Foundings Matter: Thiel’s Law Applied To Biotech

Posted June 11th, 2013 in Biotech financing, Biotech startup advice

Thiel’s law: A startup messed up at its foundation cannot be fixed.

Much like an organism, the “DNA” of a startup gets encoded at the outset – which genes or attributes will really matter going forward, and the possible deleterious (or advantageous) mutations that will impact the startup’s maturation down the road. Once in place, it’s very hard to change the genomic DNA of a startup.

I came across a reference to legendary venture investor Peter Thiel’s “law” recently and think it captures the essence of the DNA analogy we use so often in biotech: a startup with messed up DNA isn’t likely to survive.  It applies as much in the Life Sciences as in the tech sector from which Thiel’s observation originates.  There are at least six major ways of messing up a startup’s DNA at the outset, and I’ve reflected on them below.

Unreproducible science.  As a science-led investor, let me start with this obvious one.  The foundational science brought into a new biotech startup is obviously a critical component, and sadly one that often comes with liabilities – a lack of reproducibility and generalizability.  This topic has been discussed elsewhere (here), but remains a root cause of high loss ratios in early stage biotech.  Begley’s Six Rules for robust science are a good filter to ‘check’ the basis of foundational science.  Derisking this one during the founding period of a company is key.

“Incipient founder-itis”. Like the pseudo-medical term suggests, it’s a condition of an expanded, inflated, or inappropriate set of expectations around founder roles going forward at the inception of the company, and is a common inborn error at company creation. It can take many forms and etiologies: the overzealous scientific founder who tries to shape all the startup’s science from their academic post (e.g., avoids the killer experiments around his “baby”; never maturing team from R- to D- expertise); the grad student founder whose experience with drugs involves usage not biopharm R&D.  Other forms of founderitis can develop as a company matures, but incipient founderitis can mess things up at the outset.  Fundamentally, this condition involves a disconnect on experience and roles. Unlike the 20-something year old computer engineer tech entrepreneur, our C-level startup entrepreneurs tend to be veterans of the regulated biopharma R&D industry, and most have been hunting for drugs for years.  Furthermore, in most of our seed-led startups, we don’t put CEOs in place initially for most of them (we take on the acting roles) – these are science-driven startups and therefore the CSO tends to be the lead member of the management team.

Poor board governance.  Startups don’t need complicated Boards, and governance early on in the life of a company should be very fluid.  In fact, many startups don’t need traditional boards at all until much later in their existence.  My tech partner, Fred Destin, has said jokingly that tech startups need an “anti-board” – high touch sounding board for early stage product/market fit issues and iteration, not a 4-hour pro forma circus every 2-3 months.  I think the same principle applies to many early stage biotechs, especially during the seed “prove” phase of their existence: let carefully planned science and killer experiments demonstrate their value, attract a solid team and lean operational model, etc…  Very often founders think it’s a great idea to set up a Board of Directors with big names or high profile mentors before raising their first institutional round.  Sometimes this is helpful as a source of investor interest and referrals, but more often than not it creates issues down the road.  Reconstituting a Board during a Series A or B round isn’t easy, and asking someone to step off a Board can be painful.  Further, having too many Board members can lead to real strategic entropy: every Board member will have at least two opinions on the same subject, and opinions about others’ opinions, so with n Board members you’ve got 2n opinions to deal with.

Hydra-like founding syndicates.  Hydra’s are mythical creatures with multiple heads, all of which can spew lots of venom.  Without a clear lead or co-lead investor, syndicates can take on hydra-like qualities.  This can be painful for a team at any stage of the company, but in our experience having multiple relatively “equal” investors in place without a clear “lead” at the founding round of a company creates a real challenge.  Even if there are multiple co-leads, one should often be designated as the primary lead investor.  The clarity of this type of syndicate greatly benefits startup management teams; conversely, the lack of this clarity can damage them, as responding to the many heads of the hydra is typically an all-consuming task.  Its worth noting there is also the opposite effect at times in larger syndicates (though more common in tech party rounds than biotech) – where the beast has no head at all: big multi-investor rounds where no investor has a significant enough piece leads to no one paying attention.  To avoid these issues, we tend to help found and seed biotech companies where we are the only venture investor initially, or perhaps with a co-lead like-minded investor.

Cumbersome founding agreements.  Unlike many IT startups, most biotech companies begin with a negotiated licensing agreement (or option to one) from an academic institution or corporate partner.  The terms of this agreement are usually hammered through during the founding phase of the company.  Unfortunately, once the ink has dried on these agreements they are not easily changed.  The terms that “looked reasonable” at the outset can quickly become an albatross for a startup company: field definitions, diligence requirements, economics, governance and dispute resolution, patent prosecution, etc…  For assets spinning out of larger corporations, deal terms like buy-back rights, options, milestone triggers, and rights of first refusal or first negotiation need to be carefully crafted at this stage; unclear language can lead to endless alliance disputes. This is where good legal counsel is worth the steep hourly rate – scrub a license early so that its clear, doesn’t lead room for lots of future misunderstandings, and helps put the company on a strong foundational footing.  Nothing impairs a startup’s future trajectory like sub-optimized founding license.

Inappropriate capitalization.  Lastly, a critical component of any startup’s founding thesis is forecast for the capital required to the major value inflection (initial exit opportunity).  Too little funding and a company can get stuck without enough progress – an anorexic state that leads to a failure to test the hypothesis.  Too much funding and a company becomes bloated, loses focus, and creates a capitalization burden carried through its later rounds.  And at least in the past decade, the high burn capital intensity in the latter situation has greatly diminished returns in biotech.  Getting the funding trajectory right (with hand grenade accuracy) is key to success for all the founding stakeholders – the scientific founders, founding investors, and founding management teams.  Get it wrong, and the former two get washed out in later dilutive rounds, and the latter gets replaced.  Lastly, I’m a big fan of tranching around the derisking milestones – and firmly believe its good for all three types of founders listed above.  If the company can achieve great progress and exit without calling future funds, founder ownership will be higher.  If the company fails to deliver on the initial tranches, then a big recap typically isn’t required and investor founders haven’t lost their shirts.  If it the whole founding round went in, and science doesn’t play out well, then a large liquidation stack of investors sit on the top of a company’s founders – an unpleasant place to be.   My advice to startups is to focus on a Goldilocks financing: raise what you honestly think you’ll need to get through the key value inflection point – not more, not less.  If the VCs are pinching you for less without merit, then push back if you can – raising an initial financing that has a razor thin margin of error leads to bad outcomes when research plans hit reality.  But similarly, asking for four quarters of extra cash as a cushion after the expected inflection is just not going to fly in today’s founding financing rounds.  A separate founding capitalization challenge to consider is when to raise from angels vs institutional investors.  Many biotechs are increasingly turning to angels, and we’ve worked with a number of them in our seeds.  But often angels tap out at $10M or so in a given biotech, which leaves a company at an early stage, with an above market valuation, but without the deeper pockets required to get to the big inflection.  This is painful place to be for founders and companies – and the trajectory is often set at the outset.  Getting institutional engagement on pricing and funding alongside angels well worth considering.  For startups, setting a founding strategy around fundraising/capitalization that attempts to avoid the pitfalls above is likely to pay dividends later in life.

Starting new companies and in particular new biotechs is not easy.  It’s a high risk environment and many ideas won’t pan out.  But as Peter Thiel has said, the “beginnings of things are very important” – making sure the founding DNA isn’t messed up with mutations at the outset gives a startup its best shot at success.

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