Starting a biotechnology company requires thoughtful strategies for the development of your product, and for your intellectual property portfolio, team, and many other areas. One such key aspect is your financing strategy. Deciding on what types of capital to raise and how much financing is required has major implications for the type of business you can operate, the amount of control the founders retain, and the types of exits available. In this post, I discuss the implications that financing has on two critical aspects of your business: the dilution of founder’s equity and the exit options available after financing is secured.
Dilution. When an entrepreneur takes money from an investor, the investor receives a percentage of the company that is proportional to the amount invested. For example, say you and your investor agree that your company is valued at $500,000 (this is called the pre-money valuation), and that the investor will give you $1,000,000 to operate your business for the next 12 months. Following investment, your company will have a valuation of $1,500,000 (the post-money valuation = pre-money valuation + investment cash) and your ownership will be diluted to 33% from 100% of the company. Dilution is an inherent aspect of equity financing, however this affect has the greatest impact when the company is at its youngest and has its lowest valuation. In the accompanying figure, I outline four scenarios that demonstrate the significance that the ratio of money raised to pre-money valuation has on the resulting founders’ percent ownership.
Figure 1: Dilution following financing. Red indicates investor’s funds and resultant investor equity; blue indicates pre-money valuation and resultant founder’s equity.
In most areas of biotech, particularly in therapeutic, medical device, and diagnostic areas (where the regulatory burden requires significant capital investment), it is expected that investor financing will be required and that investors will become significant shareholders of the company. In fact, most companies require multiple rounds of financing, which can compound the dilution effect. As such, entrepreneurs should put in efforts at the earliest stages of their companies to fund their work using alternative financing sources in replacement of, or in addition to, traditional investors. These ‘non-dilutive’ sources include academic grants, government funds, industrial partnerships, making sales, etc., and allow entrepreneurs to retain control of the company while providing much needed operating cash. A savvy entrepreneur will use these funds to conduct critical proof-of-concept work that can increase the company’s valuation, leading to reduced dilution in future financings. In upcoming posts I will more specifically outline potential sources of non-dilutive funds in North America and give examples of how companies, including my own, are primarily funded by such sources. I will also discuss the cons of these monies, which can include an increased effort to secure, constraints on the use of capital, reporting requirements, and others.
Exit options available. A less well appreciated aspect that financing has on your business is how it can dictate the exit options available to your company. For example, compare two founding teams, NewCo A that raises $1 million from investors and NewCo B that raises $10 million. For simplicity, assume that in both cases the companies have a $1 million pre-money valuation, and both sets of investors expect to receive a 10x return on their investment upon exit. As shown in the table below, the two investments create very different business requirements for these companies.
Whereas it may take a successful entrepreneur 3 – 4 years to build a $10 – 20 million company, it will likely take 7 – 12 years to build a company to a >$100 million valuation, and the probability of achieving such a level of success is lower. Considering that the founding team will receive the same absolute return upon exit (10 x $1 M = $10 M), the founders’ incentives for these two scenarios needs to be carefully considered. In addition, the methods of exit of the two companies are very different. For the smaller company, NewCo A the exit will likely be through an acquisition from either a large or medium sized company looking to expand their businesses or product line. The larger company, NewCo B, may exit through an initial public offering (IPO) on a public stock exchange or through a large acquisition by a large company. Based on the financing strategy chosen, the management team will need to align their skills and other elements of their business with these very different outcomes.
In summary. The capital requirements of your business will determine the amount of money that needs to be raised. Although simplistic, the financing scenarios I outline above start to demonstrate the impact that a financing strategy will have on your business. Alternative business models or the use of non-dilutive funding sources can help to reduce the amount of investor money required at the earliest stages of your company. In future posts I will describe alternative funding sources and the advantages and the costs associated with these monies.
Further reading. To have an understanding of how financing and dilution impact a business and its founding team, have a look at the resources put together by Venture Hacks (includes workable cap-table in spreadsheet format).
Basil Peters, an entrepreneur turned angel investor based in Vancouver and Silicon Valley, has written extensively about the impact financing has on exit strategy. I highly recommend both his book Early Exits and blog Angel Blog.
(For further opinions and insight into biotechnology, technology, financing, and innovation please see my blog at: www.persistentchange.com ; twitter: @jtbiotech)