Negotiate the Exit before the Entry

Jay and I recently had a nice chat with a prominent entrepreneur. He has worked on many successful startups that raised a lot of venture capital money and eventually went public and/or sold. His current start-up is having a bit more difficulty than his previous companies getting off the ground. (If someone of this stature is having trouble raising money, I can only imagine the first time CEO with an early stage product trying to raise capital. Ouch!). He mentioned to us an idea for a new strategy to concurrently raise VC money and look to partner the asset, not sell the company. In times past, this idea was asinine. I think it makes perfect sense and is something I was discussing with other colleagues several months back. Maybe there is something here.

The idea isn’t as crazy, in my mind at least, as once thought. You used to be able to fund a company, develop to phase 2a proof-of-concept and sell for $250-400M for a 3-5x return. With acquisition values going down and taking more of a licensing feel with deferred milestones, the returns are simply not there for VCs. Because exits are harder to come by, I would argue that you need to de-risk this previously less-risky aspect of venture investing. Remember that in biotech, VCs generally take technical risk, not market risk like their tech VC cousins. Getting good phase 2a data is no longer a guarantee of financial success and thus you need to lower the risk profile of these investments. The only way to lower the risk profile without somehow reducing technical risk is to reduce market risk. In this case, market risk is really exit risk. I think you should pre-sell the exit.

If you negotiate a license or M&A deal before committing significant additional capital, you cap your upside but can guarantee a 2-3x if your company is willing to take the clinical and execution risk. While this strategy might not be widely adopted now, I think that pharma companies will increasingly partner with VCs to lock down assets more cheaply and earlier, while still taking getting the R&D spend off of their P&L. As I mentioned previously on this blog, a license can be a form of an exit so this can enable you to still not cap your upside if you take royalties and commercial milestones into account.

VCs won’t want to do this for every company in their portfolio. However, to have a “guaranteed” return for a few companies in a portfolio to take out the exit risk, I’d sure take a hard look at that strategy.

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