Sales of Portfolio Companies by VCs

Michael Lytton discusses the factors most important to a venture capitalist in deciding whether to sell a portfolio company.

Question: Given the dismal biotech financing climate, intrabiotech mergers are a common topic of discussion. What factors are most important to a venture capitalist in deciding whether to support the sale of a portfolio company?

Answer: While VCs can't al-ways force the sale of a portfolio company, their approval for a sale is nearly always required. This approval right is typically contained in negative covenants drawn up as part of the venture financing documents, which survive at least until the IPO. These covenants provide for a class vote of each series of preferred stock to approve a sale, regardless of the magnitude of a class's holdings relative to the total number of shares of outstanding stock (See Advice of Counsel,Start-Up, February 1998.)

It is fair to say that, when compared against the mosaic of widely differing agendas that populate the average biotech company board of directors, venture capitalists generally take an economically rational view of acquisition proposals. They look for such necessary attributes of a successful deal as economies of scale, complementary resources (i.e., non-duplicative laboratory facilities), compatible corporate cultures, and other textbook elements.

Venture capitalists will analyze acquisitions from both a business and financial viewpoint. As to the former, the fundamental question is whether the acquisition will create a broader technology platform, resulting in multiple product opportunities centered around a specific disease focus. The experiences of the past few years with so-called platform technology companies has led most investors to conclude that the pure "service" model has its limitations, and that long-term sustainability will only come from a business model that permits retention of some of the upside associated with a successful drug. If a consolidation can result in a more complete drug development pipeline with fewer gaps (i.e., stretching from pre-clinical to Phase III), this is especially commendable.

Since few biotechs are profitable, VCs will want to see an acquisition strategy that includes a plan for underwriting two burn rates. The post-merger company must also have a strategy for funding the rapidly accelerating cost of drug development (i.e., 70-80% of drug development costs are incurred in Phase III testing).

The financial markets in biotechnology in recent times have supported the hypothesis that bigger is better. Increased aggregate market capitalization permits a greater number of financial institutions to invest. Analysts are more interested in covering larger companies with active trading volume. A more widely traded stock offers investors greater liquidity. The recent downturn in public biotechnology stocks has most severely impacted the small-cap biotech stocks.

As compensation for giving up control over their portfolio company, VCs look for a significant premium over the most recent valuation of their holdings, usually at least 25%. Over the lifetime of their investment, they would like to realize an annualized internal rate of return of at least 25% as well. This rate of return and valuation step-up should cover the VC's sacrifice of the undiluted upside of staying an independent company.

Most often with intra-biotech deals, the acquirer pays with stock, though he sometimes uses a small amount of cash as well to buy out small holders. VCs will insist on receiving registered stock, so that they can sell stock in the new entity if they so choose. Acquirers, who fear the VC dumping shares and depressing the stock, will insist on a minimum lock-up period before the VCs can sell. VCs must also balance their desire for selling off their shares in the newly merged entity against their interest in taking a board seat or otherwise being actively involved in the governance of the new entity. Insider status restricts, as a matter of law, one's ability to trade in the stock of the combined entity, a legal principle which often forces VCs to decline a board seat or accept some restrictions on their shares. VCs also would generally like to structure a tax-free reorganization (which is easy to accomplish if the consideration for the acquisition is principally stock of the acquiring company), unless the investment is being liquidated at a loss, which will argue for a taxable transaction.

Often, a portion of the acquisition consideration is deferred, to be paid upon achievement of negotiated drug development or other milestones. In such event, the target company's venture capital investors will seek to keep the operations of that entity separate until the milestones are achieved, or otherwise negotiate some protections so as to ensure that adequate funding and other resources are available so that the milestones can be achieved within the projected timetable.

Given the many personality and cultural issues that can derail an acquisition, VC board members can play a valuable role in negotiating the acquisition, since they need not be concerned about impressions created on a future employer. Further, a venture capitalist's stake is largely economic, theoretically leading to a balanced and impartial voice of reason during difficult moments in a negotiation.

At the same time, a VC may also be subject to non-economic influences. Deals can fall apart purely for inter-board ego reasons, such as bragging rights in the VC community for ending up with 51% of an intra-biotech merger. Bragging rights can also involve contests over who sits on the board of the combined entity (despite insider trading issues). Perhaps it's a relief to know that VCs are human as well.

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, e-mail them directly to [email protected].