Structuring a Venture Capital Deal with a Pharmaceutical Company
This article was originally published in Start Up
Executive Summary
When the drug company is also the venture fund, are there any special issues in structuring an investment?
Question:Are there any special issues to consider in structuring a venture capital deal with a pharmaceutical company?
Answer:There is growing interest on the part of corporate investors in taking equity in start-ups, whether simply as a financial investment or as a part of a corporate collaboration. As to the former, perhaps the most recent example is BioChem Pharma Inc. 's new $70 million fund to invest in genomics, which is intended to give BioChem a window on new technologies, but without any formal first right of refusal on the technologies or companies that are funded. Older examples include SmithKline Beecham PLC's SR One; and the corporate venture funds of Johnson & Johnson and Bayer AG.
The first and most critical issue is valuation. Will the equity be valued solely as a financial investment, or will it be accompanied by preferred access to some strategic rights? In other words, will there be any strings attached to the equity?
The most common strings fall into three categories. First, the pharmaceutical company may ask for a right of first offer for new technology opportunities in a specified area, obligating the biotechnology company to first offer partnering opportunities in that specified area to the pharma company. This is not a very troublesome right since, if the parties cannot agree on terms within a specified time period, then the biotechnology company is free to pursue other partners.
A bit more inhibiting is the addition of a most favored nation provision, which requires the biotechnology company to come back to the pharmaceutical company with a revised offer if the deal it negotiates with a third party is less favorable to itself than the deal which it first offered to the pharmaceutical company.
Most troublesome is the right of first refusal. With such a right, the pharma investor has the ability to match anypartnering deal negotiated by the biotechnology company—whether the deal be less or more favorable to itself. Such a right has a chilling effect on the ability of the biotechnology company to do a deal with an independent partner, thereby depressing its valuation. Of course, it is best if there are no strings attached, not only from a strategic standpoint, but also because this is the only circumstance under which other financial investors (i.e., venture capitalists) will take the valuation seriously.
A second issue is whether the equity investment (typically denominated in shares of preferred stock) comes with the usual constellation of rights negotiated by a venture capitalist, such as liquidation preferences, dividend preferences, registration rights, and positive and negative covenants with respect to operation of the business. It is usually possible to persuade the corporate investor that all he needs are financial benefits, such as the right to piggyback (i.e. sell shares) in a subsequent public offering. The pharma company need not participate in rights which are related to corporate governance. Expressed differently, it is appropriate to argue to the corporate investor that the venture capitalists will protect its interests as a result of their participation on the Board, through their ability to control management's actions with various covenants and stock incentives.
It is not a good idea to offer a seat on the Board of Directors to a corporate investor. This will frighten off other potential corporate partners, who will worry that their confidential information may be shared with a competitor.
A critical issue is getting the corporate investor to commit to investing in future financing rounds, as typically do venture capital investors. The best way to insure this is to include a pay or play provision in the documents, which punishes an investor for not participating in a future financing round prior to the IPO. This typically takes the form of the loss of anti-dilution protection in the event of a subsequent offering price below the current financing round. This provision is best negotiated by the other venture capitalists (who are also interested in seeing it included in the documents), rather than by the company.
Although it is becoming relatively common to include equity as part of a broad-based corporate collaboration, it is very important to understand the internal pharmaceutical company decision-making process with respect to the equity before introducing it into the negotiating equation. Decision-making processes in large pharmaceutical companies can be occult. Frequently, the decision to take equity and the negotiation over its terms will be with an entirely different group of people (i.e., the chief financial officer and his minions) than the people with whom the corporate collaboration is being negotiated. This can introduce significant delay into the deal. If the pharmaceutical investor has not had a great deal of experience with taking equity in start-ups, it may have unrealistic expectations as to the terms of the equity or the valuation at which the investment should be made. If an equity investment is desired as part of a collaboration, it is advisable to understand upfront what criteria the pharmaceutical investor will use to arrive at a valuation for the investment. One pharmaceutical company until not so long ago had made few equity investments other than taking equity in the early days of Amgen. As a result, its hurdle rate for an equity investment in a start-up was the rate of return on its Amgen stock, a rather daunting task for any early-stage biotechnology company.
Despite all of these issues, it is still a terrific vote of confidence for a company to have its corporate partner invest in its equity. This is usually viewed as a ringing validation of the company and its technology. It is even better if the investment occurs concurrently with the company's proposed IPO. It then becomes a very helpful marketing tool in selling the offering. This is a very common time for corporate partner investments to occur. By the way, be prepared to argue with the underwriter about whether they can collect their 7% commission on the investment concurrent with the IPO!
Michael Lytton is Chairman of the Technology Group at the Boston-based law firm, Palmer & Dodge. If you have any questions you'd like addressed in this column, or if you have comments, email directly to mlytton @ palmerdodge.com.