Current Funding Environment

As you are thinking about raising capital, it’s important to consider the funding climate you are entering.  2018 was a record year for venture capital financings into biotech, and a record number of institutional funds raised specifically for the life sciences. Figure 1 shows a 34.8% increase in financing values (compared to 2017) as 2018 reached over $13.3B. We are in a funding climate that is supportive of early stage biotech companies, which is a benefit to entrepreneurs.

With this context in mind, Locust Walk analyzed some of the key trends in venture capital term sheets (provided by our friends at Cooley LLP). The data demonstrates that in today’s venture capital funding environment, terms have been more favorable to founders than they had been in the past.   

Round Size and Valuation Step-Up 

Recently, venture-backed companies have been getting favorable financial terms when compared to the past—and at higher valuations.  

In particular, there are a few notable trends:

• As seen in Figure 2, there is an increasing proportion of deals with a pre-money valuation of >$100M—up to 25% for 2018. This mirrors the positive sentiment that the markets have shown biotech companies over the past few years, and we here at Locust Walk are keen to watch how this trend changes throughout 2019

• As seen in Figure 3, the proportion of companies raising capital at an up-round (raising money at a higher valuation than their previous funding round) is trending higher—83% of all deals in 2018 were at an up-round. We expect this to continue as over $6B of fresh funding for biopharma was raised in 2018 to supplement existing sources. Investors will likely have a desire to put new funds raised to work, creating a favorable funding environment for entrepreneurs. 

Key Deal Terms to Consider in your Term Sheet 

Getting to a term sheet is an accomplishment for entrepreneurs, but this is where experience and full knowledge of deal terms are critical to success. It’s important to consider the downstream consequences of the terms you agree to in your term sheet. 

In any financing, the terms will relate to one of two categories: economic value and company control. The balancing act between these terms is among the most difficult tasks facing entrepreneurs. 

> Economic Value Deal Terms to Consider

Economic value refers to the return that an investor receives on the money they invest in the company. One of the most important economic considerations is liquidation preference. The liquidation preference and the associated waterfall determines which investors are paid first and how much each party is paid in a liquidation event, such as a sale of the company. Investors utilize liquidation preference as downside protection in the event of a sale below the post-money of the financing round in which they invested by ensuring they are the first investors to be repaid, and as an upside to ensure they are first in line to claim their portion of the sale amount in a profitable liquidation event. 

Though there has not been significant movement on what is standard for liquidation preferences, occasionally less experienced management teams can agree to unfavorable terms if they do not understand the terms’ implications. As seen in Figure 4, a 1x liquidation preference has remained the industry standard in non-distressed situations, and entrepreneurs should resist any deviations. 

The most obvious other economic term to consider is your company’s pre-money valuation. A common point investors try to negotiate is a lower valuation to increase their ownership percentage of the company, which impacts their return on exit. As an entrepreneur, it is your job to generate demand in the financing market, thereby creating competitive tension and increasing the pre-money valuation to an amount that is more favorable to existing investors. 

> Company Control Deal Terms to Consider

While your economic windfall is certainly important in evaluating a term sheet, of equal or greater importance is your control (or lack thereof) of the company. It can be difficult for entrepreneurs to finance the company at a favorable valuation while retaining significant control over their venture. 

A key consideration we regularly grapple with at Locust Walk is how fundraising rounds will impact the company’s corporate governance, including board composition and voting requirements. 

Board composition is important to contemplate in the context of the present financing and future funding rounds. The best functioning Boards have 5-7 seats with odd numbers and a good mix between independents and investors. Too many is unwieldy, while too few is not enough diversity of opinion and expertise. 

Once funding is secured, the questions that often dominate our clients’ mind are: Have I brought together the proper investor mix to guide the company? Will my relationship with the new Board of Directors be strained? 

Concluding Remarks 

Generally, we are seeing a favorable climate for founders in the current financing environment, as there is substantial investor capital seeking to be deployed. Yet, there are many pitfalls and hurdles that founders will need to navigate successfully to protect themselves and maximize their value.

In a financing process, it is critical to get as many parties to the table to build competitive tension and get the best deal for the company. Locust Walk runs many of these capital raising processes in addition to buy-side and sell-side processes for biotech and medical device companies. If you are considering raising capital in the future, please contact one of our Deal Team Members to begin a dialogue as to how we might be helpful.

About the Authors:

Brian Coleman, Managing Director, Global Head of Financing and Sales at Locust Walk

Brian Weil, Analyst at Locust Walk