Angels In Life Science America – Mondaq News Alerts (registration)

What happens when the FDA approval process slows down and
imposes higher hurdles, when cost-reduction becomes central to the
healthcare provider business model, when clinical trials and
commercialization costs for medical devices and biotechnology
products spiral through the roof, and when exit returns are
compressed by general economic conditions and the decline of the
IPO market?

Venture capital funding for early stage life science companies
markedly contracts. In fact, venture capital funding for these
companies declined consistently over the last few years. Even if
federal grant funding for basic research increases, there will
still remain the proverbial “valley of death” in funding
the necessary first steps of translating research into products and
ideas into companies. The emerging life sciences company must find
a bridge to the development and commercialization of new
life-saving technologies.

So what is a life science entrepreneur to do?

Enter the aptly named “angel investor.” More
specifically, enter the new breed of investor who understands the
needs and the opportunities of early stage life science companies.
According to Dr. Richard D. Gill, a member of Boston-based
Launchpad Venture Group, “Over the last 10 years, the angel
investment community has stepped into the breach left by the
venture community. At last year’s Acceleration conference held
at Nutter, McClennen & Fish, Bill McPhee, a prominent life
science angel investor and former venture capitalist, went one step
further and declared angels as the keystone to early stage life
science funding.

So why do angels do it?

According to most industry experts, angels are willing to tackle
the massive risks of life science ventures because of the
opportunity to reap out- sized returns and to participate directly
in a company through board or advisory roles where they can add
outsize value. David Verrill, Managing Director of Hub
Angels in Boston, points to the upside: “New England
angel groups have had a big impact on local life science startups,
with some significant exits recently, including SmartCells and
Intelligent BioSystems.”

SmartCells, developer of SmartInsulin, is often considered the
poster child of the successful angel- backed life science company.
Merck paid up to $500 million after milestone payments on less than
$10 million of invested capital, without the participation of
venture capital funds.

Leveraging experience

Because of the tighter market for capital, only stronger and
leaner companies are making it through the fundraising gauntlet.
Said Richard Anders, Managing Director of Massachusetts
Medical Angels, a group that focuses exclusively on life
science deals: “All companies are having to tighten their
value proposition, sharpen their pencils, and figure out how to
make a compelling company with fewer dollars and often, for a
while, no dollars. The result is stronger, more competitive
candidates.”

These leaner, stronger companies are using the success of
earlier ventures as their playbook. Many early stage companies rely
on the guidance from angel investors, who typically can bring
experience from many different entrepreneurial settings to bear on
charting the surest path to success. Angels are particularly well
positioned to assist companies in adopting a lean startup
methodology, offering low angel valuations, and focusing on capital
efficiency using virtualization and other outsourced infrastructure
models. They can often help steer a company to early market
feedback from strategic partners and high-quality clinical data on
comparative effectiveness early in their testing programs.

Angels often also help accelerate the fundraising process
through introductions to their respective networks and assistance
with the preparation for the fundraising process. Leveraging an
angel’s expertise can be a critical aid to decrease the process
time of fundraising and to maximize the potential capital raise to
meet the high needs of life science ventures.

By working with additional angel groups and by engaging regional
and national deal sharing processes, angels are able to rapidly
raise sufficient capital to help companies achieve valuation
milestone inflection points. Said David Verrill, “The Angel
Capital Association is stimulating crossborder syndication of life
sciences deals in order to find the best deals in the country, and
aggregate enough angel capital to meet the financial needs at much
more significant levels of funding.”

It’s not all altruistic. Angels are hedging their risks
while accelerating venture development by getting actively involved
in ventures, providing product and industry expertise, and serving
as champions for their portfolio companies. Henry Kay, a leading
life science investor with Boston Harbor Angels,
noted: “An investor who plays in this space knows the risks
and more importantly knows the opportunity and is willing to help a
startup company with personal expertise or contacts in the
industry. A life science startup should look for these types of
investors, typically called ‘smart money.’ They bring more
than capital; they bring skills that the entrepreneur can call upon
during the development process.”

But a gap still remains…

Even with the opportunities to realize huge exits, to develop
life-saving technology, and to deploy their impressive array of
scientific and business skills, angels are proving to be only part
of the solution. For the first time in decades more dollars are
being invested by angels into Internet companies than into
healthcare companies. In the first half of 2012, $123.9 million was
invested by angels across 70 deals into life science companies.
This represents 26.5 percent of the total angel dollars invested
and 20.5 percent of the deals, and is a marked decline from the
40.8 percent of total angel dollars invested and 23.3 percent of
deals in life science companies in the first half of 2011. It is
not clear whether this shift in angel investing emphasis is a
market correction to earlier over-funding of the life sciences
sector, or if this represents a new and troubling gap in the
fundraising landscape.

As this gap has appeared, other players with a vested interest
in a healthy pipeline of life sciences companies have begun to
respond with new and innovative solutions:

• Universities will continue to fund early research and
  development and to engage in commercialization efforts as a way to
  bolster their brands and increase their licensing revenue. Many
  have reacted to uncertainty about the availability of federal money
  by partnering with industry in massive collaboration projects
  around commercializing technology.
• Pharma and medical device industry giants have begun their own
  incubation programs, ranging from in-house venture capital, to
  creating stand-alone entrepreneurial enterprises, to acquiring a
  portfolio of options in early stage companies in exchange for
  distribution and acquisition rights.
• States have begun stepping into the fray. Understanding the
  link between new venture creation and economic development (and a
  stable tax base), states have increased general venture capital
  support (such as Massachusetts recent refunding of MassVentures).
  Additionally, given the “sticky” nature of life science
  companies and their necessity of onshoring key jobs, states have
  also increased funding specifically for life science companies
  (such as the debt programs from the Massachusetts Life Science
  Center)
• Entrepreneurs are likely to seek out a broader base of capital
  through crowdfunding as securities regulations are relaxed under
  the recent JOBS Act, although it is critically unclear whether
  obtaining such early stage capital, at possibly inflated
  valuations, will inhibit or reduce the opportunity to raise the
  follow-on capital that is required for such companies.
• Some angels are bucking the traditional taxefficient strategy
  of growth capital for the risk (and return) reducing strategy of
  investing in income streams generated by early medical product and
  health IT companies—although this is clearly a strategy that
  will not adequately address the needs of biotech
  entrepreneurs.
• For-profit life science companies may begin to have increased
  access to grants and programrelated investments (PRIs) from private
  foundations, particularly as new L3C and Benefit Corporation type
  structures evolve.

What will happen to the angels in life science?

It is entirely possible that one result will be a realignment of
expectations around angel investment returns. In a market in which
broad-based public equity and debt indexes are returning tiny, if
any, returns, interest rates are at historic lows, and venture
capital portfolios have been in the doldrums, angels may begin to
target their portfolio returns in the 15-20 percent range rather
than in the 35-40 percent range. While the underlying risks of
commercializing life science technologies continue to climb, it is
possible that angels will adopt a highervolume, lower-return
strategy, thereby maximizing the portfolio effect of addressing
risk. If so, the market for “solid doubles” will
increase—which will likely favor medtech deals over biotech
deals.

Venture capital participation

Additionally, angels may return to the days of actively seeking
investments which will attract rather than avoid follow-on
investment from venture capital firms who, at later stage
valuations, will absorb the capital requirements and risk of life
science companies. Many angels have become nearly pathological in
their fear of deals which require venture capital. Some fear the
dilution, and others the loss of control that often comes with
reconstituting the board in the wake of such venture investment.
Some fear that VCs want to stay in deals longer because, unlike
angels, they cannot recycle capital and thus need to maximize total
returns at the expense of IRR which is adjusted for time.

Most of this thinking misses the mark in today’s venture
investing environment. First, percentage dilution has never been
that important for minority stake investors. Only value dilution is
relevant. Which of us would prefer 100 percent of a startup to 1
percent of Facebook? Second, the loss of control is natural and
often appropriate. Investors should always seek control provisions
that permit them to drive the company towards the goals stated
during the investment process. If a company early on indicates that
the strategy will be capital intensive and will seek angel and
venture involvement, then angel investors should be satisfied with
swapping out their appointed directors for those selected by
later-stage venture capital. Such capital should be brought in by
the company with the clear participation of the angels to execute
such a strategy. If the angels believe that such investors and
their directors will opt for deals that do not support returns for
all investors, then they have made the same kind of mistakes that
occur in angel deals that pay angels but not founders.

On the issue of exit timing, views among the angels differ. IRR
was invented as a metric to com pare multiple investments with
differing capital requirements and timelines. Because quality deals
are harder to find, exiting quality deals early is likely to
decrease total portfolio returns. The next use of the recycled cash
is likely to be a lower risk-adjusted return than the existing
business. However, if the existing deal is likely to stay illiquid
for long stretches of time, it is hard to know, in advance, what
the “optimum exit valuation” looks like for planning
purposes.

Additionally, it will be important for angels to properly
appreciate the relative value of new cash versus the existing asset
base (consisting of human, financial, and intellectual capital). It
would be inconsistent to demand very low values at the angel
investing phase and then high values for the venture capital phase.
One hallmark of biotech life science investing is that the efficacy
and regulatory risks are the biggest risks and they exist through
the clinical trial phase. Market risk, on the other hand, is often
relatively easy to assess. This is very different from software or
engineering type companies where “does it work” is a
question that gets answered much earlier in the process, but market
adoption and sales risk remains the dominant risk as the business
progresses. Life science companies, and their angel investors,
should expect modest but not radical step-ups in valuations as
angel cash, during the proof of concept phase, is converted into
intellectual capital and human capital.

One interesting outgrowth of this expectation is that angel
investors might return to using a convertible debt format for such
companies, with the expectation that the negotiated discount to the
next round will be the sole step-up in valuation from their
original investment. By aligning expectations in such a fashion, it
is possible to satisfy investor expectations while providing some
increased protections of debt to the angels during the proof of
concept phase. Founders, however, should assume in such a deal not
that they are getting the angels to invest effectively at
laterstage venture capital valuations. Rather, both the angels and
the venture capital investors will be investing at the more modest
POC pre-money valuation (which means angels should also prepare for
the dilution impact). The upside is that the companies and angels
can accelerate the investment process by not wasting time
negotiating valuations, and the investment can properly be
understood to be a bridge to the next phase of company
evolution.

But why do companies need to fund this phase with equity? In
most cases, after consuming all of the angel cash, life science
ventures will continue to require significant capital to achieve
regulatory approval. This capital is well aligned with venture
capital for two reasons. First, the green-light/redlight nature of
such risk means that the risks are very high and therefore the
market will likely price the cost of capital very highly. Second,
and related, unlike their digital brethren who may be generating
revenue and aggressively adding fulltime employees (both of which
may attract lower cost financial investors), life science companies
will continue to lack meaningful collateral and will therefore be
poor candidates for debt financing. While, as noted above,
strategic, grant, or PRI type capital may be attractive, there
exists a far larger pool of equity financing.

Ongoing role

While deal structures, return profiles, financing terms, etc.
remain unknown, it is probably safe to say that angels will
continue to be a cornerstone of early stage support for life
science ventures. Angels’ industry and entrepreneurship
experience is too valuable, their instincts and rigor in evaluating
quality opportunities is too strong, and their desire to
participate in the next wave of life-saving and enhancing
technologies is too resilient to allow investment market conditions
to remove them from the playing field.

Originally published on Xconomy.co
www.nutter.com

This update is for information purposes only and should not
be construed as legal advice on any specific facts or
circumstances. Under the rules of the Supreme Judicial Court of
Massachusetts, this material may be considered as
advertising.

Specific Questions relating to this article should be addressed directly to the author.