Today I listened to a very interesting, albeit brief, discussion about pre-negotiating the exit before the initial investment at the Venture Panel at the 2010 Wharton Health Care Business Conference.  The moderator asked about structured transactions where the upside is capped by way of an option with a pharma company to purchase the asset/company after a predetermined milestone.  The panelists were almost all bullish on this idea with some suggesting that they employ this with great frequency.  While I’m not surprised, I do think it has become much more acceptable than before given the continued poor exit environment.

Brenda Gavin, Partner at Quaker BioVentures, mentioned that there were only 20 M&A exits in 2009 from venture backed companies that would constitute a good return.  She mentioned that there are 3,400 biotechs, all of whom are for sale at any given point.  The exit ratio therefore isn’t so good, especially with effectively no IPOs taking place.  As such, if a VC can pre-negotiate a “4x” as she mentioned, she would take that any day over an uncertain 10x.

Steven St. Peter from MPM commented on the MPM/Novartis strategic fund as well as other non-disclosed deals of a similar option nature with other pharma companies.  He said their fund was doing these deals since 1996, but it wasn’t formalized until 2006 with Novartis.  His interesting insight is that there is a real range of exit values for biotech M&A.  Given the amount that generally needs to be invested to get there, there already is an effective cap on returns.  There might be one outlier per year but you can’t set-up your fund expecting outliers.  Given the effective cap on M&A returns, why not cap your return earlier to derisk the exit?  This makes perfect sense to me and something that was mentioned in this blog half a year ago.

Pharma companies rely on biotechs for a supply of innovative assets to fill their pipeline.  They need the VCs to make these risky investments to fund the early stage development.  More companies will be asked by their board to find a partner prior to the next round of financing both to derisk the round as well as provide validation.  This type of pre-negotiated exit arrangement I predict will become even more common going forward as VCs try to improve their returns.

I had a very interesting conversation on Friday with a business development executive from a major pharmaceutical company (both shall go unnamed to protect confidentiality).  He had read my posting about negotiating the exit before the entry and was very intrigued. He told me that his company had started exploring this idea several months ago.  They were very attracted to the idea of getting a quality asset without having to pay venture homerun-like returns for the product.  Unfortunately the VCs that were approached were not interested.

If entrepreneurs would be willing to cap their upside (albeit with downstream economics that can improve the final number) and pharma companies are interested in making this type of commitment, there has to be a way to attract funding.  What investors in this market wouldn’t want a completely uncorrelated 2-3x return with potential longer term upside?  My guess is that eventually the VC community will stubbornly come around and invest at least part of their portfolio with this concept.

The other answer is to start a fund whereby the top 5 pharma companies all agree to share these deals with a pre-negotiated exit with the new fund.  The entire remit of the fund would be to fund these companies.  While the upside for each individual investment might not be gigantic, the downside theoretically is much less given it has gone through “pharma diligence” rather than “VC diligence” which is arguably much more thorough and has a much higher success rate.  Anyone willing to give me $300M to make this happen?