None Better than One? (A Brief Note on VC in Smaller Hubs)

Biotech venture funding metrics continue at historic highs, highlighting that the robust financing environment in the public markets continues to fuel the private markets as well.

 – Bruce Booth, partner Atlas Venture in Data Snapshot: Venture-Backed Biotech Financing Riding High, April 2015

Here in Madison, Wisconsin, you might not know that was true if you didn’t read the news. The equity funding environment in smaller hubs (e.g. Madison) is different that in major centers of biotech (e.g. Boston, San Francisco). There are both old and new dynamics that make building the next big thing (quickly) a significant challenge outside the coasts. Today I wanted to look at one of the old dynamics that remains true today.

When out looking for venture funding, one of the early questions a biotech company located in a smaller hub will get is about their local VC – are they in on the deal? (This query may be before or after another common question: is the company willing to relocate?) The answer seems like a clear yes or no but in practice is much more nuanced. To explore, let’s look at the typical life cycle for a venture fund. I’ll break down the issues using a hypothetical venture capital firm that is the only institutional biotech investor in the state during the course of the funds. Because I am not feeling creative, I am loosely basing the numbers on our single WI-based fund, whose internal dynamics are completely unknown to me other than their website and related news stories. (I know the people at the firm from various community efforts.) Therefore, I’ll make a large number of assumptions, noting when/if there is actual support for them.

Lifetime of a Fund

Venture funds historically have a ten year life cycle. The funds are generally invested in the first three to five years with the goal of an exit by the end of the ten years. (In practice, many funds last longer.) Due to the finances of running a fund, most firms will try to raise a new fund that begins as the previous investing ends (3-5 years into a fund). For our purposes, we’ll consider an initial $120M fund followed after five years with an $80M fund (similar to the local fund). While in theory, a fund would running out of money at the end of year five, a fund will be holding on to money for follow on rounds for their portfolio companies (even if the target number of companies was reached). As you have likely guessed, my explanation about getting local VC on board is more nuanced than cash in the bank.

The greater challenge here is to determine the number of companies each fund will support. For the assumptions, we will use 25 companies with the $120 million fund ($4-6 million/company) and 30 companies with the $80 million fund ($2-4 million/ company in part to reflect change from mostly biotech). (The local fund indicates “Seed rounds starting at $50,000 up to $8.0M over time.”)

Business Type

While a fund may invest in a single sector, the one fund headquartered here in Wisconsin invests across sectors, so we’ll use that approach. We are going to assume that the first fund was weighted towards biotech and that the second fund will be more equally weighted with sectors such as energy and technology (similar to description of local fund). A poor assumption that will make this exercise easier is that the fund will view all companies/markets in a sector equally, without considering what is already in their portfolio. While there are a handful (e.g. in oncology are Aglaia and Nextech), most biotech venture firms have a broader view than a single therapeutic area.

So perhaps in Wisconsin we would see four new biotech companies per year getting funded from our hypothetical fund, so where is the problem? Bruce Booth, partner at Atlas Venture, suggests that ~100 new biotechs are formed each year, which would mean little ol’ Wisconsin was seeing a disproportionate share of the early stage biotech investment. But there is another stop on this assumption trail…

Geography

There are two factors to consider: 1) Funding rounds happen in syndicates (multiple firms in each round) and sometimes you have to give not take. 2) Some funds have to make geography-specific investments. (Our local fund has a Michigan office and needs to make certain investment targets there.) Here, we carry over our assumption about number of companies and add that the first fund is more heavily weighted to Wisconsin while the second is more evenly distributed across Rest of Midwest (namely Michigan) and US. Rather than our theoretical high of 5 new Wisconsin companies per year, geography issues scale our numbers back to a total of 2-3 new companies in Wisconsin raising money from the fund each year.

Net Result?

Given the constraints on funds, perhaps the surprise should be when the timing and needs of companies in small hubs overlaps with the local funds. I could say let’s double down on funds for Wisconsin but my limited exposure to that solution suggests we would see more local/regional syndication rather than attracting coastal capital.

There is a bigger issue underlying the question about local investors; it is a proxy for whether a trusted source has vetted a team, technology, and product (and passed). A couple of years ago, I suggested that management needs to invest in long distance relationships to solve the capital problem, and I still believe that is the case. Stronger relationships with coastal funders and partners will help close the credibility gap that exists. I will write more about this topic later, but success in this area will require not just the entrepreneurs and biotech companies but also support from community players. As a mini-preview, here is an example that Bruce Booth from Atlas recently shared about a “regional” fund of funds out of Ohio that has an interesting approach.

“Mo Money, Mo Problems” – Notorius B.I.G

This post was prompted by this report on the status of Dane County’s (includes Madison) biotech industry in In Business magazine. Beth Donley, CEO of Madison-based Stemina Biomarker Discovery, noted this issue related to the practice of both the Wisconsin Alumni Research Foundation (WARF) and State of Wisconsin Investment Board (SWIB) to invest only alongside institutional investors rather than individuals. Since there is only one local VC firm investing in biotech, these supplemental funds are limited to a small portion of local companies. But it is very easy to get caught up in the local investment dynamics. Here is a table of recent biotech investments in Madison. You see a lot of angels and very few venture capital funds. One shining example is Propeller Health, which I hear has raised only a small proportion of their funding from an early Wisconsin angel and the remainder from coastal VCs. The bigger challenge is how to we position ourselves to participate in the “historic highs” that the rest of the biotech community is seeing? Doing so allows us to tap into capital at a scale that will allow our businesses to thrive.

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