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Denmark: A Biotech Venture Investment Arena

Thomas Tscherning & Jesper Zeuthen, BankInvest Bio Venture


Reprint Permission from Aspatore Inc., All Rights Reserved

Although the venture capital industry is not as mature as it is in the US, and biotech venture investing is even younger, it is impressive that the Danish capital market has sustained three big pharma companies (Novo Nordisk, Lundbeck and LEO Pharma) and four biotech companies (Neurosearch, Pharmexa, Bavarian Nordic and Genmab) on the Copenhagen Stock exchange alone. A number of biotech venture investors in the Copenhagen-Lund area (know as "Medicon Valley") has emerged in the last four years, which gives the biotech venture investor an increased belief in the industry as a solid investment vehicle.

Good venture capital investment must maintain a high industry standard to sustain long-term development. This is especially important in the biotech field. Companies in this industry typically have a product development cycle of twelve to fifteen years from the time an idea concerning a disease target molecule is conceived until an approved product hits the market. Guidelines on the investment process, published by the European Private Equity and Venture Capital Association (www.evca.com), are very helpful to assure investors in venture funds of high standards and also to reinforce to the portfolio companies the need for compliance in reporting and corporate governance. Since ethics stand very high on investors' radar-screen for investments, transparency and consistency of behavior are major hot-buttons for Danish investors.

One major difference between the US and Denmark/Scandinavia is the shareholder view on all concerned stakeholders, i.e. the investors, the management, the employees and the surrounding society, that some in the US might find almost socialistic in nature. A couple of years ago, the corporate governance guidelines for biotech companies were strengthened, which made transparency and eradication of potential conflicts of interest a focus. The pendulum is now to some degree turning back toward a more investor-focused venture market.

Major Danish Venture Investors

The major players in Denmark (and Scandinavia as a whole) are the pension funds, which either have their own specialized departments to analyze venture projects, or outsource this task to specialized fund managers like BankInvest. Since health care is an old industry of Medicon Valley, and especially for Denmark, numerous corporate venture funds exist, although they usually only analyze internally derived projects from their own big pharma companies. As in most venture circles, the players almost always want to participate as a syndicate with at least three major experienced players. This is not only for the security of uncovering different aspects during the due diligence process, but also to be fairly secure of the follow-on investment needed for the financing of the long-run drug development.

In Denmark, both corporate venture and pension funds exist, although pension funds have the most say concerning capital allocated to private equity/venture investments. Due to the high tax rate in Denmark and to some degree, the complicated way of receiving cash back on an earlier investment without paying very high taxes, the role played by high-net individuals is limited. Some governmental grants, loans and equity investments exist, but it is fairly limited.

Finding and Assessing Companies for Investment

There are very few barriers of contact between venture capitalists and entrepreneurs in Denmark. Usually, the phone numbers and email addresses of the venture capitalists are public and freely available, and many companies approach the decision-makers directly.

As in all industries, anyone with a track record of exits will be preferred over less experienced people. If a person can show that he has built a biotech company and exited with a nice historical return for the co-investors, his value to future venture investors is immense, and he is likely to receive capital. However, since most entrepreneurs are first timers, this is usually not the case. In those situations, investors look for entrepreneurs who have clarity in presenting the investment case - meaning that the entrepreneur has put a lot of careful thought into every possible scenario over the next couple of years and has determined steps to prevent failure.

At BankInvest Biomedical Venture, we are looking for three things:

  • First is clarity of plans. What are their goals? What might prevent them from reaching their goals? What steps are taken to alleviate those risks?
  • Second is focused management. Can they attract co-investors? Are they cash-focused? Have they made a six-year cash liquidity plan including expected valuations of the company tied to significant (corporate, scientific) milestones?
  • Last is the technology platform, which generates numerous potential products. What, exactly, is the product to be sold, and why would anyone pay a premium to buy this product?

Evaluating Risk

Our risk evaluation and decision process is very thorough via six groups/institutions in the BankInvest Group:

  • The Asset Management Team, which is committed to portfolio management
  • The Expert Consultant Network, comprised of 25+ heads of clinical departments. This group evaluates unmet medical need and feasibility of the products, i.e. focus on the needed phase I (toxicity), phase II (administration of drug, practical feasibility), and phase III (effectiveness against the disease)
  • The Advisory Board, which evaluates the long-term product strategy of the enterprise
  • The Controlling Unit, which evaluates any conflicts of interest
  • The Venture Fund Board of Directors, which evaluates overall corporate governance issues
  • The Transaction Department, which is responsible for optimizing the transaction itself concerning the transfer of proceeds, etc.

Risk is always weighted against the potential of a return. Therefore, performing a SWOT assessment (internal strengths and weaknesses, external opportunities and threats) as a means of visualizing both the upside and downside is crucial. BankInvest Biomedical Venture has other instruments to evaluate the risk vis-a-vis the potential upside, such as the example on the next page:

Graphic3

This results in a risk/return matrix, where different projects are evaluated, giving the investor the possibility to choose:

  • An absolute risk-level, above which he does not want to go (the vertical line in the graph below)
  • The best projects on a risk/return line (the dashed line in the graph below)

As depicted in the graph below, three projects are evaluated:

Graphic4
Graphic5

Since the Project B (black circle) is above the risk-level preferred (80 percent evaluated risk above the 70 percent chosen risk-level), Project B is rejected. And since Project A (the grey circle) is above the mean risk/return frontier (the dashed line), it is chosen above Project C (white circle), since Project C has a higher risk compared to return, although Project C demands less capital invested (the size of the circle in the graph) than Project A.

Valuing a Company

We have three levels of valuing a company, which we also use each quarter to evaluate existing investments. The first level is what we call ƒ?ogut feelingƒ? -- a pure, almost subjective opinion about what valuation is appropriate for a company. Usually, this valuation is based on single data points, such as significant difference in treatment groups in animal experiments, the capability of the CEO, patents, etc.

The second level is based on comparables. We look at companies in the same field who have a similar level of development and who are either quoted on stock exchanges or have been sold to larger companies, and are thereby valued.

The third valuation level is probability-weighted discounted cash flow (pwDCF). This is a method of valuing future cash flows and discounting them back to the present value. We have implemented this method for the companies that have products in clinical trials because of their increased chance of success compared to earlier stage products. In each pwDCF the following parameters are estimated and timed over the lifetime of the products:

  • Overhead administration expense
  • General R&D expense

On each development project:

  • patients in indication
  • % eligible patients
  • market growth (including peak sales)
  • penetration of market (timing & size)
  • probability of success (discovery => preclinical => IND =>Phase I => Phase II => Phase III => NDA approval) for each project under development
  • Upfront payment (timing & size)
  • Milestone (timing & size)
  • Royalty (timing & size)
  • Discount rate (risk-free rate + liquidity premium (e.g. 7%) + financing need premium (e.g. 5%))
  • S,G & A costs
  • CAPEX on investment in manufacturing etc.

Term Sheets

Denmark has the same standards of clauses in terms sheets as venture investors in other countries. Here is the basic format:

The Offering

  • Amount
  • Use of proceeds
  • Pre-money valuation of the enterprise
  • Pre- and post-money ownership of current and new owners
  • Warrants outstanding and newly established, terms for exercise (strike price, period, milestones)
  • Milestones connected to warrants

Preferences of Share Classes

  • Redemption rights
  • Dividend rights
  • Liquidation preference
  • Conversion
  • Anti-dilution
  • Voting rights
  • Lock-up period
  • Drag-along of other share classes on a sale
  • Piggy-back on registration on an exchange
  • Tag-along on a sale
  • Pre-emptive right to new offering
  • Play or pay: invest or be diluted
  • Transferability of shares
  • Termination of rights

Corporate Governance

  • Protective provisions (what can the board decide on its own, what should each share class be able to veto)
  • Membership of board of directors
  • Board of Directors insurance

Information Rights

  • Annual, quarterly and monthly reports
  • Budgets
  • Board of directors meeting agenda and minutes

Due Diligence

  • Amount to be used
  • Who will perform the task
  • What special issues will be evaluated
  • Warranties and presentations to be made
  • Indemnification of investor and directors

Investment Round Clauses

  • Termination rights (who, when, fees)
  • Settlement of conflicts
  • Exclusivity between signing of term sheet and signing of final legal papers
  • Closing timelines & expiration deadline
  • Who writes the final legal papers

If there are any differences between term sheets in Denmark and the US, it might be the method of bridging disagreements over pre-money value. At BankInvest Biomedical Venture, we have constructed a method of increasing the ownership by founders/management if they reach certain corporate and scientific milestones set at the time of investment. If these milestones are reached, the "value" of the company for the founders will be at the size as promised before the milestones are reached. Instead of talking about valuations to comparables, this approach gives each party the incentive to discuss technology, progress and strategy to achieve valuable goals.

Important areas to watch are:

  • Corporate governance. How easy is it for new investors to take control and direct the company in new strategic directions? New investors want to see this easily done, so flexibility is a valuable option.
  • Exchange of board of directors. How to incentivize board of non-executive directors to drive the company in line with the investor intention? Can they easily be exchanged for other more valuable board members in the next stage of development of the unit?
  • Liquidation preference. Who receives a return on a liquidation versus a positive exit in preference over others?

Timelines

A typical timeline for an investment is between one and five years, with an exit expected within three to seven years from the beginning of ownership. It is important from the start to clarify exit scenarios with management, former owners and current investors to make the corporate restructuring over the years as easy as possible.

Return on investment is guided both on a multiple and an expected internal rate of return over the lifetime of the single venture funds. It is important to consider earlier investors' interest before performing crossover investing, where fair market values are hard to validate.

Many factors shorten or extend the timeline of investing, restructuring and exiting in a single biotech portfolio company. One major factor to consider before investing in a biotech enterprise is the milestones to be achieved and how long it will take to achieve them. Can the company extend product development into clinical trials (at least phase II)? Does anything (e.g. toxic effects, low absorption, low effect) prevent an IND that will diminish the value of the company? You want to make sure the management and board of non-executive directors have a clear strategy of reaching these milestones and that the milestones that have been set are valuable in the eyes of either the next venture investor, the public (via an IPO) or a potential big pharma acquirer.

Advice for Entrepreneurs

Every investor has three questions on his mind: How much must I invest?; When can I get it back?; and What is the risk of not getting it back? Address the latter two questions by visualizing the exit for the investor, be it an IPO or trade sale. How are you going to change each dollar invested into two dollars of return? Always establish value (i.e. risk/return profile) for the investor before establishing price (i.e. pre-money valuation & investment needed before realizing return). Only as a second step does the entrepreneur focus on the technology features under development.

Make the financing round an auction. Even though it is hard to construct, try to find several bidders. Do not rely on only one investor making his due diligence and investment decision: It means dragging the investment round on and the valuation of the enterprise slowly declining. Make sure that the different investors do not talk to each other and build a syndicate with a low bid on valuation and terms.

Find the competitive benchmark. Look at other good projects and do what they did to raise capital from investors. Call the CEOs of biotech companies, talk to their employees and listen to the investors -- they are all good sources of information. And then perform better than the competition in the presentation.

Build rapport -- start with investor's likely concerns and show how you will address them. Venture investors are looking for excuses not to invest in a biotech venture project. They have a list of risk and uncertainties in their mind for which they want sufficient answers. If the venture entrepreneur is able to show that he not only understands their worries, but also explains how he will handle them, the rapport will be much stronger. One way of doing this is via a flow chart of cause and effect. Some of the undesirable effects that venture investors want to avoid are:

  • Not enough capital backing for the full length of the venture project (i.e. before an exit)
  • Management is not capable of focusing the company
  • Resource allocation of time and capital is used on non-value-adding activities (e.g. deadlines are not established and subsequently not reached)
  • No competitive edge of product when finally on the market, which means the pricing will be low
  • Development risk of the product derived from the technology platform is higher than expected
  • No fall-back options if lead product fails
  • Fraud and negligence in accounting

Show that you are aware of all of the undesirable effects and that you can address them.

Write a genuine business plan. Do not circulate a generic version, because everybody else does this and you will not stand out in the crowd. Focus on your goals, how you plan to get there, what it will cost and the risks of not meeting your goals. Emphasize how you will minimize risk on each developmental step of the lead project instead of how you maximize the potential reward (the upside) for early development projects. This way you make sure the investor feels comfortable that he will get his money back via the lead project and still have some upside on the early pipeline. Nobody else does this so it could be your edge. Don't be afraid of describing the mission, vision and strategy in detail. In essence, it should give a recipe for what a total outsider should do if the primary plan of action fails to reach its target. Go straight to the subject and state the facts. Present the business case from the investor's point on view: How will he get a return on his investment?

The more feedback you get on the business plan from different angles, the better it can withstand questions from venture investors. Investors are constantly looking for reasons to say no, so get rid of the worst issues ahead of time by asking for feedback from colleagues, family, business relations, etc. Play out crisis scenarios, anticipating responses from the entrepreneur.

Time your approach to the venture capital market. Follow the dealmaking frequency and amounts in the quoted and non-quoted capital market, and go to the venture investor when the resistance to investing is the lowest. One favorable indication is when there has been a period of lackluster investments in private equity. Investors with capital can cherry-pick among low-cash-level biotech companies. Another favorable factor is when the valuations of private equity investments are increasing. The data can be found at www.venturesource.com and should be presented to the venture investor as the opportunity to invest at the ƒ?olowƒ? of the market. A third factor is when the index values of the quoted biotech market (e.g. the AMEX biotech index ^BTK at finance.yahoo.com) are rising, which means that the venture investor might receive more value (i.e. the raised capital received less ownership) for its assets when it pushes for an IPO. Once the timing is right, ask for more than you need -- at least twice the budgeted amount for the next three years.

The golden rules to venture investing in Denmark are as follows:

  • Relationship consistency, i.e. the entrepreneur "walks the talk"/delivers on promises (even so small).
  • Flexibility in negotiations between each party (i.e. the founders of the enterprise on the one side and the venture investor on the other side) to move position on proposals, e.g. by building a commonly acceptable milestone/warrant plan to bridge disagreements between return and risk.
  • The intention to talk about exits on internal values built on strict capital expenditure via milestones achieved (e.g. several animal models proof-of-principles).
  • Validation and documentation of results achieved
  • A clear scenario description of several fall-back options, should the primary lead project fail.
  • Products before science ("Science into life")
  • Corporate governance: transparency, prudent view on financial solvency (i.e. 3 months run-time are not good enough when having 20+ people on the payroll)

Trends

Health care and biotech have been the darlings of venture investors the last couple of years (especially compared to the IT investments), and we expect this to continue to be the case in the next three years. From the venture perspective, we think we'll see the deal capability of a single VC expand to include investing at all stages, from the early stage to the IPO. That demands large dedicated funds. In terms of specific deals, one big trend is milestone-driven compensation for management and a bigger emphasis on corporate governance. The term sheets offered during the last two years are also much tougher regarding liquidation preferences, and pay-to-play clauses are used extensively.

As the economy picks up, we will see a waterfall of companies floating on the large stock exchanges. There will be a few lucky ones, but many will experience congestion in the financing system, creating lowered performance for the current investors. New businesses will have to perform exceedingly well to drive the development of biotech products into clinical phase trials or onto the market and at the same time still have cash on hand. They will need to be very product-focused (i.e. have at least phase II clinical trial data to show from wholly owned compounds) and have capital contingencies for at least twelve months of run-time to secure the strength of negotiation.


About the Authors

Thomas Tscherning, Director

M.D. Thomas Tscherning received his degree in medicine from the University of Copenhagen in 1995 and was awarded a gold medal for his research work. From 1995 to 1998 Thomas Tscherning worked at various Danish hospital, has published several articles on immunology and been investigator on several clinical trials.

Professor Jesper Zeuthen, Managing Director

Professor D.Sc., Managing Director of BI Technology A/S with ultimate responsibility for all the BankInvest Group's pharmaceutical and biotechnology investments.

Jesper Zeuthen is an expert in cell biology, molecular biology and immunology and has to date published more than 200 research articles. From 1980-88, Professor Zeuthen was employed by Novo Nordisk A/S as Research Director, and from 1987-92 he was Adjunct Professor of biotechnology at the University of Copenhagen. In 1998 he was appointed Nordic Visiting Professor at the Karolinska Institute in Stockholm. From 1988-2000, Professor Zeuthen was head of department at the Institute of Cancer Biology of the Danish Cancer Society.

About Bio Venture

BankInvest Bio Venture aims to become the leading European biotech venture investor. We concentrate on investments in companies doing research into the treatment of human diseases. Due to our focus and selective investment strategy, we aim to achieve top tier return on our investments.

Our focus is on:

  • Biotechnology therapeutics
  • Pharmaceuticals
  • Technology platforms leading to products

Investment Strategy

Bio Venture builds partnerships with entrepreneurs by investing capital and providing top industry knowledge and experience to high growth life science technology companies with global potential.

Geographic focus

  • Primarily the Nordic region, northern Europe and the USA

Stage

  • Early expansion, close to Nordic markets, mid to late expansion, globally based

Investment size

  • EUR 1 m - 10 m.

Involvement

  • Active involvement - normally lead investor with board representation as Biomedical Venture's strategy is to become the preferred biotech investor alliance partner.

Time Horizon

  • 3-7 years

Exit

  • Trade sale or IPO

Investment Criteria

  • An innovative business concept with technological and competitive edge over current knowledge
  • A strong technology platform with one or more product candidates in development
  • Clearly defined medical needs (patient population) and customer focus
  • Markets must be sufficiently large or there must be a significant niche potential
  • Proof-of-principle for scientific and clinical claims
  • Products and technologies must be safeguarded by a strong patent portfolio

The company must be able to:

  • Have a strong operational management team with experience from pharma industry
  • Offer proof-of-concept that its business model works
  • Show that it is able to attract potential strategic partners
  • Show that it has a realistic operational development plan ready for implementation
  • Show that the valuation is realistic considering risks and return of investments