In my previous post (see here) I developed a static financial model that incorporated all the necessary parameters to evaluate the potential investment return gain for entrepreneurs and VCs after a successful exit (through M&A).
The model incorporated what VCs usually ask from entrepreneurs: a percentage of the firm’s equity in the form of convertible preferred stock, liquidation preferences, control over the BoD and full rights of refusal.
However, after some thought and further readings I have refined the model. The assumptions are more accurate and realistic so that the model can be applicable in the real world.
The case is built as follows:
NewCo is a biotechnology company that with its own funds and Angel investors has succeeded in bringing a drug from research to phase I and is currently seeking VC funding to progress its lead drug candidate into late phases. On average an early-stage biotech company needs $70m in total (nominal value) throughout the clinical development period (6 to 9 years). Due to the huge amount of investment required, the company plans to receive three series of investments: Series A, Series B and Series C. The company has 10m of outstanding shares at the moment.
The assumptions of the model are the following:
- Series A investment of $5m with a 20% ownership of Newco’s equity shares and liquidation preferences requirement of x3
- Series Β investment of $10m with a 35% ownership of Newco’s equity shares. and liquidation preferences requirement of x2
- Series C investment of $55m with a 40% ownership of Newco’s equity shares. and liquidation preferences requirement of x1.5
- Exit strategy is M&A with an exit multiple of x6 (based on evaluatepharma data).
The initial assumptions and calculations are summarized in the table below:
Based on these calculations, the ownership structure at exit (without any rights of first refusal for series A and B investors) can be built: Shares to be issued in each series divided by the total number of shares post-series C (i.e. series A gets = 2.5m of outstanding shares / 32.0m shares post-series C = 7.8%):
In a successful exit scenario (M&A or IPO) a promising biotech firm can be acquired for x6 its total initial investment (i.e. $420m) in this case. Looking at these returns number, it might seem impossible for a pre-revenue firm to be valued at that level. However, if the firm has developed a highly innovative therapy that addresses an unmet medical need (especially in the orphan disease space) and has showed promissing phase II or phase III trial results, it is highly likely to attract big biotech / pharma for an M&A move. This is usually the case when a biotech firm has developed a fully-integrated technology platform enabling the potential acquirer to generate multiple drugs from the platform (i.e. not a one-off product company), which is where all the “future value” comes from. However, if the acquirer is a troubled, cash-cow, big pharma company that is unable to innovate and therefore looks for a short-term pipeline refill, the target company might very well be a single-product business. In short, this example demonstrates the value that can be generated from a very successful mid-stage biotech firm.
Below, is the M&A exit scenario (optimistic scenario as series A and B investors get diluted in each series) that calculates entrepreneurs’ return:
As you can see in a successful exit of the NewCo, an incredible amount of wealth is created for both VCs and entrepreneurs. But what happens if series A and B investors exercise rights of first refusal?
In that case entrepreneurs get 1/7th of what they would normally get without first refusal rights (which is the case in most VC deals).
There are a few assumptions made to develop the model:
1) Time value of money has been ignored for simplicity: This is a static model examining the relationship between the value and the early-stage investing at discrete time points (pre-money and post-money). The model does not take into account the changing risk profile of the company as it gets closer to the market.
2) All VC investments are assumed to be allocated for R&D, personnel and other operating or capital expenses. Any potential net income is assumed to be reinvested in the company.
The key takeaway from this analysis is that VC deals always dilute entrepreneurs and, in exchange, entrepreneurs can achieve a value-adding exit that can help them become wealthy and fund future start-up ideas. As they say in the VC world “its better having 5% of something than 100% of nothing”.
You can download the model here.