As part of a series in which we ask leading venture capitalists to answer a question of fundamental importance to entrepreneurs, Apple Tree Partners entrepreneur-in-residence Raj Mehta explains how much equity a start-up should give away in a Series A fundraising.
Forward: features are independent pieces written for Mewburn Ellis discussing and celebrating the best of innovation and exploration from the scientific and entrepreneurial worlds.
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Raj Mehta is a VC experienced on both sides of the deal. He spent three years as entrepreneur-in-residence at Apple Tree Partners, an investor in life sciences with $2.65bn in committed capital. Mehta is also a serial founder of fast growth companies. At GammaDelta Therapeutics he led a $100m fundraisers, and prior to that he founded Revitope Oncology and Blink Therapeutics during 18 years at Cancer Research Technology in multiple roles. He is now CEO of Adendra Therapeutics, which is focused on next-generation immunotherapies for cancer and other illnesses. He earned a Natural Sciences degree from the University of Cambridge and completed his doctoral research at the National Institute for Medical Research, now part of the Francis Crick Institute. |
This is a great question, and the truth is the amount of equity to offer an investor is an art. There is no magic formula. All you can do is set goalposts in a number of areas, with minimum and maximum values, which will get you to the right numbers.
One reason there is no exact answer is that not all money is the same. When exchanging equity for investment, it is important not only to assess the monetary value of that stake, but what the investor brings to the deal. If family and friends invest for an equity stake, then they may only bring a cash sum to the deal. However, a VC can bring a contacts book and a wealth of experience that the founder can turn to. If I were raising money, I would swallow a lower valuation to go with a VC that can add value.
Now let us look at the way companies are assessed by VCs. VCs look at three things: the risk, the potential return and the time-frame.
Risk varies by industry. Life sciences are inherently risky. Very few new drugs make it to market. The tech industry, by contrast, is more predictable. There is no real question over whether an app or new service will work, only whether customers will pay for it. The risk profiles of the deals in the two industries are therefore very different.
Returns also vary. Life sciences are high risk, high return. A licenced drug can generate millions or billions. Furthermore, a life sciences company may have more than one drug in the pipeline, so investors are buying into those too. Technology companies are lower risk, but the returns are usually commensurately lower as well.
Finally, there is time. VCs have a fixed time-window to make their money back. If a company can realistically be cash positive and do an IPO within three years, the deal is more attractive than if the time-frame is ten years.
These three factors are all qualitative. You cannot calculate numbers for them mechanically. It is also true that beauty is in the eye of the beholder. Some VCs may prefer a certain sector, or companies at a point in their cycle, and that will affect the valuation. Industry conditions matter too. In life sciences right now, we are seeing VCs conserve their cash for existing investments. It is a difficult time for founders and hence will influence valuations.
However, there are ways to arrive at numbers for a deal. Benchmarking is invaluable. Companies’ in-house data can be used for this or an expert hired to do the work. In addition, founders can talk to other founders about their experiences.
Founders must also think about their growth strategy. I recommend raising as little as possible in Series A, so the founder can retain a higher equity share. Dilution is not bad per se, as the capital raised will make the overall pie bigger. However, raising too much in a Series A can be costly for the founder, because the deal will be deemed riskier by VCs, who consequently would want compensation for their increased exposure. My advice to founders is to do a Series A, de-risk, and then raise more in Series B and C. This will allow the founder to retain more equity by the end of the process.
Founders also need to think about deal structure. There are issues such as liquidation preferences, controls and milestones to consider. When a company issues a press release claiming to have raised $150m, it is often an illusion. The company probably only received $5m initially, with the rest only released on condition of hitting milestones.
If this sounds complex, then I respond by saying – it is. There are supposedly ‘hard-wired’ methods of arriving at numbers for a startup deal using spreadsheets and metrics, such as risk adjusted-net present value. I tend to disregard such approaches for early-stage life sciences startups.
My final tip is to always hire a specialist lawyer when fundraising. They are expensive, but they are worth far, far more than their hourly fees.
Finally, remember that VCs want deals to succeed. They want founders to be happy during those difficult early years. Reputation is important to VCs. I am very sensitive about the reputation of myself and Apple Tree Partners. The idea that VCs are the big bad wolf is largely misplaced. They care about how they are seen in their sector by entrepreneurs. VCs are trying to create a deal that works for all parties.
Strong and effective relationships with VCs
Nick Sutcliffe, Partner, Patent Attorney and Litigator at Mewburn Ellis comments:
Raising money is a huge challenge for the founders of biotech companies and relies on strong and effective relationships with VCs. A robust IP portfolio that is ready for due diligence by VCs makes an important contribution to the value of any biotech company, helping to sway investment decisions and leading to successful funding rounds.
