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Life Science Start-Ups: Financings, Modelling and Valuations

In December of 2013, I was invited to give a presentation to a group of MD and PhD researchers at Sunnybrook Health Sciences Centre, which is one of the largest research hospitals in Canada.  The is part of the Schulich Innovation Seminar series, and is intended to help researchers interested in commercializing their work.  I was asked to provide an introduction to some of the financing, valuation and modelling issues faced by early-stage start-ups.  The video and slide show can be viewed here

Couple of comments:

- The seminar series is led by Dr Brian Courtney, Dr Graham Wright and Dr Bradley Strauss.  Dr Courtney, who introduced me, is a cardiologist and is also the founder and CEO of Colibri Technologies, which is developing a catheter imaging system for use in cardiac procedures.  Dr Strauss is the division head of cardiology and is founder and chairman of Matrizyme, which is a clinical-stage biopharmaceutical company

- Some terms and comments are specific to Canada.  A couple of times I reference the show “Dragon’s Den” which is a popular angel investing show on Canadian television.  Also, the tax credits mentioned in the financial modelling slides are specific to Canada

- During the medtech modelling slides, I state that class II devices require a 510(k) for regulatory approval, however, the appropriate term is regulatory clearance

- On several occasions, I incorrectly state that Versant Ventures is based in Boston, when , in fact, its offices are based in California, Minneapolis, Basel and Vancouver

All the best for 2014!

- Stefano









Synthetic Biology Startup Bonanza: Biotechstart @SynBioBeta

Now in it’s second year, the startup conference focusing on Synthetic Biology or SynBio will be held in SF.  Yours truly will be giving a short update talk but mostly it’s about the various constituents of the ecosystem: entrepreneurs, investors, service providers.
More below:
On November 15, 2013, SynBioBeta will once again be bringing together the synthetic biology community for the second annual SynBioBeta Conference at Mission Bay Conference Center UCSF.
The conference provides a venue for companies, both established and startups, investors and academics to meet, partner, exchange ideas and learn about the latest advances in the rapidly evolving field of synthetic biology. Some of the topics on the agenda are: Advances in Gene and Genome Synthesis, Scale-up in the Bioeconomy, SynBio Angel and VC Funding and more.
The conference will be followed by a cocktail reception Friday evening and on Saturday, November 16, 2013, SynBioBeta will be presenting a Networking Brunch Cruise for anyone in the synthetic biology community to attend. Register using promo code SBBIG3 to receive a 20% discount on the conference registration. For more information on the conference and the Brunch Cruise, please visit www.synbiobeta.com
Biotechstart is a media partner for SynBioBeta.

How to Divide Co-founder Equity

“Co-founder equity” brings to mind a small group of entrepreneurs huddled in a basement, feverishly working days, nights and weekends to launch a start-up.  There are a number of prominent life sciences companies that sprung from humble beginnings (i.e. Boston Scientific, Arthrex), although, for the most part, venture capitalists seem to be moving away from “funding start-ups” and towards “founding start-ups.”  Regardless, for those interested in how to fairly divide equity with co-founders, this article may be of value.

Before I begin, I figured I would list three rules that supersede the mostly legal and mathematical exercise of allocating shares among co-founders.

Rule #1: You need co-founders (at least one)

Although I am not a professional venture investor, I would never invest in a start-up with a single co-founder.  More important than the complement of skills that a co-founder can offer, every entrepreneur needs someone with them “in the trenches.”  Without veering too far into the world of positive psychology, there is enough evidence to suggest that people are better equipped to handle stressful situations when they have strong social support.

Rule #2: You need co-founders that you can trust

In my observation, trust among co-founders results from starting a venture for the same reasons that are the right reasons.  Trust takes time to observe and develop, and therefore, the best co-founding teams tend to have a pre-existing relationship.

Rule #3: Focus on maximizing the pie, not the pieces

Once the equity is divided, there should be consensus that the intent is to maximize the overall valuation.  ”If the company wins, everyone wins; if the company loses, everyone loses.”  This philosophy prevails when there there is strong mutual trust among the co-founders.

Returning to the how of the matter, I favor the following structure:

- All co-founders agree to restricted stock arrangements.  A restricted stock is like a stock option in that it is subject to vesting (i.e. it is not earned immediately), but, the price to acquire the stock is nil or nominal

- As part of the restricted stock agreement, each co-founder must sign a contract, which contains a job description, as well the number of hours or range of hours per week the person is expected to work

- Contracts are structured over a two year period, renewable and reviewable quarterly.  A contract may be terminated quarterly at the discretion of either the co-founder or the company.  Restricted founder shares vest at the conclusion of each quarter.  If a co-founder leaves the company, vested restricted shares may be subject to claw-back (e.g. 50%).   Two years typically reflects the timeframe over which founders are working primarily for equity as the company is unlikely to have adequate cash flow to pay market wages

- The number of restricted founder shares vested quarterly is computed as the number of expected hours worked in the quarter multiplied by the imputed hourly rate of labor.  For example, a senior person may be granted 100 shares per hour, whereas a less senior person may be granted 50 shares per hour

- The contracts are reviewable quarterly to allow for changes to be made to the job description, number of hours worked and the imputed rate of labor.  Often, it is difficult to evaluate a person’s contributions at the out-set, and therefore, the contracts must be structured to accommodate change.  However, overly frequent (i.e. monthly) renewal periods can be an administrative burden.  Time sheets are also not required, as everyone should be operating on good faith

- The contracts do not preclude the co-founders from entering into employment or consulting agreements once the company has raised or generates sufficient cash flow.  Vesting schedules are also subject to change in the event of a series A or seed round

Once this is done, it is best to put together a cap table that summarizes the number of fully-vested shares belonging to the co-
founders as well as percentage of shares.  I also like to add an option pool, as well as a seed and Series A round to estimate the co-founder’s interest in the near future years.

As per usual, I welcome any comments or questions people might have.  In my observation, this system is both sufficiently simple and effective in that non-finance co-founders can understand the mechanics and appropriately focus on driving valuation



Problem with government life sci start-up incentives

I must admit that I was politically indifferent for most of my life, but there was a sharp and sudden change when I entered the world of life science start-ups.  Government intervention impacts all stages of the life science value chain, from the funding of basic research, to the approval of new technologies, to the eventual reimbursement and delivery of health care.  Some countries (like Canada, where I live) are also committed to supporting the life science ventures through a variety of direct (loan, grant, equity) and indirect (tax credits for investors or R&D) programs.  Considerable ex post empirical attention is given to whether these initiatives are successful, but there seems to be little ex ante discussion of the inherent limitations.

In my opinion, there are three critical issues with government incentive programs for life science start-ups:

(i) Government programs cannot fix underlying business model issues

For many years, commercializing a life science start-up was about “does it work?”, but the current sentiment is “does it matter?”  Long gone are the days of Amgen and Genentech when companies with exciting technologies can raise large amounts of money with reassurance of a pot of gold at the end of the rainbow.  This change in circumstance has resulted in a change in business model, forcing ventures to be leaner, smarter and more focused, however, there still seem to be a number of misguided philosophies (e.g. “Silver Medal Companies”).  Successful ventures make for successful government programs, and not vice-versa.

(ii) Undue focus on job creation

Political myopia is widely acknowledge, and as someone who has a number of friends in politics, I can confirm that 80% of their time and effort is spent on how to get elected, and the remaining 20% is spent on what to do when elected.  A surrogate endpoint for political performance and support is job creation, because more jobs equal more votes.  As a result, many direct life science incentives are unduly focused on short-term job creation, when they should be focused on holistic long-term “value creation”, which encompasses value accruing to investors, founders, researchers, patients and employees as a whole.  Whereas the concept of a lean start-up and the zero person virtual biotech might be gaining industry support, it probably will not gain political support.

(iii) Bureaucracy

To quote a friend of mine in politics, “anyone who thinks government is the solution has not worked in government.”  The life science venture community tends to move and evolve at a much faster pace than government administrators, and I have personally witnessed a number of start-ups held in limbo due to the bureaucratic process.  Also, it doesn’t take a Russian oil tycoon to realize that, whenever government intersects with business, special interests are often unjustly enriched.

Based on these comments, one might conclude that I am a libertarian, which is actually not the case.  I believe that the government has an important role to play in fostering the massive positive externalities that result from the creation and success of life science ventures.  Also, I believe strongly that it is of little value to identify a problem without suggesting a solution, so, my next article will outline some government initiatives that I feel of greater value than what currently exists.

MDs as Angel Investors?

If the customer is always right, then why not make them an investor?  This might seem like an obvious statement, but I think it has powerful implications for start-ups in the innovation space looking for capital.  I have written before about a finance value chain, which is business lexicon for funding a company from start (i.e. seed capital) to finish (i.e. exit and/or positive operating cash flow).  The finance value chain exists in parallel to the overall company value chain of how an idea becomes a product and eventually reaches a customer.  The idea of engaging customers as early as possible has firmly planted roots in the ICT start-up space (see Minimum Viable Product), so, can it be similarly adapted to the life sciences space?

As most know, there are three buyers of devices, drugs and diagnostics, namely patients, payers and providers.  Of those three, I would argue that providers, namely physicians, are the “de facto customers” as they hold the bulk of the decision-making power.  The rise in specialized and sophisticated health care has also given rise to health illiteracy, so, patients tend to carry the least weight.  Payers are certainly influential in that they determine reimbursement rates (i.e. price) but just because something is reimbursed, does not necessarily mean it will be adopted (i.e. quantity).  Ultimately, it is physicians, alone and in concert, that perform procedures, prescribe medications and request diagnostic tests, so, they are the linchpin in the customer equation.

I came across the idea of raising a seed round from physicians a couple of years ago when I saw a video about a Toronto-based start-up commercializing a prognostic assay for age-related macular degeneration.  At about the 13 minute mark, the CEO discusses how the company was able to raise money from a group of ophthalmologists presented with the technology.  At the time I first watched the video, I was “very new” to life sciences (as opposed to now, when I am just “new”), so, at the time I did not quite grasp the value of this approach.  Over time, I have come to believe that this is a promising but uncommonly explored avenue for start-ups looking to raise a seed round.

As part of my research, I have put together a list of the pros and cons of MDs as Angel Investors.  I welcome any comments and additions readers have.


-  Established MDs tend to be high net worth individuals and would qualify as accredited investors.  They have stable and predictable incomes, and can allocate a portion of their portfolio to start-ups

-  Medicine is becoming increasingly specialized and segmented.  Specialists are able to understand the science underlying the business, as well as factors such as adoption, standard of care and work flow that drives their decision as eventual customers

-  Doctors provide important and unparalleled non-financial capital, namely credibility, insights and connections.  Not only is this valuable to the start-up, but it also means better expected risk-adjusted returns for them as investors

-  Although a group of MDs is unlikely to fund large rounds (i.e. seven figures and above), they serve as an important signal to investors looking to syndicate or provide follow-on funding

- There are horror stories of angel investors squashed by venture capitals in follow-on rounds via down rounds, liquidation preferences, etc.  By virtue of their position as customers, MDs as investors mitigate this risk


-  There is an acknowledged lack of later-stage life science funding, so, many angel investors are hesitant to participant in a seed round if there is little prospect of a Series A

-  Recruiting and managing one large investor is considerably less challenging than managing a large group of small investors

-  MDs are generally not seasoned start-up professionals and may feel overwhelmed by some of the business aspects of the science, such as valuation, intellectual property, regulatory, reimbursement, etc.  Also, some might expect “halo deals” (i.e. 100X+) that occur in ICT but not life sciences

- For a platform technology with multiple indications, it may be difficult to identify the group of specialists best suited to investing.  Also, investment from a group of specialists related to one indication may make it difficult to pivot to another if need be

-  MDs using a new technology in which they have also invested may be perceived as a conflict of interest.  Generally, this can be avoided by raising money from practitioners other than those on your Clinical Advisory Board and likely early adopters .  (Being in Canada, an advantage is that the United States and Europe are often targeted as initial markets, and therefore, domestic MD investors are not the first users)

-  MDs are busy people and are constantly being pitched by big pharma, biotech and medtech.  It can be difficult to breach that barrier of being seen as just another “sales rep”

How to raise a seed round!

Question: How do I raise a seed round?

Answer: By raising a series A!

I apologize if this comment seems rhetorical (or, for those struggling to raise a seed round, insensitive), but this Q&A perfectly illustrates the concept of a finance value chain, which is something that (I feel) every life science entrepreneur should be aware of.

When I first decided to get into this sector, I met with a number of experienced people and specifically asked what value a non-science person, like myself, could add to a start-up.  One of the earliest and best pieces of advice was to help them get money!  For some time, I thought this meant honing my skills to craft the best financial model or business plan.  I soon learned that this was totally wrong, and that much of raising money has to do with the rules of meta-finance.  I probably don’t have to explain the “meta” prefix to an audience of science folks, but, for those who are unfamiliar, it is the philosophical equivalent of “about”.  So, whereas finance deals mainly with how a  deals is (i.e. term sheets, valuations, etc.), meta-finance is more concerned with why a deal is or is not done.

Beyond the perception of risk and reward, there are a number of meta principles that underscore life sciences start-up finance.  As mentioned in a previous article, one such principle has to do with economies of scope, and the fact that venture capitalists and large companies tend to stick with not only “what they know”, but also “who they know.”  So, if you are pitching an investor in field W and they have historically done deals in fields X, Y, and Z, you may be out-of-luck regardless of the potential payoff.  The finance value chain is also a meta-finance principle, as it suggests that raising capital at any stage (particular the earliest) must be done in the context of raising capital at all stages.  So, just like a manufacturing company will design a widget while also thinking how it is to be manufactured and sold, a life science start-up must consider how it will raise seed funding while anticipating follow-on funding (i.e. Series A, B, etc.) and an eventual exit.

Even though this seems fairly obvious, if you sampled 100 life science entrepreneurs, my guess is that 20% would not get this, 60% would sort of get it, and 20% would understand that it is crucial.  Those in the bottom 20% would likely be blinded by the “if we build it, they will come” myth, believing that if they raised a seed round, the proof-of-concept or pre-clinical data would be so compelling that follow-on investors would pounce without question.  I can think of at least five reasons why this is not the case, but that is a matter for a future article.  The middle 60% would see this as important, but leave it to conjecture.  To suppose that a particular VC firm(s) would be provide the Series A and onward financing and that a particular company would be the acquirer are two more assumptions to add to an already long list.  The top 20% would not only have a plan, but also find a creative way to validate these assumptions and establish some level of commitment.  Imagine the leverage a start-up would have in pitching to angels given interest from a venture capital firm.  Further, interest from an eventual acquirer could be used as leverage when pitching to venture capitalists.  Money flows upstream, and validation flows downstream.

In closing, I have never directly (or indirectly) raised a seed or Series A round, so, as always, my comments carry a measure of qualification and I welcome feedback.  I would like to note that the inspiration from this article was not motivated by the struggles of entrepreneurs, but rather, the fundraising activities of  venture capitalists.  The number and size of industry-venture funds seem to be growing, as well as the emergence of Corporate Strategic Partnerships.  If you are going to sell something, whether it be a widget or a life sciences company, it helps if you engage the customer.

Do angel tax incentives really matter?

Recently, I have heard much discussion in Canada and internationally about offering tax incentives to angel investors in life science deals.  Typically, these tax incentives are either or both of

(i)  Entry-level tax credits, whereby an investor receives a refund calculated as a percentage of their upfront investment

(ii)  Capital gains holiday, whereby some or all of the capital gains tax is forgiven when an investor realizes on (I.e. liquidates) their investment

In my observation, there seems to be an unquestioned belief that these incentives are beneficial, and the focus is lobbying the government and tax authorities to enact the change.  The purpose of this article is not examine the latter, but to reconsider whether tax incentives will increase the number of life science angel deals as suspected.  Specifically, will they have a sufficient impact on an investor’s expected return to make an otherwise unattractive opportunity seem attractive?

In order to answer that question, I will suppose that most life science angel investors require a compounded pre-tax annual return of 30-40%, which, depending on the tax rate, roughly equates to something north of 25% after-tax.  (NB: It should be noted that the disposition of shares are taxed as capital gains, which, in most countries, are taxed at lower rates than other sources of income).  This range of desired return is certainly debatable, and I welcome comments from anyone with recent experience raising or investing capital at the seed level.

I will consider a “borderline” investment opportunity before and after the tax incentives to determine the extent of the impact.  Suppose an investor provides $1,000,000 to a seed-stage start-up to conduct pre-clinical drug development.  At the time of investment, the investor believes there are four possible outcomes:

(i)   The drug development fails and the company is dissolved for nil proceeds.  There is a 20% chance of this happening

(ii)  Drug development does not fail but is also not promising.  The company is able to divest its intellectual property and data for $1,000,000.  There is a 20% chance of this happening

(iii)  Drug development is successful and the company enters into clinical trials.  The company secures follow-on funding and within eight years, the company is acquired after Phase 2.  The market is not as large as initially suspected, and the return is a 3X.  There is a 20% chance of this happening

(iv)  The outcome is the same as in the previous scenario, however, the market is quite lucrative, and the return is a 10X.  There is a 40% chance of this happening

Assuming a capital gains tax rate of 20%, the outcome for each of the scenarios is as follows.  Note that, in the first scenario, the proceeds of $200,000 are based on the tax shield of the loss.  For those unfamiliar with taxation, losses and expenses can be off-set against gains and revenues, and a tax shield is the amount by which either reduces the balance of tax owing.

Outcome After-tax proceeds ($) Probability of outcome Weighted ($)
(i) 200,000 20% 40,000
(ii) 1,000,000 20% 200,000
(iii) 2,600,000 20% 520,000
(iv) 8,200,000 40% 3,280,000
Total 4,040,000

In total, the expected after-tax outcome is about a 4X, which, on an eight year time horizon, is a compounded annual rate of return of 19.07%.  Although this is good, it does not meet the hurdle set forth of 25%.  So, if a capital gains holiday were to be enacted, would this make the investment sufficiently attractive?  Again, the outcomes are as follows.  Note that, in the event of outcome (i), I am assuming that the investor is still able to claim the tax shield of the capital loss, which might not be the case, as a tax authority might feel that taxpayer should not enjoy non-taxable gains and deductible losses.

Outcome After-tax proceeds ($) Probability of outcome Weighted ($)
(i) 200,000 20% 40,000
(ii) 1,000,000 20% 200,000
(iii) 3,000,000 20% 600,000
(iv) 10,000,000 40% 4,000,000
Total 4,840,000

This equates to a compounded annual return of 21.79%, meaning the capital gains holiday increased the expected rate of return by only 2.72%.  Again, this is insufficient to reach the hurdle rate.  However, suppose we combine the capital gains holiday with an entry angel tax credit of 20%.  In this case, the principal value of the investment is $800,000, which helps to increase the rate of return.  (NB: For the first outcome, the tax shield of the loss is reduced by the pro rata amount of the credit, as the credit also reduces the cost of the investment)

Outcome After-tax proceeds ($) Probability of outcome Weighted ($)
(i) 160,000 20% 32,000
(ii) 1,000,000 20% 200,000
(iii) 3,000,000 20% 600,000
(iv) 10,000,000 40% 4,000,000
Total 4,832,000

Due to the decrease in the principal amount of the investment, the compounded annual return is 25.21%, which is an increase versus the base case of 6.14% and barely clears the hurdle.  If the tax incentives doubled or tripled the expected return, one would expect a serious influx of capital to this sector, but this is clearly not the case.  Therefore, in all likelihood, implementing tax incentives would not result in more life science angel deals being done, but rather benefit those deals that would happen regardless.  Although this is of merit, it would be up to the government to decide whether the cost justifies the benefit.  Without tax incentives, expected tax revenues are $760,000, and with both tax incentives, expected tax disbursements are $192,000, resulting in an expected cost of $952,000.

With that being said, it is important to note two non-financial reasons as to why angels might not invest in a deal for which no amount of angel tax incentives will suffice.  First, many angels struggle with understanding the life science underlying the business, as well as the business of life science, specifically the regulatory and reimbursement process, as well as provider adoption.  Second, there is a generally acknowledged lack of Series A capital in the ecosystem, and it makes little sense to seed a deal for which the prospect of follow-on funding does not exist.  Personally, I believe resolving these issues, particularly the latter, is of greater benefit to the life science start-up community than offering tax incentives to angels, although, they are not mutually exclusive.

As always, I welcome any comments or criticisms people have.  I am hoping this article stirs a little bit of debate in terms of accelerating early-stage funding.

Financial reporting for life science start-ups (part 3)

In my opinion, one of the most challenging (but also rewarding) aspects of running a life science start-up is juggling the competing demand to see the big-picture, high-level stuff, with those small things requiring attention to detail.  Financial reporting is an excellent example of this.  In parts one and two of this series, I discussed the information needs of stakeholders, and the importance of an ongoing budget-to-actual process.  I categorize both of these things as high-level because they are critical parts of the decision-making process.  This article addresses internal controls for the purchasing cycle, which are nitty-gritty, procedural, and certainly less exciting, but equally important.

Internal controls are to financial reporting as quality assurance is to quality control.  In any process, the quality of the output is a function of the processes governing the input, or, as commonly said, “garbage-in, garbage-out.”  In either case, the issue is not so much in designing or implementing the processes, but rather being sufficiently disciplined to adhere to them.  In the same way that it may be tempting to take a short-cut in calibrating equipment, it can be equally tempting to skip preparing a purchase order.  The risk of either omission might be relatively minimal, but this could still lead to the inability to repeat an experiment, or an unwelcome hit to the budget at month-end.  Given all the systemic risks involved in a life science start-up, it does not make sense to ignore those that you could otherwise mitigate.  Of course, an oversight like this might seem silly, but less so when you are tired, over-worked and behind on a deadline.

This list itemizes best practices for internal controls involving the purchasing cycle, which is the front-end of the reporting & budgeting process.  For those currently running a start-up, it may be useful to compare this list with your current process and address any short-comings.  For those aspiring to run a start-up in the future, I recommend printing or bookmarking this list for reference:

- The purchasing cycle consists of the following steps: Requisition -> Approval -> Order -> Receiving -> Invoicing -> Payment -> Reconciliation

-  Many large companies enforce a segregation of duty to prevent fraud or error by assigning each task to a different person.  In a smaller organization, a comparable outcome can be achieved by segregating the requisition step from the next three steps (approval, order, receiving) and from the final three steps (invoicing, payment, reconciliation).  At the minimum, the initial step must be segregated from all others so a person cannot place an order without at least one other person knowing

-  Although somewhat onerous, I am of the belief that all requisitions should be submitted in the form of a purchase order.  A purchase order (PO) is an internally generated document outlining the quantity and price of good or service to be purchased, as well as providing vendor information, reason for purchase and other information such as lot number.  Most suppliers of reagents require a PO or PO number to be supplied as evidence of a contract.

-  POs can be categorized as recurring (i.e. for ongoing services like rent, waste disposal, phone service, etc.) and non-recurring (i.e. one-time purchases of reagents, etc.)  Recurring POs need only be submitted once for the term of the agreement, whereas non-recurring POs should be submitted as needed.

-  It is incumbent on the person placing the requisition to research the best available price and terms, as well as in the context of existing inventory.  In the case of non-recurring but frequently used reagents and supplies, a three month supply is ideal.  This ensures that the company is not accumulating prepaid supplies that may be expensive to store and may spoil, but is also not repeatedly placing POs and has sufficient time to plan for backorders.

-  Once submitted, the PO must be approved.  This is done by comparing the purchase to the rolling budget to determine whether it is appropriate.  The best way of keeping track of submitting and approved POs is by maintaining a PO Log, which is a spreadsheet of all approved purchase orders listing quantity and price, on a shared drive.  It is also recommended that individual POs be saved to the shared drive so that others can access them if need be

-  Following approval, the purchase order is placed with the vendor.  Many purchases are placed online, in which case the vendor will generate an automatic order confirmation, as well as an expected date of shipping.  An unexpected delay in shipping should be immediately communicated to the person who placed the requisition.  The order confirmation should be printed and attached to the hard copy of the PO, and saved in a PO binder.  Again, this is handy when it comes time to re-ordering goods, as well as following up on goods that have not been received

-  If not already part of a quality system, received goods should be inspected and qualified before being released to the lab.  Once an order has been received, the receiver should mark this in the PO log, and also file the receiving document included in the shipment

-  Invoices are matched to purchase orders and receiving documents and then entered into the accounting system.  Referring to part two, an invoice can be recorded as an expense as at the invoice date.  This does not follow the accrual basis of accounting, but, unless you have finance support, this will make things overly complicated.

-   In terms of payment, a cheque run should be done every two weeks so vendors are paid on a timely basis.  Typically, it is best to do a smaller mid-month cheque run, followed by a larger one after month-end.  The month-end cheque run should not occur before budget-to-actual results have been compared for the month.  Also, cheques should be endorsed by two cosigners with expenditures above an arbitrary limit (e.g. $5,000) requiring Board approval.

-  Finally, the bank statement should be reconciled monthly to ensure that all cheques to vendors were received, and that no unauthorized payments have been processed against the account.  A bank reconciliation is done to agree the balance per the accounting system to that per the bank, and the difference is due to outstanding cheques and unrecorded bank fees

Strong financial controls will not ensure that a start-up is successful, however, poor controls will expose it to unnecessary risk.  Again, this information is not particularly exciting, so maintaining discipline and commitment to the process is key.  I promise that the next article will be a little more thought provoking.

Financial reporting for life science start-ups (part 2)

As discussed in the previous article, “reporting” for life science start-ups encompasses both financial and non-financial information for a variety of stakeholders.  In part 2, I had promised to cover both budgeting as well as some basic internal controls.  As it turns out, this article will only discuss budgeting as both are important topics and are deserving of their own attention, so, there will be a part 3.  Again, this advice is aimed seed funded lean start-up with a small team of founders, but, the concepts are still applicable to larger, series A funded start-ups.

The most relevant financial metric for any start-up is cash, and the budgeting process is intended to (i) plan for future spending, (ii) analyze actual spending, (iii) identify variances, and (iv) anticipate the timing and amount of future financing (series or tranches).  The starting point for any budget should be the business plan used to arrive at the term sheet.  Suppose investors in a therapeutics start-up might agree to invest $1,000,000 with the purpose of doing preclinical tests on a lead compound in order to file an IND and attract a series A investment.  Assuming the start-up (and investors) have done their homework, that $1,000,000 will be stratified based on use of proceeds (i.e. salaries, lab space, materials, consulting fees, etc.) and substantiated by quotes or researched estimates.  All start-ups seeking funding prepare a long-term financial projections illustrating their prospects in five to ten years, but, in the seed stage, a use of proceeds budget is just as critical.

From this high-level budget, the company should prepare a “starting budget” over the life of the seed round.  A well prepared budget appears is done as follows:

- Although there are a myriad of budgeting applications and software programs available, a spreadsheet is the least expensive and easiest option.

- The budget should be done on a monthly basis, as most expenses occur or are billed monthly (i.e. rent, consultants, lab service providers, etc.).  Some people like to include a column for cumulative project to date (PTD) expenses for each month.

-  Expenses should be categorized by groups and/or subgroups, such as Lab and Research Costs, Corporate and Administrative, and Regulatory and Reimbursement, and Intellectual Property and Legal.  For example, under Lab and Research Costs, you might have a individual expenses for reagents, preclinical samples, consumables or scientific consulting payments.  In terms of granularity, the goal is to be sufficiently specific so that you can easily spot variances when comparing to actual results, but not overly specific such that you are scanning hundreds of items.  Typically, 25-30 individual expenses grouped into four or five main categories is ideal.  Also, the expense hierarchy used to prepare your budget should match that used to record invoices and expenses.

- For each month, there should be a reconciliation between opening and ending cash, in that Opening Cash – Expenses + ∆ Accounts Payable = Ending Cash.  Unless there is a significant time difference between the time the start-up expects to incur expenses and pay them, such as the case of an ongoing payment arrangement with a law firm, the change in accounts payable can be ignored.

The “starting budget” forms the basis of the “rolling budget”, which is used to compare actual results on a monthly basis and investigate variances.  The procedure for preparing a “rolling budget” is a follows:

-  Within ten business days of month end, the start-up should have all of its invoices recorded for the month, and an export of results.  Ten days is a sufficient window for invoices to arrive, but ensures reporting is done on a timely basis.

- Invoices should be recorded as an expenses as at the invoice date.  Although this is not compliant with the accrual basis of accounting, it is permissible in this instance as budgeting and reporting is based on cash.

-  The export of results should be compared to the monthly budget on a line-by-line basis, and the difference calculated in a column called “Monthly Variance.”  A variance may be favorable or unfavorable, and there are two types of variances.  A timing variance, and results when an expenditure happens in a month other than initially expected, such as a customized reagent that is delayed shipment for several weeks due to quality control issues with the vendor.  A timing variance will always reverse in a subsequent period, resulting in no net effect.  A permanent variance results from unanticipated over and under-spending, and does not reverse.  If the customized reagent supplier provides a significant discount to compensate for the delay, this would be consider a favorable permanent variance.

- Reporting is only valuable to the extent that it informs decision-making, so materials variances should be investigated on a monthly basis.  Specific attention should be given to permanent unfavorable variances, as these contribute to a faster burn rate and shorter runway.  Variances should also be considered in the context of milestones.  A start-up that is on budget but not progressing as expected is in the same position as one that is over-spending but meeting its targets.

- Once results for the month have been analyzed, budgets for subsequent months should be adjusted to reflect changes in expectations (hence the term “rolling budget”).  Again, emphasis should be placed on the company’s updated burn rate and runway to determine if investors need to be informed about raising additional funds or releasing a tranche earlier than expected.

Without a sample spreadsheet, it might be difficult for some people to visualize the budgeting process (and if readers would like to see one, please feel free to mention that in the comments.)  But the appearance or method of preparation is secondary.  Ultimately, it is most important that a start-up that adheres to the four budget principles  mentioned above.

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

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.

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.

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.






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