In Good Times and In Bad
2018–03–12
A friend at Harvard Business School recently told me about a project he has taken on, analyzing the current startup financing environment. Times are good, and he is interested in the following question: In an ecosystem with so much available risk capital, will all good ideas find funding? It’s not entirely clear what “good” means in this context, but I wanted to attempt to analyze this question through a biotech-centric lens.
Bigger funds means bigger deals not more deals
A rising tide lifts all boats. Public markets continue a record-setting bull run, the IPO merry-go-round is whirling away (in biotech anyways), and fortunes are being made in both tech and life sciences. In this environment, venture capitalists, crossovers, fund-of-funds, etc are finding themselves able to raise outsized funds. Compensation structure for most folks managing these funds is such that they are incentivized to quickly deploy capital under management so they can raise another fund before the good times inevitably come to an end.
Core investment theses have not significantly changed, nor has the number of general partners making key investment decisions for these funds. As funds get larger, first financings have grown more than 2x since 2014 in order to deploy all this capital. It’s simply not feasible for a venture firm to manage a portfolio with twice as many companies (without cutting in a ton of partners), but they can do deals that are twice as large. Further highlighted here and here.
These larger early financings seem to typically be on the order of $30+ million for a Series A. These kinds of numbers will help investors to deploy new outsized funds, but do large early rounds really help companies to develop their platforms faster and to derisk lead assets? I believe that these financings will lead to the same kind of waste endemic to overcapitalized West Coast tech startups. I bet we see early-stage biotech companies with Michelin-starred chefs, on-site massages, and all the rest of the trappings of a Dropbox over the next several years. Executive compensation figures at these early-stage companies will likely correlate with the size of the Series A financing, but will odds of company success?
A lemming with money is still a lemming
A large percentage of investors appear to chase the same handful of technologies at the same time, often those typified by recent large high profile exits. Life sciences companies focused (even tangentially) on immuno-oncology, CRISPR, gene therapy, and the microbiome are significantly more likely to find investment interest and, correspondingly, outsized valuations.* In tech, it’s anything with blockchain, artificial intelligence (AI), or machine learning in the company tagline. Things have gotten so ludicrous that I have seen a number of biotech startups describing their technology as artificial intelligence or machine learning plays, or, in at least one example, blockchain for genomic information. Recently, I had an experienced antibiotic developer ask me if we had considered applying our antibiotic discovery platform to immuno-oncology; he did not suggest this because it would be a good fit for the technology, but simply because it would reduce the burdensome process of raising working capital. *I wish I had better data here, someone help me out
Investors compete for companies in the trendy areas, propping up valuations and deal sizes, while viable innovative ventures in less fashionable areas struggle to keep the lights on. In the current life sciences ecosystem these are the medical device, diagnostics, drug delivery, vaccine, and antibiotics companies. Although, putting “machine learning” in front of an old technology can apparently get you a huge series A from a newcomer to the ecosystem…
Human capital as a key constraint?
I have seen “human capital” highlighted as the constraint that keeps the number of funded companies constant, even as the amount of available risk capital balloons. Experienced high-caliber startup management teams are investing their time and specialized skillsets into building new companies and they can afford to be choosy. I fully agree that there is an extremely limited supply of these repeat-winner serial-successes in the world.
But…there is a never-ending supply of gray-haired former pharma middle-managers looking to try their hand at entrepreneurship. These (probably older, probably male) management teams may look and act the part. They may even be intimately familiar with specific development processes and navigating complex bureaucracies. But they are not company-builders. They may have less relevant experience than a 28-year-old chemist or engineer. Too many brilliant, high-energy, young founder/CxOs will struggle to find early working capital for their ventures even as incompetent “seasoned” management teams burn through tens of millions in venture investment. It’s important that venture capitalists work harder to identify, support, mentor, and invest in younger startup management talent.
Many high potential companies will fail to raise working capital
Investors are missing out on very good and likely undervalued companies. Many of these ventures have high-caliber founding teams and worthy technology that can be applied to real market needs. Too many will die on the vine, even when the ecosystem is flush with risk capital. Groupthink is a fact of life. Investors will always compete for companies that fit the mold of recent large exits, despite exits being a decidedly lagging indicator of the potential of a given technology or market focus.
As funds grow, VCs are doubling down and increasing financing size, rather than bringing on more GPs and identifying additional compelling investment opportunities. Lack of experienced entrepreneurial talent has been used as justification, an argument that I regard as pretty thin. Entrepreneurship is now a focus of top business training programs. The largest percentage of the 25 million entrepreneurs in the US is 18–34 years old. I have a vain hope that, in coming years, investors will begin to recognize that a 29-year-old founder can be more formidable and experienced than a 48-year-old former large company executive. Hopefully we don’t enter a new recession before they come to this realization.