This post was written by Michael Gladstone, Principal at Atlas Venture, as part of the From The Trenches feature of LifeSciVC.
Ex-Citigroup CEO Charles Prince famously said in July 2007, regarding Citi’s leveraged lending business, “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Unfortunately, Chuck was still dancing four months later when the music stopped and the financial world (including Citi) was imploding.
Is the music still playing in 2016 for our dancing unicorns, the private VC-backed companies with billion-dollar-plus valuations?
Tech VC Bill Gurley of Benchmark Capital published an excellent post last week about the dangers (to founders, management, employees, investors, and LPs) of the unicorn financing market. Here I’ll muse on Gurley’s mostly tech-centric observations and opine on their relevance to biotech and what might be done to avoid (or at least mitigate) recapitalization catastrophes.
Where have all the unicorns come from?
Gurley attributes massive unicorn proliferation to a years-long abundance of cheap capital. With tons of money chasing hot tech companies, valuations sky-rocketed. Gurley glibly summarizes the unicorn fundraising process: “Pick a new valuation well above your last one, put together a presentation deck, solicit offers, and watch the hundreds of million of dollars flow into your bank account. Twelve to eighteen months later, you hit the road and do it again — super simple.”
That sounds fun, exciting, and lucrative! So, what’s the problem?
Well, like any good party, eventually the cops show up, the music is turned off, and everyone has to go home – sometimes with a hell a hangover. If paper valuations for loss-making companies continue rising long enough, most of these companies eventually reach a point where neither liquidity nor attractive follow-on financings can be achieved, leading to massive write-downs or losses upon a recap, a punishing IPO, or an acquisition below cost for many shareholders.
Oh no! Why is this happening now?
As Gurley points out, a shortage of liquidity opportunities is leaving tech unicorns with paper valuations that late-stage private financiers are now less eager to cleanly finance. This can go sour fast, as many of these growth-hungry companies built out major infrastructure and serious burn while cash was easy to raise. This self-amplifying burn-and-raise cycle can lead these companies right into heavily punitive financings when cheap capital disappears but their spending doesn’t. Gurley thinks that turn in the late-stage tech private financing market is already happening, causing tech capital to become more expensive or “dirtier.”
“Dirty” financings? What does that mean?
As Gurley puts it: “’Dirty’ or structured term sheets are proposed investments where the majority of the economic gains for the investor come not from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document. This allows the Shark to meet the valuation “ask” of the entrepreneur and VC board member, all the while knowing that they will make excellent returns, even at exits that are far below the cover valuation.”
So, management/investors may accept financing that superficially maintains/optimizes their valuation (a partial list of reasons they’d do this is below), but actually get crushed by that deal. In fact, this is probably far worse for them than just taking a reasonable down-round (without ratchets, steep liquidation preferences, etc.) and getting back to building value with a focused business plan and a reasonable burn rate.
Making matters worse, even relatively “clean” late-stage rounds often include liquidation preferences that do become serious overhangs for founders, management, and early investors when up-rounds come to an end and liquidity is hard to find.
Why don’t those founders, employees, and prior investors see this mess coming and avoid it?
This is easier said than done. Gurley largely attributes this to 2 factors.
First, many unicorn founder/management teams have only operated and fundraised in a market where valuations and terms only get better with each raise. So a nasty mix of naïveté and ego can combine to put the company’s leadership into a strategic tailspin that sometimes is only exacerbated by its investors’ perverse incentives (see below).
Second, management and investors alike can feel psychological opposition to accepting a “down-round” of financing or an acquisition below the post-money of their last raise. The dual injuries of bruised egos and vaporized paper gains can be heavy deterrents, perhaps particularly for VCs currently trumpeting their returns while raising their next fund. So, explicitly or implicitly, they may feel pressure to kick the write-down can down the road, which usually only exacerbates the problem.
Why isn’t this happening (much/yet) to biotechs?
The VC-backed biotech ecosystem differs from that of our tech brethren in a few key ways, which may be insulating us somewhat (so far, and certainly not entirely) from the imploding unicorn phenomenon.
We just don’t have many unicorns to begin with, as few VC-backed biotechs have raised as much pre-IPO money as the tech unicorns, and precious few have achieved multibillion dollar valuations. Per VentureBeat as of January 2016, only 3 out of 229 unicorns were biotech therapeutics companies – and 1 of those was acquired last week for up to $10.2B. So biotech is a miniscule portion of the $1.3T in aggregate valuations and $175B in funding locked up in those unicorns. As such, most biotechs don’t have nearly as much layered preferred stock “overhang” complicating governance and standing in front of founders’/employees’ common stock when it’s time to get paid. And, by the same token, the total amount of aggregate VC investment at risk for cram-downs is much smaller than the trillion-plus dollars of paper value tied up in tech unicorns.
As somewhat of a corollary to the point above, promising private biotechs have, for years now, faced multiple attractive liquidity options. We saw record-breaking IPO counts in 2013-15, many at great valuations and with excellent after-market performance. And at the same time, Big Pharma/Biotech have continued to be voracious buyers/partners of promising therapeutics. Thus, great biotech companies (and their investors) have had numerous lucrative “exit opportunities” to crystallize gains (via M&A or shares sold after an IPO) or at least render share price sensitive to semi-efficient public markets (when shares are retained post-IPO).
But could painful recaps happen to biotech companies?
Oh God. Why?
There certainly are private biotechs that have raised too much money, grown/spent too fast, or carry inflated paper valuations.
Some of these will “grow into” their paper valuations, using their cash to fund effective drug development and enable an attractive subsequent financing or acquisition. But others who run into setbacks or spread themselves too thin will face a reckoning if IPO headwinds and decreasing appetites for late-stage private rounds continue to challenge a >3-year long cycle of fairly consistent venture up-rounds, IPOs, and public biotech index outperformance.
Already, 2016 has seen a substantial correction in the public biotech indices and a slowing (though still great, by historic standards) appetite for IPOs. So far, the world isn’t blowing up for private biotechs, as these companies used the boom period to pad their balance sheets, but it will be interesting to see what happens as they near the end of their cash reserves and need to evaluate BD and fundraising options with less tenable paper valuations.
I don’t have a crystal ball and maybe I’m too optimistic, but I actually have a fairly non-apocalyptic outlook. I believe Big Biopharma’s appetite for partnering with and acquiring biotechs will continue to partially buffer financing headwinds, though there are certainly some Series B/C/D rounds that will get major haircuts.
But I thought this time was different? How can we avoid this?
It’s a challenging (and highly risky) proposition to try to “time the market.” By this I mean pouring in capital and prematurely cranking up spending with an assumption (or at least a hope!) that the capital market music will still be playing when you next need capital or liquidity. A bearish turn in the late-stage private or public financing markets can leave you running out of cash with a bloated valuation and a lot of unhappy employees and investors.
The solution? Unfortunately it’s the same boring-but-effective solution it’s always been, the one so many people always want to find a sexy alternative to. Fund great teams to develop innovative therapies with milestone-gated investment, continually improving your cost-of-capital as capital intensity increases.
Capital efficiency doesn’t have to mean small-ball or drip-feeding. It just means tranching $10M (rather than $50M) when the next inflection point is $10M away. And it means making sure that if your company’s next round’s post-money is $100M, you are extremely confident that someone will be eager to fund or buy it for significantly more than $100M before your current cash runs out, even if the music isn’t playing as loudly as it was in the go-go days of 2013-15.
As Brother William says in Umberto Eco’s The Name of the Rose, “A Venetian traveler went to very distant lands … and he saw unicorns. But he found them rough and clumsy, and very ugly and black. I believe he saw a real animal with one horn on its brow.” Indeed, with illiquid private companies, the unicorn is only in the eye of the beholder. When sentiment shifts, some unicorns may turn out to be wounded goats.