Seed Capital: Beyond Angels And VC

By Gail Dutton, Contributing Writer
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When bootstrapped Covella Pharmaceuticals, Inc. needed a fresh influx of capital last fall, it approached larger biopharmas and was acquired by Santarus. When Taiga Biotechnologies, Inc. needed seed funding in 2006, it turned — like most start-ups — first to family and friends. Then it applied for government grants and cultivated super angels.

Twenty years ago, these companies would have gone directly to venture capitalists. Venture firms today, however, are saving their cash to ensure subsequent funding to companies they already have funded. “It’s not wise to look only at the venture world,” emphasizes Larry Fritz, until recently president of Covella and currently a consultant for Santarus and CEO of Xetrios Therapeutics. “The goal is to get a product or project financed — not to make money out of the company, but to prove the product is worthy of developing. Then, everyone does well,” Fritz says.

“Think about how much money you need to reach the point that will impress the next set of investors,” Fritz advises. From that perspective, raising one $15 million round may make more strategic sense than three $5 million rounds if it gets a project through Phase 1 or Phase 2 trials. Although “the United States is seeing more tranches than in the past,” says Paul DeStafano, partner at McDermott Will & Emery LLP, Fritz insists that big deals are still possible, particularly when intellectual property is in-licensed after much of the early-stage work is completed.

“Entrepreneurs need to look at multiple options simultaneously,” Fritz says. Taiga Biotechnologies used a multipronged strategy, winning NIH grants and gaining super angel funding and a corporate deal simultaneously. Cofounders Yosef Refaeli, Ph.D., scientific advisory board chairman, and Brian Turner, Ph.D., president and CEO, approached accredited investors, selling shares that could be converted into equity later.

New Angels
Angel financing is dwindling. Between the end of the second quarter of 2009 and that same period in 2010, the number of active angel investors decreased 11% and the deal size decreased 9%, according to the Angel Market Analysis, published by the Center for Venture Research at the University of New Hampshire. Angel seed investments dropped from 35% last year to 26% in 2010.

Today’s angel investors tend to be either organized into investment groups similar to venture capitalists or are independent, somewhat successful business people interested in a single good investment, according to Jerry Miraglia, attorney with Connolly Bove Lodge & Hutz LLP.

From that group, “You can potentially form consortia of investors who don’t normally invest in life sciences,” Dr. Refaeli says. Their drivers are different from those of the usual angels and venture capitalists. As Miraglia elaborates, “They don’t have a firm term sheet, and they are willing to put in sweat equity. Find them through your professionals,” he advises.

Biopharma Interest
Pharmaceutical companies and even small biotechs are interested in working with projects quite early in development. Unlike venture funds, which are concerned about financial risk, life sciences companies are focused upon maximizing their opportunities. This corporate interest reduces the risk to subsequent investors and provides a potential exit strategy, increasing the likelihood of venture investment.

“Biotech and pharmaceutical companies also are finding creative ways to put money in earlier and are willing to take risks that venture firms won’t consider,” Fritz continues. Some have formed internal venture capital firms or developed close relationships with academic institutions to identify promising technologies at a very early stage. San Diego-based Huya Biosciences, for example, works with Chinese universities to identify promising technologies and also has the right of first refusal with approximately 15 biotech parks.

Likewise, university tech transfer departments are going beyond licensing to identify potential investors and arrange the economic terms of financings. Stockholm’s Karolinski Institute leads the field. In the United States, the University of Maryland and Johns Hopkins University are very active.

Foundations And Governments
“Foundations are applying their funds differently than in the past,” making larger, but fewer, grants, according to DeStafano. He says one of his clients just received a family foundation grant that funds all clinical trials up to $50 million. Research hospitals like City of Hope and Brigham & Women’s Hospital also are playing matchmaker, shopping technology to investors in a more formal way than previously.

Taiga Biotechnologies received its first NIH grant in 2007, one year after it was founded, extending its cash flow from a projected 18 months to 40 months. So far, Taiga has won 25% of the grants it submits, netting a total of $2.1 million in Small Business Innovation Research (SBIR) grants from the National Institutes of Health (NIH). For comparison, “Academia receives about 8%,” Dr. Refaeli adds.

Geographic Options
Many U.S. states and foreign nations have established seed funds for companies in their region. For example, Oklahoma’s i2E agency has a $10 million seed capital fund for $500,000 to $1 million investments, $1 million EDGE research grants, and other funds. “We require half of the employees or assets to be here in Oklahoma,” Tom Walker, president and CEO, says. An extensive list of government-industry funding programs is available through the State Science and Technology Institute (http://www.SSTI.org).

Many European nations also make funds available to their own start-ups through governmental or quasi-governmental agencies. Phillippe Pouletty, M.D., founder of SangStat, structured that company to access both French and American funds by basing the administrative offices and patent attorney in the United States and the research and development laboratories in France. Using convertible shares, DeStafano explains, SangStat could collapse one division into the other as needed to tap into grants from either government.

Christopher Savoie, CEO at Gene Network, used that approach a few years ago to access Japan’s emerging angel and VC community. He worked with a Japanese investigator and established facilities in California and Japan. “The price of accessing geographically tied funds is a great deal of mobility,” DeStafano says.

Crowd Funding
Start-up companies also may consider tapping into peer-to-peer private placement investments (also called crowd-funding) options like MicroVentures and, soon, Profounder.com. Crowd-funding usually raises very small amounts of money on the Internet to produce independent films and similar projects. That model is just beginning to be applied to larger entrepreneurial endeavors, including biotech companies, according to MicroVentures Marketplace Inc. CEO Bill Clark.

MicroVentures was licensed as a broker in October under the Financial Industry Regulatory Authority. Clark says the firm expects to raise $150,000 to $1 million per placement by escrowing investments of $250 to $5,000 under the SEC’s Regulation 504 or 506 governing accredited or sophisticated investors, until the target is reached.

According to Dr. Jeffrey Sohl, director of the University of New Hampshire Center for Venture Research, there are potential problems with a crowd-funding approach. Aside from the hurdles of ensuring that investors are accredited and adhering to SEC regulations, companies may find themselves with hundreds of small investors and thereby decrease the firm’s attractiveness to future angels or venture capitalists.

Angels and venture capital still play a role in life sciences financings, but as their roles decrease alternatives are emerging. Investigate them diligently, and recall that the most successful strategies today require pursuing multiple options simultaneously.