Starting a New Venture. October 11, 2018 Frank Grassler, J.D. VP For Technology Development

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1 Starting a New Venture October 11, 2018 Frank Grassler, J.D. VP For Technology Development

2 Starting a New Venture Decision Time The question: Form a business now OR continue to grow the science and development within the university? This is a cost-benefit analysis and you re definitely not ready until you ve done the analysis. Costs: Formation, rent, equipment, supplies, office overhead, salaries, insurance, accounting, legal, registrations, fees, travel, entertainment, license costs, loss of academic discounts, loss of steady income stream Benefits: Limited liability, IP is less costly, capital is less costly, satisfaction of getting it going 2

3 Starting a New Venture Types of Companies The Sole Proprietorship One owner Everyone else who works in the company is an employee, not an owner Owner has unlimited liability Duration is limited to life of the proprietor Simplest to start Pick a name for the business-own name or a trade name File the business name with the county clerk ($10) Get any licenses or permits you ll need Get an Employer Identification Number from the IRS Open a business bank account don t co-mingle funds Obtain General Liability insurance Select an accountant 3

4 Starting a New Venture Types of Companies Partnerships Multiple owners Share profits, bear the expenses and the losses Has to be re-organized if the partner list changes Partners have proportional shares of liability All non-partners are employees Start in same fashion as sole proprietorship, plus Draft a partnership agreement Each partner s capital contribution Allocation of profits, losses, expenses & draws Each partner s authority and duties Voting rules Dispute resolution steps 4

5 Starting a New Venture Types of Companies The Limited Liability Corporation (LLC) Harder to be held personally liable Personal assets harder to reach by creditors Minimal record keeping compared to a C corp Choice of being taxed as a partnership or corporation Can be as few as one member Early investors favor this so losses can be passed through investor s personal income tax return Start with same steps as sole proprietorship plus Appoint a registered agent File certificate of formation with Sec y of State Draft an operating agreement Ownership and operating procedures Separate personal assets from those of the LLC 5

6 Starting a New Venture Types of Companies S Corporation works essentially like an LLC, and is rapidly declining in use due to ready availability of LLC formation C Corporation Has perpetual existence Is treated as a natural person for legal purposes Very difficult to hold stockholders liable for company obligations or liabilities Earnings and losses do not pass through to investors Ownership is in the stockholders, not the executives, employees, directors, creditors, contractors, customers, or suppliers, unless they own shares of stock Highly flexible in creating different classes of equities 6

7 Starting a New Venture The C Corporation This form of company is preferred by UTSW for the license Is subject to highly detailed state & federal corporate statutes, while LLC s are subject to the provisions of their operating agreements Complicated to set up and organize File certificate of incorporation with Sec y of State Name a registered agent Pick a stock structure Draft articles of incorporation and corporate by-laws Draft shareholders agreement Draft voting rights agreement Create a Board of Directors and recruit directors Select an entrepreneur if not already done Entrepreneur can be interim CEO or first regular CEO 7

8 Types of Investments Personal savings and credit cards Family, friends, colleagues High Net Worth individuals Family offices Angels & angel networks Venture capital firms & other financial firms All of these are dilutive, meaning you trade money for stock Non-dilutive sources of capital are grants from government agencies or non-profit organizations Patient advocacy groups Foundations Institutions 8

9 Types of Equities Common stock Preferred stock Convertible debt Options Warrants Note that none of these equities can be publicly bought or sold until the IPO 9

10 Issuing Equities First, the newly-formed corporation authorizes a stated number of shares. Out of the authorized pool of shares, different equities are issued. Common stock is generally issued first to the founders. Common stock might be issued to the licensing university. Such stock is referred to as founders shares, but this is not a legal term; they are just common stock unless agreed otherwise. A valuation is placed on the new company, which is divided by the total issued shares, which yields the price per share. Shares are assigned a par value in the filing papers, but that is a purposely very small number and does not control the valuation and initial share value. 10

11 Issuing Equities The Seed Round Common shares can be issued in the early life of the company to family, friends and colleagues for cash or value ( sweat equity ). Common shares might be acceptable to angels (sometimes called the angel round ). Angels, foundations, or others might be willing to loan money to the company in the form of convertible debt (notes or debentures). Convertible debt can have a negotiated right to be converted to common or preferred stock under agreed circumstances. Options can be created to reward the initial CEO or to key employees. Warrants can be created to act as an incentive to future investors. 11

12 Issuing Equities The Series or Venture Rounds Series A First round of financing after the Seed Round Typically an angel network or a VC firm In exchange for significant investment amounts, preferred shares of stock are sold Preferred shares have preference legal rights If the company goes bankrupt, preferred shares are repaid before common shares (but preferred shares are repaid after creditors of the company) Preferred shares may have greater voting rights at shareholder meetings Preferred shareholders may have the right to nominate one or more directors to the Board 12

13 Issuing Equities The Series or Venture Rounds Preferred shares may have anti-dilution rights Registration rights Tag-along rights Drag-along rights There can be any number of Series Rounds, but rounds beyond Series E are not typical Series grow in size if the company is doing well A typical A Round size is around $17.5M (2014 dollars) 1 With each new financing round, shareholders percentage ownership of the company will shrink (dilution) but generally the share price is rising, which may offset the dilution in value 1 Nature Biotechnology Vol 3 No 1 January 2015 page 18 13

14 Angels and Angel Networks Angel groups like to stay in a pre-money valuation of ~$10M. Practice your pitch Join an accelerator to hone your skills Take advice from any source Be humble Making the approach Find a champion or advocate on the panel first to pre-lobby it the panel will find you to be more credible Making the pitch Know what your SG&A s are going to be Pick your self-compensation carefully; you don t want to look like you ll burn through money too fast on yourself Again, be humble they will always see things you don t There is usually a data hole they ll probably find it Display a willingness to learn during the experience they ll like that and it will prove that you are coachable 14

15 How Angels View Investing Strategy Rules For Angels If the angel can t decide, then that means it doesn t feel right and they should skip it and look for something else there are just too many promising opportunities out there. An angel ultimately wants to be invested in up to 30 companies; some will go as high as 70 to 100 companies it s all about shots on goal. Angels want to be in pre-traction investments ($1M-5M pre-money; Studies of pre-traction companies show 4x to 100x returns); they will shy away from investments at $8-10M pre-money, which is more of a VC-level investment. They optimally want 0$B companies that could be worth $1B tomorrow; they want a x return, such large exits are the only way an angel achieves a venture-like return. They want to learn a few markets really well and then find the best scientists in the market. They look to invest in technology, not in companies that don t develop meaningful technology Don t have an opinion the founder or entrepreneur will be smarter in their market than the investor; listen, learn, and then decide if the founder is smart, honest, and hard-working. The best source of investing advice is from other angels since everyone else (management, lawyers, VCs, incubators, etc.) naturally looks out for their own gain first and foremost. They can build their investing instincts by playing a version of fantasy football in which they study a startup but don t invest in it. Holding power is more important than the terms in a contract. Contracts can be re-negotiated if the power rests with the pressuring side. Real-world decisions are based on knowing your power; contracts are simply documents written to cover a worst-case scenario., e.g., you have more leverage if your product candidate passes Ph I. Don t be a herd animal (blindly follow the prevailing thinking) but do move in a pack (be in a group or network of angels). 15

16 Venture Capital Firms (VC s) Very robust source of investment biopharma and medtech startups raised $19.7B worldwide in Have significant money available to invest Finance amounts ranging from $10,000,000 to $40,00,000 at Series A In downstream rounds can round up a syndicate of large investors (usually other VC s) to put together $50M- $500M or more Will not invest in an LLC, only a C-corp structure They will only purchase preferred shares and they negotiate a LOT of preferences Usually end up controlling the company, both in votes and in directors 1 In Vivo 3/6/18 16

17 VC s VC s make their money three ways: 1. They charge their own investors 2% of the value of the portfolio they manage. 2. They keep 20% of the increase in value of the portfolio per year. 3. They make a profit on the increase in the value of the shares they purchase from the company, which they realize at the time of an Initial Public Offering (IPO). Once there is an IPO, all of the shares convert to common stock and they can be freely bought and sold to anyone on a public stock exchange. 17

18 Venture Capital Deal Algebra Pre-money valuation = Share Price x Pre-money shares Investment = Share price x Shares Issued (Sold) Post-money Shares = Pre-money Shares + Shares Issued Post-money Valuation = Pre-money valuation + Investment Fraction Owned = Shares Issued to investor/ Post-money shares (total) Or Fraction Owned = Investment/Post-money Valuation = Investment/(Pre-money Valuation + Investment) Example: $2M Investment at a $3M Pre = 40% ownership share (2/2 + 3 = 40%) $2M Investment at a $6M Pre = 25% ownership share (2/2+6 = 25%) 18

19 Venture Capital Deal Algebra Share Price = Pre-money Valuation / Pre-money Shares Shares Issued = Investment/Share Price NB: Share price is the same before AND after the deal. VCs require that a stock option pool for future employees be set aside prior to the Investment, thus diluting the founders. Individual Ownership Fraction = Individual Investment / Post-Money Valuation (for the entire deal) If you re trying to keep the share price flat, the Pre-Money Valuation for the subsequent round has to equal the Post-Money Valuation for the prior round. VC s goal is to own a particular fraction of the company for an appropriate investment. 19 Valuations don t mean anything about what the company is worth.

20 Venture Capitalists in 2017 put $13.2B into 386 biotech and medtech companies in the US; $3.97B into 221 companies in Europe IN 20176, Rounds averaged: A Round B Round C Round US $29M $41M $43M Europe $11M $19M $35M 20 Source: Scrip 3/29/18

21 Methods of Setting a Pre-Money Valuation I. What is the average value for a similar company in our area? In NYC, average pre-money valuation is $4.6M In San Fran, it s $5.1M Take the average as a comparable value, then adjust it up or down for factors specific to your company s situation Model the risk factors in multiples of $250,000 from $500,000 for high risks, to +$500,000 for very low risk. BUT How much dilution is acceptable by the founders? 21 For example, if an average value is $2M, giving out 15% to 25% for a seed round comprised between $300K and $500K, or making sure that the founders remain majority shareholders after a series A; then an investor offering $500K for 30% is a bad deal; for 18%, it s a good deal.

22 Example: Initial Value $1,500,000 Risk Factor Subjective Risk $ Value of the Risk Running Total 1. Management Risk Very low +$500,000 $2,000, Stage of the Business Normal (for this industry) 0 $2,000, Legislative Risk Normal 0 $2,000, Manufacturing Risk Normal 0 $2,000, Sales Risk Normal 0 $2,000, Funding Risk Normal 0 $2,000, Competition Risk Very High -$500,000 $1,500, Technology Risk Low +$250,000 $1,750, Litigation Risk Very Low +$500,000 $2,250, International Risk Normal 0 $2,250, Reputation Risk Very Low +500,000 $2,750, Potential for Lucrative Exit Normal 0 $2,750,000 This method works well for pre-revenue (sales) startups. 22

23 The Venture Capital Method Investor thinks your startup will exit for $100M in 8 years Investor s required return is 20-fold What is the maximum the investor is willing to pay for investing in the business, after adjusting for dilution? Anticipated Exit Amount / Target ROI = post money valuation; minus amount invested = pre-money valuation before adjustment for dilution; times dilution factor = pre-money valuation after adjusting for dilution $100M/20x = $5M, the post-money valuation $5M - $1M = $4M, the pre-money valuation before adjusting for dilution $4M x 70% = $2.8M, the pre-money valuation after adjusting for dilution By the way, only investors who can bring one-third to one-half of the round have the leverage to set the pre-money valuation. 23

24 Exemplary Therapeutics Term Sheets Non-Binding Term Sheet for Colossal University LICENSORS LICENSEE PRODUCT TERRITORY MILESTONE PAYMENTS Equity: UT Southwestern Exemplary Therapeutics Gene editing therapies using trna-aav or related technologies Global See Exhibit A Founder shares: 1,500,000 shares equity granted at company creation (15% fully diluted) SALES ROYALTIES On Net Sales <$100mm: 2% on Aggregate Annual Net Sales On Net Sales $100mm - $1.0B: 3% on Aggregate Annual Net Sales On Net Sales >$1.0B: 5% on Aggregate Annual Net Sales 24 DEVELOPMENT PLANS Founding Investor Inc. (FII) will take on future costs up to $5M not funded by grants as a lead is developed by Alfred Einstein, and will also facilitate potential partnerships for the advancement of the Product. After a lead is identified FII will help raise Series A to fund a proof of concept large animal study followed by IND enabling work.

25 Term Sheets Description Cash Amount Upfront Licensing Fee $10,000 Signing and Program Initiation: Clinical Development: Reimbursement of IP expenses $30,000 (exact amount TBD) Signing and Initiation Total $40,000 Upon dosing on the 5 th patient in any Ph. I trial $500,000 Upon dosing of 5 th patient in any Ph. II trial $1,500,000 Upon dosing of 5 th patient in any registration trial $3,000, Approval: Sales Milestones Clinical Development Total $5,000,000 First Commercial Sale in United States $5,000,000 First Commercial Sale in Europe $5,000,000 First Commercial Sale in Japan $2,500,000 Approval Total $12,500,000 First time aggregate worldwide Net Sales for a single product from selected disease project $10,000,000 exceeds $100,000,000 in any calendar year First time aggregate worldwide Net Sales for a single product from selected disease project $25,000,000 exceeds $500,000,000 in any calendar year First time aggregate worldwide Net Sales for a single product selected disease project exceeds $40,000,000 $1,000,000,000 in any calendar year Sales Milestones Total $75,000,000

26 Term Sheets This Term Sheet is to facilitate discussion and is not intended to be an offer or a legally binding contract. This Term Sheet does not describe all of the terms and conditions (material and non-material) which would be included in one or more definitive license agreements regarding a possible transaction (the Definitive Agreement ). No party intends that the preliminary terms contained herein represent the final agreement as to the transactions discussed herein. The arrangement described herein is subject to, and conditioned upon, negotiation and execution of a definitive and final agreement. Neither party shall have any obligation with respect to the proposed transaction unless and until the Definitive Agreement has been authorized by and executed and delivered by an authorized officer of each of the parties. A party is free to withdraw from the negotiation of the transactions described herein prior to the execution of such definitive and final contract without liability or obligation. Any actions taken by a party in reliance on this Term Sheet shall be at the party s own risk. 26

27 Translating the Term Sheet into a Capitalization (Cap) Table Founders Investment Founder Shares Stock Option Plan Total Shares Fully Diluted Ownership Alfred Einstein 5,200,000 5,200, % Colossol University 1,500,000 1,500, % Founding Investor 2,000,000 2,000, % Lab Members Tom 50,000 50, % Dick 50,000 50, % Harriett 100, , % Management Charlotte the CEO 100, , % Stock Option Plan 1,000,000 1,000, % TOTAL $ - 8,700,000 1,300,000 10,000, % 27

28 Pre- and Post- Series A Cap Table (Pro Forma Table) Premoney $60,000,000 Series A $/sh $ $$$$$ Financing $40,000,000 $$$ Postmoney $100,000,000 $ Equityholder Name Common Stock Series A Conversion Total Fully Diluted Shares Fully Diluted % Series A Financing ($) Series A Shares Fully Diluted Shares Fully Diluted % Founders Alfred Einstein 5,200,000 5,200, % 5,200, % Colossol University 1,500,000 1,500, % 1,500, % Founding Investor 2,000, ,248 2,814, % 2,814, % Venture Capital Firm $40,000,000 8,499, % Lab Members Tom 200, % 200, % Dick 250,000 2% 250, % Harriett 50, % 50, % Post doc 1 50, % 50, % Post doc 2 12, % 12,00 0.1% Postdoc 3 50, % 50, % New CEO 500, % 500, % Available Options 188, % 188, % Option Pool Increase 1,935, % 1,935, % TOTAL 8,700, ,248 12,749, % $40,000,000 8,499,607 21,249, % 28

29 VC-Identified Common Mistakes in Life Science Companies 1. BELIEVING THAT YOUR TECHNOLOGY IS ENOUGH TO CARRY THE DAY Don t think that your science is the single factor that attracts the VC. They are only interested in their exit when it is and how much it is. Provide a transaction context for your company by presenting comparable exits in the last 3 to 5 years. No exit = no ROI. Only 1 in 5 companies achieves an exit within 6 years.* If $80M is needed to get to approval and acquisitions over the past 5 years averaged $200M, this is a 2.5x ROI Probably not great enough. Solutions: Find ways to reduce amount of needed capital; Seek to exit before FDA approval phase; Identify differentiators that can command a premium what has been really important to acquiring companies? 2. BEING BLINKERED WITH INWARD FOCUS Develop a top-down market-driven point of view, not a bottom-up technology-driven point of view of the situation and strategy. * National Venture Capital Association 29

30 Strategy first, execution later, e.g., let your literature and internet research tell you: Who are the players? How many are there? What kind of transactions have taken place (acquisition, merger, license, joint R & D deal?) What was paid? What technology are companies looking for? What are the key value drivers for an acquisition? What do strategic buyers need to fill their pipeline? How will the technology integrate when in the hands of the buyer? How can the company create an offensive value proposition for itself, spurring others in the field to acquire the technology, to either improve their own technology or to block competition? What company did a buyer acquire? How much did they pay for it? At what development stage did acquisitions take place? How will the company s technology complement and synergize with those potential acquirors? Valuation Parameters (Comps) Comps are shaped and supported by a market segment (an entire cohort of companies), not an outlier transaction Outline & list all exit multiples over a two to three period, focus on the median examples, and realistically plan to exit at that multiple 3. IGNORING THE CRITICAL RELATIONSHIP BETWEEN TIME, CAPITAL, AND MILESTONES Show investors that you understand the relationship between time, capital, and milestones by preparing a Gantt chart that communicates a timeline, milestones, and both the time and the capital required to reach each milestone. Failure to understand this relationship yourself is a very common cause of running out of cash. A well-done slide will show the critical path to de-risking the innovation and the cost of reaching milestones. 30

31 4. CONFUSING INVENTION AND INNOVATION Life Sciences is a feeder industry most biomed companies exist to be acquired. You have to focus on innovation and maybe clinical development, but let the strategic players (big pharmas) handle things like approval, manufacturing, sales, marketing, and reimbursement. Innovation and maybe clinical development reduce risk and increase value to the buyer. Innovation in this context is NOT new product creation. It s development of a product that solves the needs of end users and improves clinical outcomes. It contrasts with invention invention allows for change in a market while innovation creates change in a market. You can argue that innovation is thus not possible without invention preceding it. For example, Edison invented direct current electricity service, but Tesla innovated with alternating current electricity service the innovation met consumer needs while the invention did not, but the innovation was possible because of the invention. Thus, innovation will support a business enterprise, while invention generally will not. Use innovation to align your invention with user needs, change the market, and change user behavior. You learn what those are through conversations with key stakeholders and end uses. 31

32 5. TAKING MULTIPLE SHOTS ON GOAL - In general, investors are more interested in a single product being developed than in a platform turning out lots of potential products because generally only big pharmas have the resources to pursue multiple programs, and investors want the startup to stay focused. - Create a chart of all de-risking milestones for a product and ensure all of your profit-and-loss spend is directly tied to those specific activities. 6. UNDERCAPITALIZATION - Since it is nearly fatal to create a budget that doesn t suffice to achieve milestones, don t be tempted to understate how much you are seeking in investment because you re worried that the VCs are sensitive to the amount of capital being sought they re not. They re not about conserving capital, they re about managing risk and creating value. - Don t be tempted to undercapitalize to achieve a better valuation or to protect your share position against dilution. - Build a comprehensive budget and understand your cash flow needs for the nest five years; review comparable companies invested capital to ensure you are in a similar capital neighborhood. 32

33 7. SELECTING THE WRONG TYPE OF INVESTOR - Look for investors that work in your field. - Look for good operational knowledge they can bring to your company (their stable of experts). - Look for investors that have enough dry powder (capital) to support you over several years, whether it s a single firm or a syndicate. Otherwise, earlier investors who can t participate repeatedly will try to stall or block new funding rounds to avoid getting diluted and to avoid losing preferences to the new investors. - Review an investor s fund cycle and how may investments they had in your space; ask to speak with present and exited companies management about them. 8. INABILITY TO MANAGE THE BOARD OF DIRECTORS - Dysfunctional boards are characterized by: (1) directors who have little understanding of the scientific and technical hurdles facing the company; (2) directors placed there by VC firms that have divergent ROI agendas; (3) directors with little operational experience; or (4) directors with little experience with launching/building up new companies. - The CEO CANNOT PLEASE EVERYBODY! DON T TRY! A strong CEO in the biomedical startup arena has the ability to manage and navigate these opposing forces. To the extent you can, try to find like-minded folks for your investors and like-minded folks to be your directors. 33

34 9. TRYING TO GO IT ALONE It is unrealistic to expect to master the disciplines of science, finance, clinical medicine, law, government regulation, and strategy. The CEO s first job is STRATEGY. The second job is FINANCE. The third job is put together a team that masters all these other disciplines. Besides, that s what consultant are for. Innovation, strategy, and execution cannot be outsourced all this other stuff can. 34