Deal terms catch up with biotech

Risk-wary investors seeking aggressive deals in medical and science
sector

Venture money has been flowing more generously into medical and science
deals than to other fields for a few quarters now.

But it looks like deal terms – the devilish details in the fine print – are catching up in
brashness to those seen in other tech sectors.

By Beth Healy, Boston Globe Columnist

Perhaps the most common feature showing up in biotech financings lately is the
”milestone.”

For example, instead of pledging $10 million to a round, venture firms now might
offer $2 million up front and make the rest of the money contingent upon reaching
certain goals. The goals could range from hiring a chief financial officer to further
proof of a scientific concept or, in the case of a drug maker, getting a product into
clinical trials.

Milestones were used in the early 1990s, says William Kelly, a partner at the law
firm of Nixon Peabody in Boston. But in the venture fever of the late 1990s, they
vanished.

”A milestone would have ended the conversation in 1999,” Kelly says.

Terms are toughest these days in second and third rounds, lawyers and VCs say.
Conservative investors are even trying to slide milestones, or so-called ”staged
investing,” into first-round agreements. It’s all about risk and the state of the market.
When investors are feeling risk-averse, they look for ways to feel safer, and to be
paid for the risk they feel they’re taking on. They also want to keep the entrepreneurs
on pace with their stated plan.

From the venture perspective, think of it as deciding, at an unemotional moment,
when it’s smart to fold the cards on a concept. In the public markets, some of the
best investors have triggers that alert them when they should sell a stock – even if
they’ve held it forever and love it – because it’s too expensive relative to other
opportunities.

The more cynical interpretation: VCs are simply looking around and seeing what the
market will bear, and they’re demanding it. At a time of low returns, they’re trying to
squeeze every last buck out of the deals they do.

”You see something that another guy’s getting, and you ask for it,” Kelly says. ”If
you can get the terms, you get them.”

Aggressive terms are showing up in bridge financing, too. In these transactions,
venture firms are extending cash to a start-up before an entire round has been
closed, in the form of an interest-paying loan that converts to stock.

Under a bridge deal, a venture firm might offer $7 million, at an interest rate of 7
percent. Once the full round is raised, the firm’s loan and accrued interest would
convert to an equity stake in the round. There are often warrants attached to these
vehicles as well. When the balance of power was with the entrepreneur, the warrant
piece might have meant the VC could buy 10 percent to 15 percent more shares in
the start-up at the price established in the round. Now VCs can demand up to 50
percent warrant coverage – meaning an option to buy 3.5 million shares instead of
700,000 (at the old 10 percent rate).

”The equity dilution to management and the stockholders is much more significant”
under such arrangements, Kelly says. Desperation in bridge negotiations is
widespread in technology deals, he says, as companies are scrambling to raise later
rounds in a tough market. And the terms are now creeping into the biotech world.

Brian Keeler, a partner at Bingham Dana law firm in Boston who has a venture
practice, said he’s seen bridge loans with interest rates as high as 10 percent or 12
percent.

More onerous than recent bridge terms, he says, are the deals surfacing with huge
”participating preferred” demands, which guarantee the VC firm a certain return
beyond their obvious stake in a sale or liquidation of a start-up.

These are most common in tech deals, he says. The greediest one he’s seen was a
”6x” participating preferred proposal. Under that deal, if the VC invested $5 million,
he’d get $30 million back, hypothetically, in a sale of the company, on top of his
expected stake. So if the company sold for $30 million or less, there’d be nothing
leftover for management, employees, or other stakeholders.

”I though 6x was bad until I talked to an investment banker,” Keeler said. ”He said
he’d just done a 10x.”

Oink. Venture capitalists will tell you in polite company that they think it’s bad
business to grab all the dough for themselves and leave no incentives on the table for
the entrepreneurs running the company. Privately, it’s clear they’re hustling to send
some dollars back to the investors in their funds, who are worriedly looking at the
worst venture returns ever over the past year.

”Investors have always had a whole lot of tricks in their bag, and they’re taking out
more,” Kelly says.

Biotech investors probably won’t get as demanding as the tech investors, Kelly
predicts. Milestones have been broken before, and other leeway given, simply
because it’s tougher to pull the plug on a possible cancer cure than to shut down a
networking or Internet company.

”Terms in bio will always be a little bit different,” Kelly says. Experienced venture
capitalists regard the sector as a long-term play.

And, he notes: ”You’ve got men and women who are intrigued by the science.”

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