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Raising money in a difficult environment

Venture capital financing in the US life sciences market has plummeted year-on-year since the industry's peak in 2000. With increasingly fierce competition for venture funding Lawrence Wittenberg of Testa Hurwitz & Thibeault provides a step-by-step analysis of what a venture capital firm should be looking for in a biotech start-up.

As many in the life sciences industry acknowledge, these are not the best of times for companies seeking to raise venture capital. According to Venture Source, only 82 companies in all segments of the United States healthcare sector received venture financing in the first quarter of 2003, and only one of those was a start-up. This represents the continuation of a decline in financing activity in the sector that resulted in only 490 companies being financed in 2002, compared to 542 in 2001 and 703 in the peak year of 2000. These numbers reflect an environment in which even the best companies require a great deal of time and effort to get financed, while companies perceived to be weaker are unable to obtain financing. In times like these, it is critical for life sciences companies to avoid traps that too often make obtaining financing difficult, or even impossible. Eight of the most common traps are highlighted in this article.

Violating the KISS Principle. When it comes to the legal structure of a life sciences company, “Keep It Simple, Stupid” is a short piece of advice that should be followed religiously by founders and managers who hope to be financed by the venture capital community. A company's goal in fundraising should be to direct the prospective investor's attention to the substance of the company's business, while minimizing reasons to say “no” to the opportunity. If a company is structured in a complicated or unusual way, the structure can become a distraction, and can be the reason for a prospective investor to turn down the investment. With few exceptions, therefore, founders and managers are well-advised to structure their companies as simple Delaware corporations, because that is the vehicle with which the broadest group of potential investors is the most comfortable.

Dead-End Funding Sources and Inexperienced Advisors. Financing a life sciences company has never been easy; and especially for early-stage companies, it often has been extremely difficult to attract institutional venture capital. As a result, many life sciences companies get their start with unconventional, non-institutional sources of financing. While many significant companies owe their existence to this type of financing, such financing is rarely enough to get the company to the point where it is cash flow positive. Only venture capital or other institutional financing (often coupled with a healthy dose of Big Pharma money) offers deep enough pockets to fuel the company to the point where it can be self-sustaining. This means that any financing a company obtains early in its life must be predicated on the notion that it is not the last financing the company will need, and must be structured so that later rounds of financing can easily be accommodated. Too often, early rounds of financing prove an impediment to later obtaining the full funding needed by a company. To avoid this, whatever the financing source, companies should employ advisors—accountants, lawyers and/or business mentors—who understand the venture capital financing market and can structure the company accordingly.

Bad or Inconsistent Documentation. A company can sink its chances of obtaining financing by failing to pay enough attention to the details when it comes to its legal structure, employee relations and other legal matters. Unfortunately, too many young companies fall into this trap in the misguided belief that they can save money now by ignoring these matters and that they will be able to “fix it” later. That sometimes worked in the frantic financing environment of the late 1990s, but it does not work today. A company is well-advised to do things right the first time.

Four Intellectual Property Traps. Intellectual property rights are the lifeblood of a life sciences company, and special attention must be paid to avoid four traps that too many founders fall into:

Rights of Academic Centers. Even today, after more than two decades of life sciences companies being built on technologies developed in academic centers, company founders often are not aware of the intellectual property rights of the university, hospital or medical school at which they invented their technology. Founders should consult with intellectual property counsel before embarking on any commercialization of their inventions, to make certain that the company will actually have legal access to the technology it proposes to exploit. In many cases, it also will be beneficial to consult with the relevant institution's technology licensing office, which is generally happy to assist entrepreneurs among the institution's faculty in understanding their (and the institution's) rights.

Rights of Former Employers. A simple fact, too often ignored, is that inventions made by an employee are often the property of the employer, not the employee. If a founder or early employee of a company has recently left another employer, care must be taken to ensure that the former employer does not have rights in the key technology upon which the company proposes to build its business. A lack of clarity on this front can be yet another factor that causes prospective investors to move on to the next business plan.

Joint Ownership. Founders and managers seem to love compro- mising the issue of intellectual property ownership in joint development situations by declaring that the two parties will “jointly” own the technology. If a patent is owned jointly by two parties, each party is free to exploit the invention, meaning that neither party will enjoy a patent monopoly with regard to the invention. If a company's business plan relies on the existence of this monopoly, the company's chances of obtaining financing will be harmed. In joint development arrangements, life sciences companies need to make the hard choices regarding ownership of intellectual property and, more importantly, use of the technology.

Premature Disclosure. Disclosures of patentable technology prior to the filing of patent applications can seriously compromise commercially valuable patent rights outside of the United States. Life sciences companies with scientific founders and other inven- tors still in academia must understand this, and those founders and inventors must accept the need to consult with the company and its patent counsel before publishing or presenting regarding their invention.
Valuation Fixation. Too many financings have foundered due in large part to unrealistic expectations regarding company valuation. Investors can help their existing portfolio companies understand that in today's environment, cash is king, and is very much the life blood that any development-stage company needs to survive. As a result, life sciences companies need to be aware of the painful realities of today's economic environment, and take a view that is relatively valuation insensitive.

By steering clear of these seemingly obvious, but oft-repeated, traps, early-stage life sciences companies enhance their chances of successfully obtaining venture capital financing. This is particularly true in the current investing environment. Of course, even after a company closes on a round of financing, the founders and the venture capital investors must remain keenly aware of these potential pitfalls as they work to grow and position the company for future rounds of financing.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP.  For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

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