We have compiled an investor checklist of some of the things that managers look for when deciding whether to invest in a potential company. Whilst many of these may make it onto a general investor checklist, others are more specific to biotech:
The Next "Big Thing"
How innovative is the company? The company product, more often than not, will be for a problem that has not been solved yet. Of course a caveat is that there may be companies that started trying to solve it years prior so one has to be careful that the idea will not be overtaken before it gets to market. Equally the innovation cannot be "ahead of its time" due to the fairly slow uptake of really new technology, in part, due to cost and unfamiliarity.
Management Team's Background
What are the backgrounds of the senior management of the investee company? This is important for the manager to best work out where their "value-add" would be in addition to their investment. Start-ups are often managed by serial entrepreneurs who have had successful exits in the past so already have experience navigating the sector and managing a small business. Sometimes though they could be a scientist with a great idea but without the business or financial savvy as to how to bring it to market, none of the necessary connections, or with an excessive focus on the product at the expense of recruiting the right people to grow the business.
Mutual Alignment
The founders of the company must still be on board and not looking for a quick exit. Investing in early-stage companies is as much about the people as the product. Things like taking minimal or zero salary as well as placing their own money into the company are additional positives. This is the "skin-in-the-game" concept. After all, why would one be expected to invest in any company if the directors will not?
Proven Concept
Is the science already proven to work and does it just need the additional capital to package and market it? In addition, has it successfully passed any necessary trials and received approval from the relevant organisations? The benefit of this is that the company would have passed its most risky "cash burn" stage and would be closer to generating a profit.
Potential Secondary Applications
One of the bonuses when considering investee companies is if there are any secondary applications of the product. An example highlighted to us by a manager was a product initially developed to help treat Deep Vein Thrombosis ("DVT") which is now additionally used to help with hard-to-heal wounds, as well as a post-match recovery tool for American football teams. This should reduce the risk and increase the revenue of that company. While this is hard to gauge, it can often be clear when a product precludes alternate uses.
Understandable
Would an investor be quickly able to grasp exactly what the business does or is aiming to do without a deep dive into the science behind it? Furthermore, it is important to see how the revenue will be generated and how they will get an eventual return. An investor should be excited by the prospects for the company and the potential to generate returns as well as relying to a large extent on concrete or, at least clear and robust business plans. In the case of particularly technical projects, or drug discovery, it is unlikely that any non-specialist would be able to understand the science or appraise the market opportunity. In such cases one must rely upon either a specialist manager or some other party with significant healthcare or technical experience. They should be better suited to assess the viability of the science in addition to the existence or likely future emergence of market demand for the product.
HMRC Approval
The investee company must have HMRC approval to decide if it meets the requirements for VCT or (S) EIS funding and thus give its investors the relevant tax benefits. If the company fails to get approval after an investment, the tax status of the entire VCT or (S) EIS could be jeopardised. Also, most companies in biotech would fall under the "Knowledge Intensive" criteria which gives them more leeway with regards to maximum investment or employee count for instance.
Competitors/Intellectual Property (IP)
Who are the possible competitors investigating similar ideas and what stage of development are they at? Also does the company have a unique IP? Is it offering an incremental improvement on the current technology or is it a disruptive innovation?
Other Investors
Who has invested previously or could potentially invest after you? Are their interests aligned with investors in terms of the direction of the business as well as seeking a potential exit? There is of course a risk with successive funding rounds that one as an investor could become diluted. Furthermore, managers may provide follow-on capital in another round of fundraising so there is a potential conflict between new and existing investors to be looked out for, particularly if the new round is at a higher price.
Type of Investment
EIS investments are entirely equity, but in VCTs, the fund can invest via equity or debt, each of which have their own elements. Debt comes before equity in the event of financial difficulty (provides more downside risk) but has limited upside for the investor other than the terms agreed on lending. The disadvantage of debt investing is that it removes capital from the company to pay down the loan during the growth stage. Equity has, in theory, limitless upside but could also return nothing. Early-stage biotech companies are likely to be entirely equity as there would normally be little or no profits to repay debt.
All of the above should form part of the manager's investment due diligence process which they should conduct on all investee companies themselves or by engaging third parties (especially when external expertise is required).
MJ Hudson Allenbridge's report on Tax-Advataged Investing in the Biotechnology Sector can be downloaded here
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
