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What does ‘early stage’ mean these days?

The concept of early-stage investing means different things to different people, depending on industry focus and stage in the economic cycle, says NIB Capital Private Equity’s Otello Stampacchia. But what does this mean for limited partners and for the companies being funded?

As with most industries, the world of private equity is filled with buzzwords that professionals routinely use. Most of these words tend to have slightly different meanings depending on the user. One of these is the concept of ‘early-stage’ company investment.

In a leveraged buy-out, for example, an early-stage investment is one in a company without earnings/EBITDA (and therefore unattractive). For a venture capital investor, it could mean several things: a) a glint in a founder’s eye (seed investment), b) a start-up with little or no revenue and a product in the early stages of its development cycle, or c) a spin-off from a larger organisation, which is still likely to be without a substantial revenue stream.

The meaning of early-stage can also depend on the round of VC investment versus the product development cycle, which itself varies according to the industry. So, for example, the recent IT purchasing slow-down by corporates has had a strong effect on technology start-ups’ development plans. What used to be a late-stage investment opportunity in this space is now probably much further removed from profitability/exit than before. This begs a couple of questions: is a “G” financing round for a VC-backed company still a late-stage investment opportunity even if the company is still far from having a marketed/approved product? And is an investment in a very early-stage product still justifiable in circumstances when times to exit are getting longer and there is much more scrutiny of companies’ business plans and route to exit/profitability?

These questions, far from being academic, have important implications for investors and their strategy in the current financing environment. They also assume particular relevance in industries, such as biotechnology/biopharmaceuticals, where product development timelines are longer than in the IT industry.

Let’s take this particular industry as an example. First a few facts:

1. Biopharmaceuticals represent 61 per cent of total healthcare investment in the US since the beginning of 2003, as opposed to medical devices, which received 31 per cent, according to VentureSource. In Europe, biopharmaceuticals probably make up an even higher proportion, because there are fewer device companies.
2. Healthcare services companies are closer in their investment dynamics to buy-out investments as they are normally profitable and cash-flow generating; likewise, healthcare IT companies are much closer to IT investments than to other healthcare companies.
3. The product development and approval cycle in biopharmaceuticals is longer than in medical devices, regulatory risks are higher, and patent protection stronger. It is therefore much more difficult to engineer around a patent in biopharmaceuticals than in devices.

As mentioned above, in biopharmaceuticals companies, the potential discrepancy between a start-up company being ‘late’ in its funding cycle and still ‘early’ in its development cycle is particularly acute, since it takes on average ten to 12 years to develop and market a drug. Two factors have increased the frequency of this discrepancy: larger pharmaceutical companies have refocused their in-licensing and partnering strategies around products and away from tools and technologies positioned before lead optimisation in the drug discovery value chain; and the closure of the IPO window and associated retrenchment of most VCs focused on healthcare has forced companies to resort to additional private financing rounds rather than look for public capital to finance expensive clinical trials.

As a result of this, a large number of companies have found themselves in an uncomfortable position. They are too early in their product development cycle to attract corporate partners yet they have already undergone a number of private financings, often at high valuations, due to the excitement of the late 1990s and 2000. The fate of these companies is likely to reside in the hands of their existing investors, some of whom will face tough decisions when combing through their portfolios (it is significant that there is an increase in the number of secondary transactions in healthcare funds and direct portfolios). The question is whether this situation has changed the investment approach of traditional healthcare VCs when they look at ‘early-stage’ companies.

There is evidence to suggest that it has. Investment in later stage rounds in US VC-backed companies (defined as second rounds and later, plus restart rounds) has grown from an average of 64 per cent during the period 1997 to 2000 up to 83 per cent for 2003 year-to-date (VentureSource data). Startlingly, restart rounds have grown from being three per cent of total VC investment in 1997 to 7.3 per cent so far in 2003. This is also exacerbated by the increased lack of flexibility for GPs to perform crossover investments for their same investee company from different funds. Although European data are probably not as reliable going back to 1997, but it is fair to assume that similar trends are developing there too. Investors are therefore looking at companies at a later stage of their funding cycle than they did in the late 1990s on the assumption that the companies have performed more ground-work on their technology and products and might therefore be closer to an exit.

This new mindset has also affected the backing of technologies/new therapeutic approaches out of academia. In 1998 and 1999 it would have been possible to fund an academic professor’s technology or concept without a large amount of validating data and with the full support of VC firm(s). This is no longer the case. Much of the ‘early’ work burden has now moved back to academia (and associated incubator or seed funds) or to much smaller regional VC firms, which have to select, among their best and brightest, the ones that deserve the capital needed for IP filings and further research validating the original concept.

Pricing pressure in first VC-backed rounds of financing has also increased, at least in Europe, since investors now face longer times to exit and a higher capital intensity to bring the company to a meaningful clinical or product development milestone. GPs need to protect their future ownership, therefore, by setting low prices at the outset.

The wide IPO window of 1998 to 2000 has also left a large number of public biotech companies (which, arguably, went public too early) with products in mid-stage of development but generally without the ability to attract public market investors again. This has resulted in a number of PIPE transactions in the early part of the year.

Does this mean that a public small-cap biopharmaceutical company, with little liquidity in its stock and a few compounds in Phase I (or earlier), can now be defined as an early-stage company? The answer is up to the limited partners and their discussions with GPs on investment strategy.

Will this newly-found conservative attitude revert back to the good old days of three or four years ago, with large amounts of funding flowing back to technologies at an earlier stage of their development cycle? Everything is possible. Judging from the much more sober optimism of VCs and public investors alike, however, it is unlikely to happen anytime soon.
 
Otello Stampacchia heads NIB Capital Private Equity Life Sciences co-investments. All comments and statements made herein are the sole view of the author, and do not necessarily reflect those of NIB Capital Private Equity, its subsidiaries and affiliates. Otello can be reached on otellostampacchia@bluewin.ch for comments.

Copyright © 2003 Otello Stampacchia