Companies are cheap, but money is expensive. Burn must be slowed, but without sacrificing value drivers. And finding the exit has never been more difficult. Can venture investors make the best of the worst of times?

They face a dilemma: the ongoing financial crisis means there are buying opportunities for VCs with cash, but it also means fewer total dollars going into VC funds and a devastating fund-raising environment.

Because of the financial meltdown, straitened endowments and institutions will have less to invest in venture capital in 2009, making it one of the most difficult fund-raising environments in memory. Even already committed capital may be at risk; despite evidence to the contrary, rumors are spreading that certain limited partners are balking on capital calls.

And that is forcing VCs to think hard about their own portfolio investments. With no access to the public market and the M&A market stalled as pharma buyers wait for private biotech prices to decline, VCs must decide whether they are willing to fund their private companies for the foreseeable future.

[Editor's note: In the January issue of START-UP, FDC-Windhover will explore venture capital strategies in the current financial climate. This is an excerpt of the original article.]

Already, underperforming companies are being told to retrench. "We're telling them to reduce their burn, and if we need to reinvest there are going to be some resets," said Francesco De Rubertis, a partner in the life sciences practice of Index Ventures.

Certainly start-ups can't turn to so-called cross-over investors - funds that play along the fault line between private and public biotech companies - for capital. According to MPM BioEquities' Kurt von Emster, private company valuations are now well north of where they should be relative to public companies.

"It will take a long time for them to catch up with the housing-market-like collapse on the public side," said von Emster.

Indeed, the private biotech sectors in both the U.S. and Europe are in the midst of an inevitable shakeout, say VCs, which should result in fewer, better firms.

To see themselves through the current downturn, companies must identify ever more creative ways to ink deals and raise capital. Meanwhile their venture investors walk the line between gallows humor and we've-been-here-before bravado.

Will The Well Run Dry?

For VCs hitting the fund-raising trail, it isn't going to be fun. Case in point: Sofinnova Partners, which recently announced the first close of its latest fund, VI. At least partially in response to the financial climate and the worries of LPs, Sofinnova anticipates an increase in the number of limited partners - from 20 to 30 - for its new fund.

"It is a lousy environment for raising money," said Sofinnova managing partner Denis Lucquin in an interview. "We were pretty proud to announce the first closing of [Fund VI] in this kind of environment," he said.

Sofinnova can't say when it expects the final close of VI, but Lucquin's best guess is toward the end of 2009's first quarter. And the firm's experience - more foot-pounding to raise a similar amount of cash - is likely to be true at other VC firms in the coming months.

That's because the pool of institutional money available for venture investing has shrunk since September, when the crisis remained confined to financial firms such as Lehman Brothers and AIG.

Institutional limited partners rely heavily on a percentage allocation system when making their private equity, venture capital and other alternative investments. As the market turmoil has slashed the values of their funds, they are running into the so-called denominator problem: their illiquid investments make up a bigger piece of a smaller pie.

"There are a number of investors at or above allocation," sums up Robert Mast, a managing director at Boston and London-based Monument Group, which acts as a placement agent for venture funds, a kind of match-maker for the moneyed. Many LPs "are waiting to see what the numbers will look like and are keeping [new investments] on hold," he said.

Moreover, they are much more likely to ask VC firms for updated projections on capital draw-downs and potential returns. With limited partners tracking cash outlays so closely, general partners have been forced to delay capital calls, passing the word on to portfolio companies that funding is tight.

They "got the message loud and clear that they should only make capital calls if needed and they shouldn't be calling down fees right now," said Mast. As one general partner at a VC firm put it, "They're telling us 'be prudent.'"

VIPEs Have Allure

Partners from firms that have raised funds before the meltdown seem genuinely relieved. They are also projecting optimism. "It's certainly a great time to invest, if you have plenty of cash," said Steve Bunting, managing partner of the health care-focused venture outfit Abingworth.

Corporate venture funds, and new funds with deep- pocketed backers, in particular, should be in clover.

Novartis Option Fund, for example, recently joined TVM Capital and Healthcare Ventures in Ascent Therapeutics Inc.'s $19 million Series A in November; in December the fund followed up with a development deal with the company around an undisclosed G-protein coupled receptor target worth more than $200 million in downstream milestones and royalties (¹ Also see "Deals Of The Week: Exelixis/BMS, Valeant/Dow, Novartis Option Fund/Ascent" - Pink Sheet, 15 December, 2008., p. 5). Meantime, ex-Serono owner and chief Ernesto Bertarelli recently launched Ares Life Sciences.

One area of sudden interest to many VCs: private investment in public equity deals. Abingworth, for instance, recently decided to add an analyst dedicated to evaluating late stage and public opportunities despite its focus on early stage companies. Together with Index Ventures, which raised a €400 million growth fund in January 2008, Abingworth co-led a $40 million PIPE in next-generation antibody player MicroMet earlier this fall (² Also see "Sign Of The Times? Micromet’s Stock Price Sluggish Despite Reasons For Optimism" - Pink Sheet, 12 December, 2008.).

Novo AS, the corporate venture arm of Novo Nordisk, announced in mid-December its intention to build a new team focused on growth equity that will invest upwards of $200 million per year going forward. Ulrik Spork, managing director of Novo Growth Equity, said the move was precipitated by what Novo saw as the opportunities in later stage companies created by the financial whirlwind (³ Also see "New Funding Source For Cash-Strapped BioPharma" - Pink Sheet, 16 December, 2008.).

Besides Abingworth, Index and Novo, there are plenty of other VCs with an eye on the public markets. "We're looking more than we have in the past at public investments," said Brian Atwood, Versant Ventures co-founder and managing director. Of particular interest: investments where Versant has the opportunity to take a board seat, what Atwood terms a VIPE, for venture investment in public equity.

In most cases, VCs like Atwood are most interested in companies with potential near-term milestones - mid-to-late stage clinical trial data, for instance - that would move the stock in a positive direction. Pre-investment diligence has focused on finding and vetting these opportunities, while getting a feel for the management team. In those cases where a board seat isn't an option - probably still the vast majority of times - VCs forsaking control are much more reliant on quality management.

"There's only so much you can change in a public company, so we're very cautious," said one venture investor skeptical of the wisdom of chasing the attractive valuations on the public market. "We only seriously look at public companies that we knew from their private days," he said.

Going Early, Going Late

Sofinnova is likewise hesitant about moving into later-stage companies, said managing partner Denis Lucquin. The firm's strategy for Fund VI is unchanged from its previous five outings. "We decided to keep our focus on early stage companies," he said in a recent interview.

But those early-stage deals come in a variety of flavors, and not all are pure start-ups. For instance, the venture firm will continue to build on its experience with Big Pharma spin-outs - one of Europe's more sustainable biotech sources. To date, Sofinnova has played a role in five spin-outs, including the emergence of GI-focused Movetis from Johnson & Johnson in January 2007 (⁴ Also see "Movetis Takes GI from J&J" - Scrip, 1 February, 2007.).

Admittedly "the competition for these deals is greater," said Lucquin, because they fit the sweet spot for both early and late-stage investors: a lower risk profile, experienced managers, and a nearer term exit - three to five years versus seven years for traditional biotech.

Another category piquing Sofinnova's interest: opportunistic recapitalizations.

Such deals are becoming more common. In recent weeks Domain Therapeutics was recapitalized with €2 million from Sofinnova and a variety of other French investors, while Prolexys Pharmaceuticals recapped with $20 million from lead investor Friedli Corporate Finance and others.

Lucquin cites Noxxon Pharma AG as another example. "It's very much a start-up but it's five years old," he said. The technology was interesting but it was a case of the [original] investors going in too early." Sofinnova, TVM Capital, Edmond de Rothschild Investment Partners and other investors pumped €37 million into the company in 2007.

Like Sofinnova, Index and Versant also see opportunities for good returns at the earliest stages of company creation. "Expect bigger A rounds than last year or two years ago," says Index's De Rubertis.

Bigger A rounds won't translate into big spending, however. VCs are insisting that new companies maintain a leaner profile.

"You can do so much more with outsourcing now, and so it's easier to be virtual," said Atlas Ventures partner Regina Hodits. "In the '90s it was about selling hope, and having a great business plan. Now it's about having a detailed operational plan, so we know where the money's going and what exactly we are buying," she said.

Instead, Atlas' Hodits and others are interested in committing more money upfront in the hopes of getting a better valuation, while simultaneously providing the company enough runway to weather the current financial winter.

Bottom line: VCs are - in most cases - only willing to put a certain amount of capital to work in each company. "We think about $50 to $60 million all-in is the right number," says Versant's Atwood. "That gives you enough headroom to make a halfway decent venture investment," he said.

In And Out Of Favor

But not every kind of biotech can make it to the exit on $60 million. "When I came into venture in the mid-'90s, you didn't think about cardiovascular," says Atwood. "You knew you couldn't get to where you needed to go on those numbers. But most other diseases were pretty much available."

That's not the case anymore. Atwood notes that Versant will still evaluate cardiovascular disease-focused companies, but it's hard to find the investment rationale at $60 million all-in. And now, other diseases are joining that off-limits category, including metabolic disease and solid tumors.

"We can't afford it. Cardiovascular risk factors for diabetes caught us off guard, and we don't know where FDA is going next," said Atwood.

Instead VCs are more often placing bets in therapeutic areas where endpoints are sharp and relatively quick, or in orphan diseases where unmet need is particularly high. Atwood lists pain, urgent and emergency care at hospitals, and a general avoidance of chronic administration of therapies among the hot spots.

As biotechs are forced out of business by an indifferent market and VCs are forced to make tough choices, a very different biotech sector could emerge in a year's time, say observers. Consolidation - and likely even contraction - will remake the landscape. Executives will come to a sort of valuation reckoning brought on by tough times. "Right now a lot of people on both sides are unsure what to do," said Abingworth's Bunting.

But that should change over the next 12 months as cash reserves dwindle. As Bunting said, "if you're driving at 70 miles an hour at a brick wall and someone offers you a set of brakes, you'll probably do a deal."

- Christopher Morrison (c.morrison@elsevier.com) and Ellen Foster Licking (e.licking@elsevier.com)

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