The 2024 Venture Capital (VC) market is still in rough waters. Several macroeconomic and geostrategic factors, e.g., armed conflicts, ongoing global supply chain bottlenecks, high energy costs, high interest rates and inflation as well as the collapse of banks (e.g., SVB, Credit Suisse), have enticed a nervous funding sentiment and led to increasing capital markets volatility. The closing of VC funds has become more challenging and VCs turn to areas like the Middle East to access alternative funding sources.
According to the EY Start-up Monitor 2024, in Germany alone, the VC deal volume fell by around 39 percent in 2023 (compared to the previous year and 65 percent compared to the record year 2021). Nonetheless there also increasing signs of a turnaround at the beginning of 2024, also with respect to VC financing in the biotech sector. 2024 has already seen some noteworthy IPOs (CG Oncology, Arrivent Pharmaceuticals and Kyverna Therapeutics) and impressive financing rounds (Tubulis, focussing on ADC-based treatments, secured a Series B-2 financing round just recently).
The VC Life Cycle in Biotech
Depending on the maturity of a start-up company, usually an increasing amount of investment is needed to grow the company as the funding is used to achieve different objectives. This entails different types of investors. While in the “Pre-Seed” to “Seed” stages the main objectives usually are the acquisition of IP rights, development of technology or preclinical testing and investors are comprised of friends, family and fools (the “3Fs”), business angels and VCs with investments amounts from EUR 100,000 to EUR 500,000 (in case of VCs up to EUR 1m to 1,5m or more) in the early stages (Series A to B) funding is used for further development of technology or clinical evaluation (Phases I, IIa and IIb). Investors in these stages are VCs as well as family offices and corporates with investments amounts from EUR 5m up to EUR 15m or more. In even later stages (Series C, D etc.) the same types of investors invest from EUR 20m onwards to extend clinical evaluation to larger patient groups or randomized control trials (Phase III). As a result of these differences between (Pre-) Seed and later stages, different financing instruments will become suitable. Besides equity rounds in the (Pre-) Seed stages the conclusion of convertibles might be a viable option whereas in later stages venture debt might be better suited. In the biotech sector, substantial funding may also be obtained by applying for public funding. There is a variety of EU wide or domestic funding options available, e.g., the EXIST program administered by the German Federal Ministry of Economic Affairs, which helps to test the technical feasibility of the given technology as well as make the company investor-ready.
Typical VC Requirements – The Investor View
While each VC investment is unique in nature, VC investments in general require certain business and operational aspects to be present such as a functioning team with valuable know-how regarding their (unique) technology and product preferably having experience in the area of business (e.g., “Big Pharma”). Typically, investors monitor the IP situation carefully and examine market size as well as viable exit strategies before obtaining a minority stake (10 to 25% per round) in the company depending on the funding required to reach the next stages of technology development or clinical testing. Valuations in prerevenue / early stages depend on a combination of funding needed, acceptable dilution and market benchmarks and increase by a factor of 1.5 to 2 on a round-to-round basis, however, in the current market situations flat or down rounds are not uncommon. Especially in start-ups, coming to a viable valuation constitutes a crucial but also challenging task for all parties involved as these young businesses are not yet profitable and do not have a significant corporate history. The risk of failure and the probability of a (total) loss of investment are therefore substantial and need to be taken into account.
Deal Terms and Recent Developments
The main (legal) documents in a VC-led financing round (“VC Transaction”) include an initial term sheet, cap table, investment agreement (IA) and shareholders’ agreement (SHA) as well as ancillary documents such as managing director service agreements or ESOP/VSOP terms. Timing-wise, from negotiating the term sheet till the signing of the final legal documents a period of 3 to 4 months is common, provided however, that this depends heavily on the individual transaction (e.g., extensive due diligence by investors, large cap table with conflicting interest between investors etc.). After signing, the funds will be made available in 4 to 6 weeks.
Deal Structuring
For entrepreneurs, it is important to at least have a basic understanding of the structure and deal terms corresponding with a VC Transaction. In the biotech sector, investments are most often subject to the achievement of operational and regulatory milestones. It is of importance to set realistic milestones and define them as clearly as possible, whilst allowing for sufficient flexibility for waiver or adjustment. From a founders’ perspective it should be avoided to issue all shares at once to the investors if a payment in tranches is agreed upon. It is recommended to try to negotiate higher subsequent valuations and capital increases instead.
Economic terms / Control terms
Generally speaking, the terms of a VC Transaction can be grouped into economic (“money”) terms and control (“power”) terms. Economic terms relate to provisions in the legal documents essentially guaranteeing a certain return for the incoming VC investor, whereas control terms decide on the distribution of responsibilities and competencies among the different bodies of the company.
Besides the investment structure, the most relevant economic terms relate to (i) prorata rights, (ii) antidilution protection, (iii) vesting and liquidation preferences. Control provisions deal with veto rights of investors (through board representatives), shareholder reserved matters (and the applicable majorities), information rights, pooling of minority stake investors, and so forth.
Recent developments
In tougher funding times, VC investors are increasingly demanding more favourable economic terms. Especially with regard to pro-rata rights, anti-dilution protection and liquidation preferences, the momentum has somewhat shifted to the benefit of VC investors:
Investors increasingly (and successfully) demand “super” pro-rata rights, sometimes even for a right to pre-empt the entire financing round and acquire 100% of the new shares, which gives them a de-facto blocking right with respect to new investors. Anti-dilution protection provisions have returned to a more investor-friendly narrow-based weighted average calculation formula (sometimes coupled with “pay-to-play” provisions). And, as for liquidation preferences, although we are not quite near the re-introduction of participating liquidation preferences, multiples of 1.5x or higher have become quite common these days.
As for control terms, there is a certain tendency to push towards a “strong“ board, i.e., a board that is equipped with the authority to appoint/remove managing directors, whereas other control-terms related terms have barely changed.
Closing Remarks
Despite multiple complexities and varying interests, VC Transactions can be handled and managed confidently by start-up founders – based on an organized and well-thought through (investment) process. Right from the start, start-up founders should be mindful about founder team dynamics and potential (unexpectedly premature) founder departures. The “right” allocation of founder equity plays an important role in adequately incentivizing the founders and honoring the different contributions by each founder. Founders should keep a close eye on a “clean” and balanced cap table and try to avoid too many small-stake investments (although, of course, especially at the beginning there is a strong tendency to secure as many investments as possible). Conceding on certain deal terms might pave the way to secure an investment, but, on the other hand, some concessions (e.g., participating liquidation preferences) can be / become too high of a price to pay. And, to capture the investment at the best possible (valuation) terms for the company, start-up founders should actually try to raise money as late as possible, but also as soon as necessary (to avoid running into liquidity difficulties).
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