Due Diligence primer, part 2.
The PhD/Postdoc blog series features scientists at different stages of career development as they explore and plan for their next steps. Over the course of six months, Yeonwoo Lebovitz, Anthony Franchini, Megan Duffy, and Celia Fernandez will give monthly updates on their progress. Check back every Wednesday for new posts.
Current position: Postdoctoral Research Fellow studying Microbial Disease, Immunology, and Toxicology; Fellow at Kerafast, Lead Consultant @CBETHNK
Program start date: July 2014
Institution: University of Rochester
Continuing where we left off last time, this month I’ll forgo usual introduction and get right into the thick of it. I’ve been grinding out experiments, hounding local clients, and balancing childcare the past few weeks. Glad 2016 has closed out. Now where is my tax refund?! As promised last month, this post will cover intellectual property, market size, and deal terms. I’m going to push exit strategies off till next month, which is also my last. Seems far too fitting a topic to wrap my final post here at NIH BEST on.
Intellectual Property (IP): It should go without saying that prior to starting or investing in a company, who controls the intellectual property (provisional patents, trademarks, copyrights, etc) should be immediately clear. It is imperative that the company has control of the IP. By some accounts, its 80% or more of a start-up company’s value. At the earliest stages, a company is nothing more than an idea. If that idea isn’t wholly the territory of the company, things can become murky very quickly. Lawsuits, threatened or actualized, can snuff out the life of a startup in a moment. And there is a real reason for that. If a company cannot devote all of its resources towards developing, perfecting, and marketing its product, it will fail. Investors, by nature, are prepared to take on some risk. There are many reasons a company will fail that we don’t need to harp on here. Investors want to know where a new company will find its niche in their specific field. Knowing that a company holds some innovative, protected advantage through their IP is what makes the risk of investment worthwhile. That said, being granted a patent takes a long time and can be quite costly to maintain. Just go ask your Universities tech transfer office.
Of course, this isn’t just a quick box that can be checked off. Because of timelines, most companies are developing their technology with patents pending. So the methodical investor wants to know when the company filed for its patent. Does their patent cover their current business strategy? I would be highly skeptical of a new spinoff working with patents that are repurposing IP covering cancer treatments for RA. The company would be unprotected from some other entity swooping in and scoping up their idea. Any researcher can understand the fear of being scooped. Happens all the time. You wouldn’t bet $10K on that not happening with giants like Pfizer, Roche, GSK around…would you?
Another important concern when looking to invest is whether or not the company has freedom of operation (FTO). This is usually part of the pre-patent application process, wherein a legal team will make sure there is no clear infringement of other patents going on. The details of the manufacturing process, step by step, could be patented by someone else. This could be how cells/seeds are cultured/grown, plasmids used to stably transfect, or that someone in that country has already beaten you to the finish line! Going down that route would open the company up to having to share its revenue with someone else! Suddenly the pie is a lot smaller and no one is happy about it. Our take: Investing in a company sans IP is very risky, and it would take an extraordinary circumstance for me to feel comfortable recommending investment. Best hold off and give the company time to sort it out.
Market size: The product being produced could be the magic cure for a disease. However, that disease first has to exist and have a customer base that can be treated with said product. If you’re a software company specializing in healthcare, Hospitals need to be using the operating system you are coding on (hint: stay away from linux!). Don’t write an app for Windows phones. Write them for Andriod and iOS (duh). Development of a monoclonal Ab that treats a rare glioma is a perfectly valid pursuit. But If the tumor only occurs 1:1,000,000 people, there just isn’t a good way to recoup the cost of development.
Most of the business plans I’ve had privy of reviewing have an internal estimate of market size in them. From my experience, there are two courses of action here: 1) make the assumption that the company has done some major lifting to study this or is working with very recent and reliable reports or 2) fact check the heck out of them. The latter obviously takes time and money, which might not be available. Like I mentioned in my resources post a few months back, there is a whole parallel industry that exists to cover this need. What really matters is how much of this market does the company believe will be its initial, addressable market. Will it be local (a few counties around a major city)? Or are they projecting a worldwide takeover in five years? That’s basically impossible in the life sciences world if you are pre-clinical. Clinical trials alone will take 5-10 years without accounting for any pre-clinical work or setbacks.
The second big concern when examining the market for a new product is its cost. Not only does there need to be enough volume in the market, those customers need to be willing to pay for it at the price that is reasonable for the company or individual consumer. Whether or not the price is reasonable comes directly from talking to current and potential customers. If they, even in a relatively small sample size, find that the value of the products price is worth it, no need to raise a red flag. However, making major claims about a product’s unreached potential and charging for it up front is a usually a bad idea. Our take: The optimal scenario would entail a market with no competition, a growing clientele (or patient population), the invention is leaps and bounds beyond anything currently on the market, a high unit price, and the company has a five year head start. A rarity, of course. Even one of these optimal conditions could set up a company very well for acquisition or a profitable exit.
Deal Terms: A lot goes into agreeing to invest in a company. But reality sets in when there is a contract in front of you and you officially become an investor. Keep in mind that not all money is created equal. How the shares are divided and what that means for their price is important. First, you have to ask if this is the right time for you to be getting in. Are you helping them hit a major milestone? Is your investment fund/group expected to lead? You could be the first domino to fall or further down the cascade. Being first to commit might also come with more responsibility. Do you believe in this company enough to go to bat for them with your peers? Or are you only willing to follow if so and so gets on board?
How soon are the next rounds being planned? I recently worked on a due diligence where the company was planning on having their series A, B, and C rounds in 2016, 2017, and 2018 respectively. We pushed them on the proximity of these rounds and were worried they just wanted to collect investment to push up the company’s value. Even more concerning was when they were behind in reaching these goals. To me, that reflects on the CEO’s effectiveness as well as the overall market and was a red flag. Not enough to scuttle investment, mind you.
Because this isn’t a donation, another important piece to consider is what the investor is getting in return. Are you being offered top tier, class A stock equal to what the CEO and board members are? Or is it Class B common stock, effectively worth 1/10th that? Is the company offering an antidilution measures to protect your early investment? The latter could suggest the board wants passive investors who can’t strongly push back if as a group they feel the company isn’t headed in the right direction. Class B stocks are also paid out upon liquidation AFTER Class A stock. Therefore, only remaining monies are split with common stock. Meaning? There is a distinct possibility you gain little or nothing at all from a subpar sale price!
Whether or not the deal has protections in place for early investors to maintain their stake in the company must also be considered. These antidilution protections allow for early investors to reinvest during later rounds of funding, usually at a discounted rate. This is the reward for believing in them early on. If you’d like more in depth, business jargon laden detail about these measures, this lecture from Joe Hadzima at MIT is worth your time. So overall, one has to look at all the terms and deem them reasonable or not. I see this as a binary decision after all the other due diligence is done. Unfavorable or unprotected terms work for the passive investor, but as someone who cares greatly about reducing risk of failure in everything he sets out to do, it is not a strategy I recommend. Our take: While some investors may be OK sitting in the second tier, I’m not comfortable with that. Deal terms are always negotiable!
See you next month for when we talk about exit strategies and say goodbye!