project plan at the management level is that it can be summarized or condensed and presented to the Board, thereby “killing two birds with one stone.”  Most seed stage Boards do not require management to submit audited general purpose financial statements, which is prohibitively timely and costly.  However, as you will see next, this is not always an option.

Government or academic contributors

Government and academic funders are widely regarded for onerous reporting requirements.  Although this should not dissuade a start-up from accepting non-dilutive capital, it should be anticipated.  Most require detailed project plans to be submitted at the beginning, during, and at the conclusion of the project, and may also require some sort of substantiating financial information to support spending.  This might include either audited financial statements over the life of the project, an audit of project expenditures, or copies of project invoices and disbursements.

Scientific or Clinical Advisory Board

Communication with a company’s scientific advisors is generally infrequent and done or a quarterly basis or coincide with significant scientific milestones.  Scientific advisors generally require detailed and refined scientific presentations, even more so than the Board, which likely does not have the same degree of technical depth.  Financial information need not be communicated to the scientific advisors, provided the company is not experiencing severe financial difficulties.

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The next article will explain how to prepare a rolling budget, as well as how to maintain basic accounting records.  I will also discuss some basic internal controls that should be implemented, particularly around the custody of cash and the purchasing cycle.  However, as mentioned, much of this is doable without an accounting background.

 

 

 

 

 

Entrepreneurship and Chess

By  Stefano Picone in May 6th 2013   No Comment »
Filed Under All posts, BiotechStart, Financing, Lean Startup, Startup Models, Uncategorized     Tags: , , , , , , ,      

This is an odd topic for an article, but I thought I would write it regardless.

I tend to see parallels between otherwise unrelated things, so I am either insightful or grasping at straws.  One such parallel is that between entrepreneurship and chess.  On the surface, both are incredibly complex and challenging, and require an elevated intelligence to succeed.  But underneath, there are some remarkable similarities, specifically in terms of strategy versus tactics.

There are many MBA courses on the subject, but, generally, strategy refers to “what you are trying to accomplish” and tactics refer to “how you are going to accomplish this.”  There are countless tactics in chess, but they are only as good to the extent they advance a strategy.   In fact, the hallmark of great chess players is the ability to execute a strategy using tactics that others cannot.  This is a rather convoluted statement, but I have a great example to illustrate it.  In 1956, Bobby Fischer, then 13 years old and relatively unknown, beat Donald Byrne,  an American chess master 13 years his senior, in a match hailed as the “Game of the Century.”

Sacrificing a piece is generally considered the riskiest tactic in chess.  On move 17 of the “Game of the Century”, Fischer sacrificed his Queen.  While Byrne likely saw this as a blunder committed by a teenager, the sacrifice was in fact an audacious tactic designed to gain control and position.  Within eight moves, Fischer reclaimed a material advantage, and by move 35, checkmate was inevitable.

In chess, there are a handful of critical strategies that are well known and accepted.  Interestingly, they correlate well with strategies necessary to be successful as an entrepreneur, particularly in life sciences.  Again, brilliance is chess or start-ups is not a matter of acknowledging or knowing these strategies, but rather, devising tactics to achieve them!

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Chess: Protect the King

Start-Ups: Protect the Cash

The goal of chess is not to win material, but rather, to checkmate the opposing King.  Similarly, the goal of a start-up is not to raise and spend money, but rather, to create and realize value.  Too often, chess players and entrepreneurs focus on amassing resources, and winning material or raising money.  Cash is king and it needs to be especially contemplated, protected and allocated only when it contributes to the end game of creating value.

Chess: Coordinate an Attack

Start-Ups: Be Resourceful

A common mistake of introductory chess players is that they rely too heavily on their Queen in attack.  As demonstrated by Fischer in the “Game of the Century”, individually weak pieces can be collectively very powerful.  Great entrepreneurs are successful at maximizing all of the resources at their disposal, whether it be their Board, Scientific Advisors, investors, lawyer, accountant, past co-workers, etc.  Simply put, a whole can be greater than the sum of its parts.

Chess: Win Tempo

Start-Ups: Be Proactive

In chess, a player has tempo when it forces the opponent to be reactive.  Again, in the “Game of the Century”, by sacrificing his Queen, Fischer was able to seize momentum and start dictate the game by forcing Byrne to be defensive.  Similarly, successful entrepreneurs are not reactive and do not respond as things happen.  They anticipate what will happen, and are proactive in their approach.

Chess: Develop the Centre

Start-Ups: Be Able to Adapt

In most chess games, the outcome is usually decide by whichever player controls the centre at the beginning of the game.  This is because the centre is the gateway to the rest of the board, which is critical as play develops.  Likewise, a key component of the lean start-up methodology is to remain flexible and adaptive by being virtual and keeping committed costs low.

–

Although Bobby Fischer would have been a terrible entrepreneur, there seem to be a number of notable chess masters turned entrepreneurs, specifically Peter Thiel.  In fact, Thiel apparently broached the parallels in an entrepreneurship class taught to students at Stanford.   So, perhaps I am not quite grasping at straws as I fear to be.

Should I pay a Finder’s Fee to a Lead Angel?

By  Stefano Picone in March 12th 2013   No Comment »
Filed Under All posts, Financing     Tags: , , ,      

Recently, I spoke to two life science entrepreneurs in the process of raising low six-figure seed rounds from angel investors.  In both cases, the lead angels responsiblefor recruiting the others asked to be compensated with a finder’s fee.  The timing of coincides with a provocative article posted on StartUpNorth, discussing fees charged by the First Angel Network (FAN) to entrepreneurs in Atlantic Canada.  The actions of FAN have drawn the ire of entrepreneurs and angel investors alike across the country.

My position on finder’s fees are as follows:

(i) Cash finder fees should never be paid, for three reasons.  First, finder’s fees are essentially redistributions from other investors, meaning the lead investor is benefiting at the expense of other shareholders, whereas they should be pari passu (Latin for “on par with”).  Second, as difficult as it is to raise a seed round, it is even more difficult when you over-raise to compensate for the fee.  For example, for a $200,000 raise in $10,000 units, a 5% means having to $210k+, and sell an additional unit.  Third, and most important, the investment thesis in any start-up (particularly life science) is long-term and exponential, whereas a finder fee is short-term and nominal.  This represents a misalignment of priorities.

(ii) I have fewer issues with equity finder fees, whereby the lead investor is awarded the cash-equivalent value of equity for syndicating the raise.  For example, if a start-up raises $200,000 in exchange for 200,000 shares, a 5% finder fee would be paid out as $10,000 in equity, or 10,000 shares.  The fees charged by investment banks for equity issuances usually follow the “Lehman Formula“, and range between 1% – 5%.  I believe lead angels belong in the low-end.

It should be noted that finder fees should be disclosed in the term sheet.  An advantage of doing so is that, if the fees are perceived as onerous, the other investors will be inclined to lobby the lead investor on your behalf.

The Myth of the Pitch

By  Stefano Picone in January 24th 2013   No Comment »
Filed Under All posts, BiotechStart, Financing, Founders, Uncategorized     Tags: , , , , , , ,      

Those who know me know that I am not particularly fond of Shark’s Tank, Dragon’s Den, or any of these shows that involve entrepreneurs asking angel investors for money.  I understand that these shows are formulated to entice viewers and pump ratings, but, in doing so, they completely misrepresent and for lack of a better term, bastardize entrepreneurship.  Those that know me also know that I consider entrepreneurship to be the great engine of economic and social growth, and consider any affront to it as sacreligious, so, I find these shows particularly irritating.

So, what is it that I find irritating?  Well, there are a number of small things, clustered around one big thing.  The small include things such as (i) investors consistently demanding at least 51% equity interest in order to have control, whereas economics and control can be negotiated independently (explained in further detail here), (ii) no discussion of how entrepreneurs and investors intend to exit or realize on their investment, (iii) no upfront mention of the due diligence process that often results in many deals often being overturned, etc. etc. etc.  In spite of this, I could stomach these issues if it were not for my biggest complaint, which is that these shows perpetuate the “Myth of the Pitch.”

If I have learned anything about business, it is that business is based on relationships.  This includes relationships between employers and employees, companies and suppliers, companies and customers, and especially, companies and investors.  Intelligent investors invest in companies as much as the founders and people involved, and this cannot adaquately be conveyed in a 10 minute PowerPoint presentation, let alone a 90 second television pitch.  As with anything, a good relationship based on trust and a common understanding takes a long time to cultivate and form.

In the conversations I have had with life science venture capitalists, and from the reading I have done, it is quite clear that ”the pitch” does not exist in life sciences.  Of course, entrepreneurs do present to venture capitalists, however, that presentation is never the basis of an investment decision.  If the venture capitalist is interested, they will proceed with due diligence that escalates through a series of decision gates.  This will open up a conversation that evolves over time, and concludes with a decision.  However, the most attractive opportunities are those whereby the management team and idea are already familiar to the venture capitalist, which explains why nearly all venture capitalists are unwelcoming in terms of deal flow.  It is their job to know the people and the ideas they want to invest in, and in some ways, it is their competitive differentiation.

With that being said, I think there are a couple of important things to take away from this article:

(i) The ”Myth of the Pitch” is that entreprenership often comes down to a make-or-break opportunity to impress investors.  This is not true, especially not in life sciences.  Venture capitalists do not make snap judgments based on glossy slide decks and smooth-talking persuaders, because if they did, they would not exist.  They succeed because they are excellent at cultivating relationships with people and using those relationships to leverage ideas.

(ii) It is important to have an 90 second elevator pitch and 10 minute PowerPoint presentation that adequately communicates your value proposition.  However, these are simply talking points, and not investment crucibles that decide whether you get funded.

(iii) All things considered, life sciences entrepreneurship is not a young persons game.  So, if you are starting out (like myself), focus on building long-term relationships with others in the space, because, many years from now, these will be of great value when you seek funding.  As my Dad reminds me, starting a company is like growing a garden… “inch by inch, row by row”.

Breaking the Mold

By  Michael Koeris in January 22nd 2013   1 Comment »
Filed Under Academic Entrepreneurship, All posts, BiotechStart, Financing, Founders, Lean Startup, Leverage Startup, Minimum Viable Product (MVP), Startup Models     Tags: , , , , , , , ,      

Happy New Year to everyone from the Biotechstart team!  The New Year always begins with an abundance of potential and brings with it so many opportunities for change and progress.  We love this time of year because it really stimulates the creative, entrepreneurial mind.

There are three themes we want to lay out in this post in particular that are of great importance to our organizations.

They are the:

  1. Democratization of the startup process,
  2. Application of lean principles to biotech startups through the Lean Biotech Startup model, and
  3. Entrepreneurial Obligation.

Let me briefly put a few thoughts around the latter two topics before diving into the first.  The Lean Biotech Startup concept we’re developing is aiming at reducing the risk inherent in any biotechnology venture by implementing some of the lean startup methods popularized by Eric Ries, as well as originating new methods specific to the risk profile of the biotech industry (look for it in the February issue of the Burrill Report).  Furthermore, it’s our strong belief that there is an implicit obligation to contribute to the betterment of the human condition, if one is capable of doing so.  This very strongly aligns with the desire of many founders to do well by doing good, and we call it the Entrepreneurial Obligation.

Look for future posts that will dive into these topics throughout 2013.

Now in this post I will focus on the democratization of the startup process.  Let me clarify briefly what that means before diving in.  Biotech startups really run the gamut and bridge the biology and technology fields in the broadest possible sense.  This is a big theme for the 21st Century, which is being repeatedly called the Century of Biology.  In my opinion that’s a bit of a misnomer but points in the right direction, as new approaches are emergent that combine biology, technology, social aspects and more in new and innovative ways.

Breaking Down Barriers

We want to break down the barriers to starting a biotech company, through democratizing the process.  The traditional hubs on the East Coast and West Coast have always been able to attract talent and capital, but innovation isn’t restricted to Boston or San Francisco—though you wouldn’t know it by following the respective Twitter feeds and blogs.  Last I checked there is no monopoly on innovation, see for example the emergent Louisville biotech cluster.

Access to resources in all shapes and forms is the greatest barrier for an entrepreneur, and in this sense we think of entrepreneurs as either having technology that advances the state of the art meaningfully, or having identified a problem and want to solve it to improve the status quo.

Resource constraint begins with information: information about what to do, what not to do, and how to tell the difference!  We at BiotechStart aim to provide some measure of relief to that particular resource constraints by aggregating information focused around the early stages of venture creation but including considerations for scaling.

Resources in the classical economic sense include talent, funding, and other assets.  If you’re located in a non-traditional biotech hub you’re stuck in a catch-22 situation.  More often than not you don’t have access to funding to build a successful company (if you have the talent), and if you got capital, it’s less likely there is good management and development talent available in your location.  All resources are important but some are scarcer and less mobile than others.  Generally speaking talent is less mobile than capital.  MK: Having tried to move people even from one biotech cluster to another is rarely possible.  For a short opinion on the importance on management talent in the biotech industry, please refer to the excellent post of Bruce Booth and Laura Strong on circulating management talent in an entrepreneurial ecosystem.

The question becomes: how can broad entrepreneurship be enabled?  How do we provide access to capital, and talent?

Breaking With Tradition

Much of venture creation has been and remains an intensely network-centric endeavor.  It depends on where you live, where you went to school, and most importantly whom you know.  Full disclosure: I have been the beneficiary of these network effects, having started Sample6 in Boston.  Let’s also make this clear, I’m not at all opposed to the VC model, it is however severely bandwidth-limited.

Let’s focus on the access to capital first.  Many biotech companies are competing with lean web/mobile startups that need a fraction of the capital, have little to no technology risk, and generally don’t have to get approval for the use of their product.  In the face of this competition, it’s crucially important to provide the initial seed capital that allows a nascent venture to prove, or disprove the viability of it’s value proposition, and pivot if necessary.  This capital can be effectively provided by organizations such as Breakout Labs, but also by Corporate and Institutional Venture Firms, if they set up vehicles.

The access to talent is more problematic and a creative strategy is needed here.  Since talent isn’t very mobile, we need to focus on providing mentorship and entrepreneurial education to the local talent to substantially grow the biotech talent pool.  Excellent examples include the Thiel Foundation’s Breakout Labs summits, and biotech-specific startup weekends.

On a more continuous basis, it’s our opinion that providing mentorship by seasoned biotech executives and VCs is critical to spreading and establishing entrepreneurial ecosystems.  This includes advice ranging from implementing Lean Biotech Startup principles, through team building, markets, IP and many more.  It’s our strongest belief that that can and should be facilitated by connected actors in the current biotech clusters.  We at BiotechStart believe we can help with the connection of mentors and mentees, and it’s part of giving back to the ecosystem.

In closing I’d like to expand the aperture of many a biotech or other entrepreneur.  Think broadly about the applicability of your technology, or your approach with respect to markets (e.g. consumer-focused biotech?), or geography (XUS before US?) to name just a few.

Break Out!

In the vein of alternative models that break with tradition, we strongly support the democratic application process that Breakout Labs follows.  This is but one mechanism to enable and accelerate access to resources, in this case capital and mentoring.  We strongly believe that mechanisms such as Breakout Labs’ are necessary to supercharge the process of company formation nationwide.

Lindy Fishburn, the Thiel Foundation’s Breakout Labs Executive Director states: “Through Breakout Labs, we’re reshaping the way early-stage science is funded, so that young companies can advance their most radical ideas no matter where they are located.  Recipients use our funds to achieve critical scientific or technological milestones, and are then better positioned to raise the necessary follow-on funds.  With our first 2012 recipients we are already seeing the catalyzing effect of our funds.”

In the spirit of lean and iterative development, everyone is required to submit a pre-proposal inquiry before developing a full proposal.  Further information is available on the web site: www.breakoutlabs.org.

Be bold and break from the pack, you’ll be surprised!

About Breakout Labs

Long the domain of major research universities and corporations, cutting-edge advances across the spectrum of advanced technologies are returning to the hands of independent scientists, engineers and inventors. Our goal is to spur innovation by supporting these scientific entrepreneurs. We consider applications from early stage companies across all disciplines that fulfill our basic aim of supporting cutting-edge breakthroughs with the potential for far-reaching impact.

We anticipate that projects will fall within one or more of the following categories:

Technology meets biology.

The combination of new biological insights and new ways to manipulate matter at multiple scales is an unstoppable force for innovation in society. Advances in nanotechnology, photonics, and synthetic biology are revolutionizing diagnostics and therapeutic possibilities. Biological insight is transforming how we envision and design materials, build machine and robotic systems, and even create intelligence itself.

Revolutionary platforms.

We welcome platform technologies because of their potential for broad impact, including advances in molecular design, instrumentation, assays, or therapeutic interventions.

Proof of concept for next-stage funding.

Many innovations fall into a valley of death between basic discovery and the potential for commercialization. We welcome projects for which our limited funds can catapult a discovery or invention across this chasm.

Research on topics outside the scope of federal funding. The bulk of federal research dollars are allocated to particular fields of study based on perceived national interests and place within the academic mainstream, which has its own biases and fads. Bold innovation often requires a break from the consensus.

Breakout Labs is a project of the Thiel Foundation

The Thiel Foundation, based in San Francisco, defends and promotes freedom in all its dimensions: political, personal, and economic. The Thiel Foundation supports innovative scientific research and new technologies that empower people to improve their lives, champions organizations and individuals who expose human rights abuses and authoritarianism in all its guises, and encourages the exploration of new ideas and new spaces where people can be less reliant on government and where freedom can flourish.

New Paradigms

By  John Mulcahy in January 15th 2013   No Comment »
Filed Under BiotechStart, Financing, Founders     Tags: , , ,      

James and I attended the New Paradigms to Fund Life Science Innovation conference last week in San Francisco.  It’s one of a couple of satellite events that’s sprung up amid the commotion surrounding the JP Morgan Healthcare Conference.  Valerie Bowling and her team put on a terrific event, with one of the best lineups of speakers I’ve encountered in what still felt like an intimate setting at the Marine’s Memorial Club.  The highlight for me was a talk by Raymond Schinazi, who told some great stories about the course of events that led to the discovery of the nucleoside reverse transcriptase inhibitors 3TC and FTC.  Dr. Schinazi is also a co-founder of Pharmasset, acquired by Gilead for its hepatitis C program for $11 billion in late 2011.  He remains very enthusiastic about their pipeline, and clearly expects the bet for Gilead to payoff.

Below are a few thoughts from the New Paradigms conference and the JPM experience as a whole:

Equity Funding

The consensus was that funding is out there, and life science VCs have actually been generating pretty good returns over the past few years, but as a sector they’re suffering from a hangover brought on by excessive fund size and poor investment decisions in the late 90’s and early 2000’s.  Paraphrasing Bruce Booth, life science is “dirty word” among limited partners, and this isn’t going to change overnight.  Fortunately, pharma has stepped in to fill the void created by the withdrawal of traditional LPs and is putting large amounts of money to work in the sector through their own corporate venture arms and strategic investments in outside funds, such as the $200M fund recently put together by Index Ventures, GSK and J&J.

The Regulatory Environment

A number of speakers suggested that the FDA has become too conservative in their standards for demonstrating the safety and efficacy of therapeutics.  The agency desperately needs more leaders and risk takers to champion new medicines as they progress through the development process.  The FDA is in a difficult position, constantly balancing the goals of safety and efficient access to new drugs.  Perhaps the pendulum has swung too far in one direction.

Partnering

As the pipeline of phase II and phase III assets runs dry, pharma is looking earlier and earlier for partnering opportunities.  It was apparent throughout the week that preclinical and even late discovery stage programs in key strategic areas were garnering the interest of very large companies as potential research collaborations or partnering opportunities.

Overall, it was a great start to the year.  I left excited to get back into the lab and optimistic about the trajectory of the industry.

Why we have not cured cancer

By  Stefano Picone in December 31st 2012   2 Comments »
Filed Under All posts, BiotechStart, Financing, Founders, Uncategorized     Tags: , , ,      

I was going to name this article “Why there seem to be few recent monumental commercial breakthroughs in life sciences”, but I think this title conveys the same in fewer words.  In my observation, it seems that most life science companies (both public and private) are focused on the incremental rather than the massively disruptive.  Obviously, the obstacles to accomplish the massively disruptive in life sciences are enormous.  Beyond just the science, there is the challenge of regulatory demands, reimbursement, adoption, etc.   But, if history has proven anything, it is that great problems can be solved if there are sufficient incentive and resources to match.

On May 25th, 1961, President Kennedy announced to a Joint Session of Congress, his desire for a “great new American enterprise” and before the end of the decade, “land a man on the moon and return him safely to earth.”  At that time, the thought of a moon landing was scientifically within reach, but also extremely ambitious.  As such, President Kennedy asked Congress to commit between $7 billion to $9 billion over the next five years (equivalent to between $50 billion and $65 billion today) to do so.  NASA had a world-changing challenge ahead of it, but it also had the resources to do so.  This is because President Kennedy had an unwavering desire and incentive for the United States to maintain its position as the most technologically advanced nation and most powerful political nation in the world. 

In some ways, I view the challenge to “cure cancer” (or better yet, effectively treat and manage it) or to accomplish any other monumental life science breakthrough as similar to the moon landing.  Scientifically it is within the same distant but near reach as space exploration.  But, unlike space exploration, resources do not exist to support it because the incentives are not strong enough.  For better or worse, the most powerful incentive is money, and simply put, life sciences is not sufficiently profitable.  The risk and reward profile is such that life sciences is the recipient of charitable capital, sympathy capital, government capital, but very little private capital.  The private capital will come when the profits do.  Cancer will be cured when curing cancer is profitable.

For those who disagree with this statement, consider the following.  I live and work in Toronto, but I am originally from Calgary, where my family still lives.  Calgary is the centre of oil & gas, and other natural resources companies, which, due to current commodity prices are doing exceptionally well.  The city is a boomtown and salaries and lifestyles are very rich.  People and capital are flowing to Calgary in abudance, which as good as it is, is hurtful for other sectors in Canada, particularly those in advanced technologies like life sciences.  In my opinion, natural resources are to life sciences as trains are to space exploration, in that one is the past, and the other is the sustainable future.  Regardless, there is only one way to reverse the tide, and that is through profits.  People and capital will flow back to life sciences once the profitability of drugs, devices and diagnostics exceeds all else.

To conclude, transformational change in life science starts here, with the start-ups.  It is not enough that ventures be started and perhaps even raise money.  They have to succeed, make money, exit or be sustainable for people and capital to take notice.  Gradually, more resources will come and greater things will be accomplished, and this generation will have its defining scientific achievement.

Happy 2013!

Equity: Series vs Tranches

By  Stefano Picone in December 17th 2012   No Comment »
Filed Under All posts, BiotechStart, Financing, Founders, Lean Startup, Startup Models, Uncategorized     Tags: , , , , , , , , , ,      

As discussed in the previous article, as part of my effort to be a “Life Science Start-Up Catalyst”, I work for, help and speak to many start-ups.  Although each venture is unique in that it is pursuing some sort of device, diagnostic or drug, many of the business issues they are face are similiar.  One issue that seems to be prevalent is whether to raise equity in the form of series or tranches.  This tends to arise once a start-ups has established proof-of-concept and some intellectual property protection, and is looking to raise its first major equity investment from angels and/or a venture capital firm.

To provide an example, suppose you are the founder of a medical device company, and you anticipate requiring $5 million over a period of five years in order to develop a clinical prototype, achieve regulatory approval, get to market, and become cash flow positive.  Generally, there are two ways this can be structured.  The first approach would involve raising all $5 million upfront and the money would be “tranched” (i.e. released) over time by the investors as needed, depending on the venture’s burn-rate.  The second approach would involve raising a smaller amount upfront (perhaps $1 million) as part of a seed deal, and then, some time over the next five years, raise another round as part of a Series A (perhaps $2 million), and then a final round as part of a Series B.  This money might also be tranches as investors rarely release the full amount up-front, however, whereas the first approach involves a single term sheet and single agreement with one investor(s), the second approach generally requires a new term sheet and agreement for each round, with potentially new investors.

Ultimately, there is no superior approach, with each offering certain benefits and hinderances:

Valuation

A drawback of the first approach is that the entire investment (including all tranches) will be made at a seed-stage valuation.  Seed-stage valuations are the least favourable to the entrepreneur as the venture is still considered very risky.  The benefit of the second approach is, with each subsequent round, the entrepreneur can argue for an improved valuation based on the milestones accomplished to date, resulting in less dilution.

Closing process

A benefit of the first approach is that the time, money and effort required to “close a round” is significantly lower.  As mentioned, all tranches will be governed by the original term sheet, and releasing a tranche is a matter of making a “capital call”, which is fairly straightforward.  Depending on the legal language of the term sheet, it may be possible for an investor to delay or withhold a tranche if they are unhappy with the progress of the venture, however, this tends to be rare.  In the case of the second approach, the next round of financing is closed independent of the first.  This may involve finding new investors, as well as a separate course of due diligence, valuation process, negotiation of economic, control and other provisions on the term sheet, etc.  An entrepreneur focused on meeting existing milestones and raising financing may be too distracted to do either effectively.

Financing climate

Ultimately, a venture cannot raise money that does not exist.  Much depends on the financing climate, which, in life sciences, is currently anemic.  So, most entrepreneurs are resigned to the second approach, where they raise small seed funds in order to reach specific milestones, and hope conditions improve in several years.  This factor is beyond an entrepreneur’s control, however, how they react and adapt is not.

Virtual or not

My definition of a “virtual” life science start-up is one that retains a small but dedicated executive management team, and heavily outsources research, development and administrative functions.  A benefit of being virtual is that most operating costs are variable, meaning that the start-up can increase or decrease its burn with relative ease.  This is not the case for start-ups with many employees, equipment, etc. resulting in high fixed or committed costs.  Therefore, a virtual start-up has the luxury of returning to “garage mode” if it is waiting or raising capital.  A start-up that requires its own infrastructure does not have this ability and must rely on the first approach of raising large rounds with predictable tranches.

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In closing, I believe the decision to raise equity as a “series or tranche” depends on a careful consideration of a venture’s milestones and cash requirements.  A therapeutic start-up with animal validation looking to out-license after phase I would be better suited to raising a single investment with tranches in order to ensure smooth progress of its clinical trials.  Conversely, a virtual medical device start-up with multiple perceived milestones (i.e. clinical trials, regulatory approval, reimbursement code, distributor agreements, etc.) would be be suited to raising multiple series, and maintain low committed or fixed costs in the event there is some delay in financing.

 

 

Issuing equity – economics versus control

By  Stefano Picone in December 3rd 2012   2 Comments »
Filed Under All posts, BiotechStart, Book Review, Financing, Required Reading     Tags: , , , , , , , , , , , ,      

In my experience, many first-time entrepreneurs seem to misunderstand or confuse the concept of “economics” versus “control” in terms of issuing equity.  The book Venture Deals is an excellent resource and strongly recommended for those preparing or evaluating a term sheet.  The book is very comprehensive and can take some time to digest, however, the underlying principles can be distilled into the following:

(i) Every equity instrument consists of two components that are of value to the investor, namely “economics” and “control”.

(ii) “Economics” represents the investor’s ability to generate a return on investment.  Generally, this includes the cost of the investment, as well as the percentage of ownership.  Howevever, there can be other complex economic terms to an equity instrument.  For example, many term sheets include an anti-dilution provision to protect the investor’s pro-rata share in the event the company subsequently issues shares at a lower valuation and lower price.  In addition, convertible preferred shares often include a liquidation preference to be enacted upon sale of the company, or some other liquidation event.  So, economics goes beyond “issuing n% of the company for $x”.

(iii) “Control” represents the investor’s ability to influence the decisions of the corporation.  It is important to note that control of a corporation ultimately resides with the Board of Directors, and a shareholder can only exercise influence to the extent that they can appoint or elect members of the Board.  The control provisions of a term sheet can be very complicated, and Board governance models can vary widely depending on the corporation, so, every situation is unique.

(iv) It follows from the previous point that x% economic interest does not necessarily translate to x% control.  For example, an investor might be issued 10% of the outstanding common shares of the corporation in the form of Class B non-voting common shares.  In this case, the economic interest is 10%, but they have no representation on the Board of Directors.  Similarly, suppose an investor owns 45% of the voting shares but none other shareholder own in excess of 5%.  Although the investor owns a minority interest, unanimous opposition would be required to prevent them from achieving control.  (NB: I like to refer to this as the ‘Dragon’s Den’ error.  Dragon’s Den is a popular show in Canada where new ventures ask a panel of wealthy business people for an investment.  Often, the supposedly astute investors ask for 51% ownership so they can exercise control, which, as demonstrated, is not the case.)

(v)  Economics and control, although separate components of an equity instrument, are symbiotic.  The greater the economic interest belonging to an investor, the greater the incentive for them to be involved in the affairs of the business, and the larger the desired control.  Given that life science ventures generally require large capital investments, it is reasonable to expect giving up significant chunks of both equity and control to investors.  So, when it comes to preparing a term sheet, it is important to arrive not only at a fair valuation, but also a fair system of representation.

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Hopefully this article clarified any misunderstanding that might exist regarding the issuance of equity instruments.  As I have mentioned to many people, the finance principles applicable to start-ups can be initially confusing, however, once understood, they are quite intuitive and easy to remember.

Deciding whether to launch your biotech start-up

By  Stefano Picone in November 19th 2012   3 Comments »
Filed Under All posts, BiotechStart, Financing, Founders, Startup Models, Uncategorized     Tags: , , , , , , , , , , ,      

In all likelihood, a fair number of visitors to this site are contemplating whether to start a life sciences venture. Most have an idea and are deciding whether to proceed.  One of the major misconceptions held by prospective entrepreneurs is viewing the decision to start a venture as akin to “jumping off a diving board.”  In reality, the decision should be approached in the same way a venture capitalist or astute investor decides to invest in a business.

Venture capitalists typically use a system of “decision gates” to decide whether to proceed with an investment. Each decision gate represents a hurdle, and as one hurdle is completed, the combined time and effort to complete the next hurdle increases.  For example, the first hurdle might be an introductory conversation with founders. If the firm has a “good feeling”, they would proceed to conducting their own due diligence.  Following that, they would conduct “paid due diligence”, where they hire external consultants, lawyers, executives, etc. to independently validate their findings.  After this, the firm will finally make the investment.

In the same way, the decision to start a life sciences venture should be approached using a series of decision gates to guide your own due diligence.  Much of that can be done by researching books, articles, news sources, etc., however, I feel that the best way of conducting due diligence is to go out and talk to people.  In a previous article, I discussed the importance of networking for life science entrepreneurs, and a resourceful network can be extremely valuable to someone deciding whether to start a venture.  I’m a strong believer that conversations can provide insights and assurances that books or articles cannot.  Some people are hesitant to have conversations with others in the absence of a non-disclosure agreement on the mistaken belief that the other person might “steal” their idea. However, this should not be the case if the people in your network are those that you trust.  Also, very few life science start-ups can be done alone, so, if another person likes your idea, they are more likely to become your partner than competitor.

Generally, there are six decision gates to consider when starting a venture.  Unlike the example with the VC firm, these gates are not sequential, but, it seems reasonable that they be conducted in this order. I believe each gate can be crossed by having an informed and prepared conversation with someone in your network that is familiar in each area.

(i) Technology – can the idea be technologically translated from proof-of-concept to a commercial or clinical product?

I’m of the belief that many academics underestimate the challenge involved in converting a research idea to something that can be administered to a patient or user.  In this case, it would be worthwhile speaking to scientists working in the private sector (i.e. outside basic research) who have experience in taking ideas from concept to fruition.  If you can find someone with experience in your field, whether it is imaging, molecular diagnostics, type of therapeutic, etc., that is extremely valuable.

(ii) Intellectual property – can the idea be patented?

Most intellectual property lawyers and patent agents are willing to meet with clients without charge to give them a high-level overview of their intellectual property options and situation.  Again, it is worthwhile to speak with someone familiar in your niche.  If the idea holds promise, and the decision gates listed seem to pass, it would be worthwhile to pay to conduct a freedom-to-operate analysis and file a provisional patent or full patent application.  However, just like the venture capitalists, you should avoid “paid due diligence” until your own due diligence has been conducted.

(iii) Regulatory – will the idea be approved for use by the FDA and other regulatory bodies?

It is important to have an understanding of the regulatory pathway for a drug, diagnostic or device.  Again, most regulatory consultants are willing to have initial conversations with potential clients at no charge to advise them of their options.  However, it is also possible to approach the regulatory body directly to initiate discussions, as well as establish a relationship.

(iv) Reimbursement – who is the payor and how much will they pay?

Reimbursement is extremely complicated and depends on a multitude of factors, many of which are outside the control of the start-up.  However, it is possible to gain a good understanding of reimbursement by looking at comparable technologies.  For example, if you have a molecular diagnostic for an allergy, how does reimbursement for the diagnosis of other allergies compare?  It would very helpful to speak to someone that has applied for reimbursement, or have an initial discussion with a reimbursement consultant, to familiarize yourself.

(v) Marketing or adoption – will this be used by doctors and/or patients?

Key opinion leaders are critical to the adoption of new medical technologies.  Although they might not be initially available, it is possible to get a good understanding of whether a new product will be used by speaking to other doctors or patient groups.  I strongly recommend holding a doctor or patient roundtable to get feedback on the idea.

(vi) Financing – can I find money to finance the idea and company?

Generally, venture capitalists will not invest in a life science company that does not have technological validation and a strong intellectual property position.  So, in absence of this, it is necessary to consider other sources of capital.  Angels are one option, however, there are many non-dilutive sources of government or institutional money to support early-stage ideas.  It is worthwhile speaking to people from these organizations to find out if your venture is eligible for seed funding.

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Those working at a university or research hospital are correct to note that their idea will likely have to pass through a technology transfer office.  The benefit of this is that the office can help by answering many of the questions listed above.  However, if you are serious about your idea, the onus should be on you to make to ask these questions and seek answers.

As always, comments or questions on this post are much appreciated!

 

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