Avalon's Sweat Equity
This article was originally published in Start Up
Executive Summary
Avalon Ventures closed its ninth fund in January with $200 million committed, $50 million more than planned and a third larger than its previous fund. For a firm that invests half its money in tiny lifescience start-ups, it was an impressive number at a time when the venture industry is reeling. That’s a vote of confidence in the firm’s unusual "sweat equity" strategy.
Dear Readers,
Welcome to Capital Matters, START-UP's monthly column to highlight new ideas and strategies for financing innovation, as well as the people and firms bringing them to life. We have been chronicling the ongoing pressures reshaping the medtech and biopharma industries in the pages of START-UP, as well as our sister publications, IN VIVO, "The Pink Sheet" and "The Gray Sheet. " We're convinced that from the turbulence of health care reform, regulatory hurdles, and the "Valley of Death" funding gap, new products, companies, and business models will emerge. Capital Matters will explore new venture models, academic partnerships, pioneering disease foundations and much more. You'll read about old dogs learning new tricks, and new players you've never heard of. Even as some traditional venture groups retreat from early life-science investment, great ideas need to move forward. That's what Capital Matters is all about. Thanks for reading, and please let us know what you think. – The START-UP editors ([email protected]).
Avalon's Sweat Equity
The early-stage diversified firm raised a $200 million fund, its ninth, even though it's a terrible time to be a biotech investor. Just ask its founder.
Founded 28 years ago, Avalon Ventures in San Diego said in January that it had closed its ninth fund with $200 million committed, which was $50 million more than planned and a third larger than its previous fund. For a firm that invests half its money in tiny life-science start-ups, it was an impressive number at a time when the venture industry is reeling and the biotech side of the business is, by some accounts, severely damaged.
In the 10-year period ending September 30, 2010, venture capital returned a negative 4.6% for its LPs, worse than the major stock indices according to Cambridge Associates. High-profile firms such as Domain Associates, Polaris Venture Partners and Atlas Venture have all closed funds smaller than their anticipated goals, and others have gone out of business entirely. Some early-stage firms now focus on their portfolio companies' survival rather than new start-ups. ( See "As Some VCs Are Running On Empty, Others Top Off The Tank," START-UP , July 2010 (Also see "As Some VCs Run On Empty, Others Are Topping Off The Tank" - Scrip, 1 Jul, 2010.).)
The new fund isn't necessarily a full-throated endorsement of Avalon's biotech side. In fact, the diversified Avalon couldn't have done it without its high-tech partners. Avalon was an early investor in Zynga Inc., a high-flying developer of Facebook games such as Farmville that just raised cash at a company valuation of $10 billion. An anticipated IPO would be beyond blockbuster, and LPs were happy to re-up. "We don't know if there will be a Zynga II in the ninth fund, but the good news is that we were able to raise the ninth fund based on Zynga," says managing director Jay Lichter, PhD.
It's notable, though, that even with the fundraising muscle the high-tech side brought to bear, the $200 million will be split down the middle, says Lichter. That's a vote of confidence in the firm's unusual "sweat equity" strategy, which consists of three main elements. First, Avalon almost always seeks to provide seed capital, pre-Series A cash. Second, it prefers to invest alone, sometimes into a company's Series A round. Third, its four general partners who lead investments typically serve as CEO of two or three start-ups simultaneously. Lichter himself is CEO of ophthalmology drugmaker ReVision Therapeutics Inc., sleep apnea treatment developer Sova Pharmaceuticals Inc., and Afraxis Inc., which is developing therapies for the rare Fragile X syndrome.
"We're all entrepreneurs, all operations people," Lichter says. "When Kevin [Kinsella] started the firm, he would earn sweat equity: find someone with a good idea, work for them, and guide them toward an exit. It's still that way, to some extent."
The firm's health care investments, 16 currently active that it has announced publicly, also include antibiotic, inflammatory disease and oncology drug developers and a medical device start-up. Of the seven life sciences investments in the 2007-vintage eighth fund, which closed at $150 million, one has folded and the rest remain private. Several have prospered enough to attract large subsequent rounds, such as ear disorder specialist Otonomy Inc.
Other early-stage investors put their own partners in management roles, notably Third Rock Ventures, whose founders ran Millennium Pharmaceuticals Inc. (now a part of Takeda Pharmaceutical Co. Ltd. known as Takeda Oncology). But Third Rock brings a lot more cash and other VCs to the table. Going solo, Avalon's seed strategy calls for quarterly budgets and funding for its portfolio companies. Once it hits its cap, it calls the cumulative seed funding – typically in the single-digit millions of dollars – a "Series A" and looks to syndicate a Series B. Avalon reserves enough capital to follow on with several times that amount in later rounds.
By investing early, the firm can receive a handsome return on a modest sale price. Lower prices mean more potential buyers and healthier competition. Lichter says an average-sized exit in the $120 to $140 million range doesn't deliver much for firms that have put in $100 million, but such a sale yields a strong multiple for a start-up backed by less than $15 million.
Avalon usually brings in a senior science executive early, but a full-time CEO can join anywhere from a few months to three years after Avalon's first investment. For example, Otonomy raised its $38.5 million Series B round last summer, two years after it was founded, and Lichter passed the reins to new CEO David Weber only after the round, led by RiverVest Venture Partners and Novo Ventures, closed. [See Deal]
Funding Pet Projects In Tough Times
The prospect of a Zynga IPO has boosted Avalon's profile, but the biotech side has notched its own victories. Last month, Amgen Inc. acquired cancer vaccine developer BioVex Inc. for $425 million up front plus an earn-out that could drive the total to $1 billion. [See Deal] That wasn't a sweat equity seed deal, though; Avalon joined BioVex's syndicate during its Series C round in 2003. [See Deal] ( See "Amgen Takes Out BioVex In Potential $1 Billion Deal," "The Pink Sheet" DAILY, January 24, 2011 (Also see "Amgen Takes Out Cancer Vaccine Developer BioVex In Potential $1B Deal" - Pink Sheet, 24 Jan, 2011.).)
Still, exits haven't come easily, and in February Avalon's founder Kevin Kinsella publicly blamed Big Pharma for pushing the biotech sector "to the point of extinction." In an interview with online news site Xconomy, Kinsella said the sluggish IPO market has handed enormous leverage to buyers, crippling an ecosystem that has historically produced innovative medicines. Avalon hasn't had a portfolio life sciences company go public in more than a decade. Eleven have been acquired since the mid-1990s.
The new fund shows LPs have at least some faith in biotech, as there are plenty of high-tech-only funds to switch to. But Avalon knows it has to go places it wouldn't normally go. The firm recently backed Aratana Therapeutics Inc., a Kansas City start-up working on illnesses afflicting cats and dogs, in a $20 million Series A alongside MPM Capital and Cultivian Ventures. "There's a shorter timeline to revenue, development is less expensive, and the regulatory bar is lower," Lichter says. "If you can get $100 million products that cost $3 or $4 million, you should do it," he says of his hopes for Aratana. "Faced with the issues [surrounding exits], you've got to do something."
– Paul Bonanos
