First Quarter 2016 Update
We recently returned from the annual meeting of a life sciences venture fund manager in our portfolio, and had some interesting takeaways on changes to the traditional venture capital model, at least in the life sciences.
In venture, whether tech or healthcare, the traditional model has involved multiple rounds of funding. Each funding round is intended to bring the company to a further set of milestones, culminating at the exit. At each round, at least one new investor is brought in, both to provide an independent valuation and to broaden the investor group.
The downside of this approach is that every 18 months or so, the company has to spend time raising money, meeting with potential investors, etc. Further, the existing investors often end up in conflict with the new investors over valuation, milestones, etc. Finally, the new investors may have different timelines and expectations for the company.
Our manager, and other life science venture firms, are moving to a model where the full amount of the investment necessary to fund the company to exit is committed up front, with the actual capital deployed in tranches as the milestones are achieved. If the milestones are not achieved, the investors don’t fund the subsequent tranches. The idea is to eliminate funding risk and board/management conflict (which is often a result of disagreements over funding). Funding risk is completely within the control of the investors, so why not take it off the table up front?
This model is not without downsides. The management team may not care for it, since they end up committing to sell a greater share of the company at a lower valuation. As time goes on, valuation becomes difficult, since there are no outsiders coming in to provide an independent assessment at each round. And in some cases, more capital is needed—usually because things are going well and the opportunity set has expanded in some way.
A syndicate of investors who are willing to support and stick with the company through its entire development process is also necessary—which, in turn, requires the company be able to go from initial funding to exit in a timeframe of five years or less. However, we feel that it results in a superior risk/reward proposition, and are glad to see our manager, and others, moving in this direction.