The life sciences venture capital industry is undergoing rapid change. Although many innovative ideas have been taken from the bench to scientific discovery to treating patients, funding today to develop new products and services is getting more difficult to attain. Getting a product to market involves not only a long scientific process, but a carefully orchestrated financial process. This article attempts to explain how a typical VC fund operates and makes investment decisions.
Although many management teams readily approach us for possible funding, more than a handful are not knowledgeable about the inner workings of a venture capital firm, specifically the process by which we decide whom we will ultimately fund. I believe an understanding of the entire funding mechanism will better help entrepreneurs understand what to expect, the types of information the venture capital fund will request, and how long the process will take.
When a VC fund is formed, the general partners’ primary responsibility is to provide positive returns to its limited partners. The limited partners may range from family offices and wealthy individuals to the large investment arms of endowments, municipalities, cities, states, and universities. For example, the California Public Employees Retirement System (CALPERS) manages almost $250 billion of retirement savings. Major universities such as Harvard or Yale manage $20 billion or more of endowment assets. These institutions will allocate a certain percentage, typically 4 percent to 7 percent of their total assets, to alternative investments with funds generally having a ten-year term. The goal for these large institutions is to find fund managers that will outperform other, traditionally safer, asset classes (e.g. publicly traded equity stocks and bonds).
In an attempt to capture a higher return, limited partners understand that time frames to liquidity must be longer. In today’s environment, this poses an inherent conflict, as recent pressure to maintain the endowments’ value has reduced their willingness to hold an investment as long as they did in the past. At the same time, many investments made in life sciences companies, depending on the stage of development, have a much longer time frame to a liquidity event.
Once a fund has received commitments from its limited partners, the VC team begins looking for investment opportunities. The fund needs to determine how many investments it plans to make during the course of the fund, how to diversify those investments and what the expected returns should be. Some VCs attempt to take more risk in the hope of achieving a 5x to 10x return on their investment, while others take less risk and target a 2x to 3x return on investment.
There is a growing trend in the investing community to attempt to de-risk the investment in a company in order to resume capital from losses. Sources of deal flow come in a number of ways. Often a company will make cold calls to the VC community to seek any interest in their company. We may get a referral from other professionals in our network. Our own investment professionals also work proactively to identify opportunities in our certain focus areas (e.g., obesity or cancer) or when we see interesting data or intriguing journal articles. Lastly, placement agents, such as investment banking firms, are often hired by companies to access the private market. Generally, companies and management teams we know are more likely to get a full hearing at a typical VC fund.
To the extent time permits, we are very willing to meet and learn more about a prospective opportunity in a company. We do so by asking the company to provide us with a brief (two or three page) explanation of the investment opportunity, including
