Introduction to Venture Capital Business Model Jari Lauriala, Specialist Councel, Partner Replicon Corporate Finance Oy May 2003

Content

The Business Model of Venture Capital Fund The risk factors Commercial Structure of Venture Capital Fund Role of public financing sources Optimal development process of drug development portfolio-company Venture capitalist as a shareholder of the company Stages of Investments Due Diligence of VC Shareholders agreement the venture capitalists control device

Business Model of Venture Capital Fund

Venture capitalists approach is to invest in quality science, commercial strategies and management which it believes are key elements in building successful technology businesses. The focus will be on investments in undervalued companies who meet venture capitalists investment criteria and exploiting consolidation and buyout opportunities. The emphasis will be on using Venture capitalists hands-on approach to identify opportunities to create and secure value for the fund while seeking an exit within three to five years of investment. In European markets biotech venture capitalists will typically seek to invest EUR 7.5-12 million per company, taking a significant minority equity or equity-related stake and will expect to take an active role on the board of the target company. The regular communication and monitoring of performance milestones of target companies and reporting to investors of their fund are also characteristics of venture capitalists approach. The entry valuation of investor will depend on qualivative factors such as the investors return expectations, the proportion of the company that the management will give up to attract the investment and the investors view of the opportunity for new concept, product or service. The investor need to analyze the product and market opportunity to establish whether the potential exists to build a large company. If the market opportunity is small, even the largest company will remain small. The information can be analysed and compared to other similar companies for an indication of a range of values. The investor will also need to consider his or her own risk/return expectations, and management will need to consider the proportion of the company it is willing to sell to an investor. It will be necessary to assess the rate at which the company is likely to expand compared to its competitors, and perform the product and market analysis to establish the companys potential.

Risk Factors

High risks are involved when investing in the early phase of high-tech companies: The concept of the target company may not actually generate the proposed results or it could create other unforeseen problems; alternative concepts by competitive companies could be as good; the expected customer benefits could be unrecognized and unappreciated by the customer once the product becomes available; the necessary patent protection, approvals including price and reimbursement approvals, could not be obtained within the expected time frame and the expected level; stock market situation is not quaranteed to allow company to go succesfully public. Information assymmetry can involve high decree of risk A company that is starting up will have no financial record; all it will have are projections based on what the companys management team believes it can achieve. If the company is developing new technology or creating a new service, there might be useful comparable companies which to measure such projections. However, additional financial information is available for more developed later stage companies which are seeking capital (for example mezzanine financing) to bridge financing to next level where they expand their businesses by opening new branches, taking on more sales or production staff, or widening their product range

Commercial Structure of Venture Capital Fund

Venture capital fund in is fund for investment of private equity in attractive, young companies with an emphasis on specicif are or industry sector. In most cases fund operates as a dual-level, fully trans-parent private company in the form of a limited-liability company & limited partnership and is hence not subject to trade tax. In a venture capital limited partnership, the venture capitalists are general partners and control the fund's activities. The investors serve as limited partners and monitor the fund's progress, attend annual meetings, but cannot become involved in the fund's day- to- day management if they are to retain limited liability. The fund thus provides both private and institutional investors with an optimal tax situation: investment is directly allocated to the investor so that any increases in value e.g. in the case of private investors should, in accordance with current tax law, be tax-free. The venture capital fund is always a purely profit-oriented fund and offers its investors the possibility of generating above-average profits by focussing on content coupled with a high level of technical competence. Investors (limited partners of the fund) are offered limited partnership interests in the limited partnership. The intention is to invest the fund within 4-5 years and to liquidate the shareholding in early phase companies after 4-8 years and in companies with follow-on funding after 1-3 years.

Role of public financing sources

In most cases the fund shall be co-investor in a syndicate with other partners. In addition, public programs are used to consolidate the capital available in the companies, in Finland these could include Finnish National Fund for Research and Development (SITRA) and financing programs of National Technology Agency (TEKES). In doing so, the fund managers are able to utilize their extensive scientific and industrial network to the full in favor of the fund. Based on the total investment, a leverage is achieved on total investment compared to a leverage of more money-at-risk resulting from warranties against loss. This means that for every euro invested by the venture capitalist, more euros were additionally acquired. This reduces the risk in a twofold manner: on the one hand, the investment is distributed amongst several partners; on the other, due to the reduced individual investment involved, other projects can be financed. This broadens the portfolio and lowers the risk.

(Laboratory) proof of principle (Laboratory) proof of principle

Source: universities and Source: universities and technology centres technology centres

Knowledge protection/patents Knowledge protection/patents

Development of own (protected) knowledge (technique, molecule, drug)

Early company formation Early company formation

Research/ideas development Research/ideas development

First seed capital from local First seed capital from local venture capitalist venture capitalist Regognition by multinational pharmaceutical companies; major research financing for developing new drug

Start financing from Finnish Start financing from Finnish government technology government technology subsidies subsidies

Optimal development process of drug development portfoliocompany

First phase drug approval process by regulatory authorities; clinical (patient) trials on effectiveness, side effect etc.

First large injection of capital First large injection of capital together with other venture together with other venture capital firms capital firms

Second large injection of Second large injection of capital by venture capital and capital by venture capital and industry industry Second phase approval process; marketing agreements with pharmaceutical industry; government marketing approval

Trade Sale (or Quotation on Trade Sale (or Quotation on relevant exchange) relevant exchange)

Venture capitalist as a shareholder of the company

Especially biotech focused venture capital fund must be managed by a team of experienced investment managers who have particular expertise with start-up companies in the specific industry sector with extensive contact-network enabling parallel investments with other venture investors Management must be suited to this task: based on services and their specific competence and experience limit the risk involved. On the other hand, the management will make full use of any opportunities available to increase the added value of investment companies. Value adding venture capitalist as a shareholder bring strong industry, operational, financial and investment banking skills to the partnership with the target company. Through the Venture capitalists expertise and network the portfolio companies could gain access to: a) follow-on capital through venture capital ties; b) knowledge of partnership opportunities in multiple markets c) in-depth operational and management experience; d)access to high quality management teams; e) ties to the investment banking community. Venture capitalist adds the most value by assisting in the creation of the best possible team to manage and supervise the target company. Management asessment is one of the major tasks to be carried out by the venture capitalist before deciding to invest.

Stages of Investments

The stage of development of the company will determine how much factual information is available to base an analysis. The stage will also initially determine the risk-reward rate of the company. Early stage companies may have proprietary technology or intellectual property that has the potential to be exploited on a global scale. The technology or lead product is usually beyond proof of principle stage. Mid-stage companies may have strong pipeline of technologies and products, which have been developed by research and management teams with scientific and commercial credibility. The lead product is usually approaching clinical trials at this stage. Late stage companies have operational and corporate finance skills ideally positioned and company may need investments to precipitate consololidations. Companies at this stage are within 12 to 18 months of an IPO and have their lead products well advanced in clinical trials.
Start-up/Early Stage Possible return Risk Time to liquidity 5-10x ++++ 5-10 years Mid Stage 3-7x +++ 3-6 years Late Stage (Mezzanine) 2-5x ++ 1-3 years

Due Diligence of VC

Subsequent to initial assessment, due diligence is performed. This involves meetings with the management team of the potential candidate in order to prepare or to critically assess the essential parts of the business plan. These meetings are intended not only to obtain the necessary relevant information, but to allow assessment of the management team with respect to creativity, ability to convince, dealing with criticism, overcoming difficulties and cooperation within the team. Based on this information, the business concept is subjected to further analysis and validation by investor by study of the literature and relevant databases, interviews with customers or potential customers, competitors, consultants and relevant experts from network connections. If necessary, opinions of external experts can be obtained, e.g. on the technology involved, patent situation, market and competitive situations or legal aspects. The financial part of the business plan is generally discussed in detail with the management team whereby all essential assumptions and premises are critically analyzed. The due diligence undertaken by the bio-tech investor typically includes several phases: In scientific and clinical investigations the investor will look at the validity of the scientific proposition, the practicalities of its scientific strategy, the credibility of the research planning and the feasibility of delivering against milestones. In particular, investor have to look at existing property held by the company, its origins and ownership and the prospects for securing a sound intellectual property estate downstream, given prior art and competitive positions. Deals in place and the likely ability to secure significant partnerships are another feature of biotech investors due diligence.

Due Diligence of VC

Regardless of the differences between the various target companies, there has to be a standard set of criteria used in deciding on whether funding will be provided. Usually these are: a) a management team with competence, experience, the will to be successful and the personal involvement necessary to achieve success; b) an attractive market (e.g. size, growth dynamics, competitive situation); c) strategic competitive advantages (e.g. degree of innovation, patent protection, marketing concept) d) growth potential, period of amortization, profit potential; e) capital requirement set against business risk; f) exit prospects. In order to be able to make realistic assessment of these criteria, investor subjects those projects that have successfully survived an initial plausibility check to a selection process.

Shareholders agreement the venture capitalists control device

Once the division of the equity has been achieved, number of other important matters require attention. These include corporate governance issues, investor rights (particularly if the investor holds a minority of the voting shares) and control over the exit process. Economists have argued that transactions subject to repeated bargaining problems should be governed by long- term contracts. The terms and conditions that govern the contractual relationship between the two parties are critical to limiting opportunistic behavior and ensuring allocational efficiency. A venture investing presents many of the same problems: once the funds have been invested, the venture capitalist has very limited recourse to these funds. One of the few remedies is to insist on terms and conditions in shareholders agreement that will limit the target company's management ability to behave opportunistically The investor will want to ensure that the company in which he is investing will be managed in a proper manner. In the shareholders agreement the parties agree to have the aim of operating and developing the companys business along the lines set out in its business plan so as to generate the maximum maintainable profits and to enable a trade sale or an IPO within reasonable time from the date of signing the agreement. The agreement also specify the terms of the parties governance and ownership in the company. Each shareholder undertakes to exercise all voting rights and powers available to it at meetings of shareholders in the company so as to give full effect to the provisions of the agreement.

Shareholders agreement the venture capitalists control device

Venture investors risk of losing his investment is always substantial and therefore investor must have certain control in the company ie. a right to veto for certain decisions. Required standard veto rights to shareholders agreements between venture capitalists and target companies include: a) the appointment of directors. Venture capitalist should be able to prevent the appointment of additional directors who would change the balance on the board; b) the issue of additional share capital/equity related instruments, since this would dilute venture capitalists interest; c) the creation of new subsidiaries d) the taking on of any debt in excess of an agreed level; e) the issue of a charge over any asset of the company; f) the licensing of any technology owned by the company; g) the commencement of major litigation; h) the establishment of an employment contract to the senior directors and employees, or its variation; i) major related party transactions; j) the alteration of the companys statutes k) the transfer of any shares; l) control over the exit process.

Shareholders agreement the venture capitalists control device

Success is always dependent on the selection of the right projects, subsequent optimal value creation and management support by exercising shareholder rights up to the exit. Agreement and the board seat in the company actually minimizes investors risks, creates information flow from the investee company and makes the control of the company possible. In many (usually all) cases antidilution provisions are also implemented to shareholders agreement. Antidilution provisions mean that in the event that the company issues or sells shares, preferred shares or warrants, options, convertible securities or other rights to purchase shares at a price per share less than the price of the shares subscribed by investor, the price of those shares shall be adjusted to a price equal to the price paid per share for such new shares or share equivalents. With accurate information investor can understand intuitively how the company is performing. Investor can assess its growth relative to the industry. An unbalanced focus can lead to harvesting behavior, leaving a company out of the race for long term growth. The important point is that investors should be as concerned about how a business achieves its financial results as about whether it meets its financial targets. Value creative venture capitalist can help companies to understand the reasons for their current performance and how their future performance will likely develop.

Shareholders agreement the venture capitalists control device

Financial indicators, however, must be supplemented with strategic and operating value drivers that provide insights about where a companys performance is heading. Venture capitalist needs performance measures that tell where it is going in the future. Market share and R&D pipeline could be the a leading indicator for pharmaceutical company. As companies and the financial markets gets more sophisticated, the emphasis is shifting to these leading indicators. When venture capital investors management control is working well, it helps different layers of the communicate frankly and effectively. In particular, effective business performance management greatly improves the dialogue between limited liability partner of the fund (fund level), venture investor (VC level) and the target company (the management level). Well developed information flow and control process gives managers space to manage, while assuring their investors that the agreed upon level of performance will be achieved. When business performance management is done poorly and incentives are weak, relationship between the target company management and VCs can degenerate into piles of paperwork and much wasted time.

Shareholders agreement the venture capitalists control device

Revise Strategic planning Strategic planning Goals and strategies in Goals and strategies in business plan business plan

Revise Budgeting Budgeting

Corrective action

Target company performance Target company performance

Rules Rules (terms and conditions in (terms and conditions in shareholders agreement) shareholders agreement)

Measurement

Report versus plan Report versus plan

Reward (feedback)

Feedback communication

Was performance satisfactory ? Was performance satisfactory ?

Other information Other information

No

Yes

Replicon Corporate Finance Oy

Replicon group is independent Finnish corporate finance and consulting house based in Helsinki. Replicon provides highly specialized and quality-oriented corporate finance and consulting services for growth companies and their potential partners as well as venture capital and private equity funds. Our core services include: Project Valuations Financial Arrangements Financial Instruments Management Compensation Arrangements Partnering Solutions Replicons special focus area is Life-Science -sector including: Biotechnology, Medical Technology, Pharmaceuticals / Biopharmaceuticals, Diagnostics, Bioinformatics as well as IT-Solutions.

Replicon Corporate Finance Oy

Replicon Oy Kadetintie 20 A 18 FIN-00330 Helsinki Phone: +358-9-4111 0347 Fax: +358-9-3455 676 E-mail: info@replicon.fi Internet: www.replicon.fi +358-9-41110347 (Petteri Hirvonen, CEO) +358-400-918855 (Jari Lauriala, Specialist Counsel)