Managing the Economic Crisis: The VC Way
Experts analyze stimulus, healthcare, and cross-border investing at ZLI conference.
Ann Arbor, Mich. — Buffeted by fallout from the U.S. financial crisis and recession, economic turmoil overseas, and other macroeconomic events, today's venture capital industry faces a far more challenging future than in past years. At the 2009 Michigan Growth Capital Symposium, experts from the investing, entrepreneurial, legal, and government sectors surveyed the changing landscape, discussed options, and offered strategic advice on how best to survive, and thrive, in a difficult investment environment that may persist for several more quarters, or even longer.
"The global economic crisis is like a boulder dropped in a pond," said keynote speaker Jonathan Seelig, the managing director of Globespan Capital Partners."It did not hit our lily pad, but the ripples are certainly being felt by everyone, the venture capitalist included."
Some observers looked for a silver lining in the dark economic cloud. "It's a tough time for Michigan and a tough time for the U.S.," said David J. Brophy, director and founder of the symposium and finance professor at Ross. "But it's a good time for entrepreneurs."
The annual two-day symposium, now in its 28th year, drew 375 participants to the Marriott Eagle Crest Conference Center in Ypsilanti, Mich., on May 12 and 13. Seven panels addressed issues ranging from the impact of the stimulus package and government funding on investments to cross-border investing and syndication in Canada. Former University of Michigan Head Football Coach Lloyd Carr weighed in on the importance of leadership, and Dr. Douglass Given of Bay City Capital analyzed investment opportunities in the healthcare industry.
Founders and representatives from 32 emerging and growth companies operating in Michigan and elsewhere showcased their innovative products and services in clean tech, energy, life sciences, information technology, and advanced technology. The event was presented by the Center for Venture Capital and Private Equity Finance of the Samuel Zell and Robert H. Lurie Institute for Entrepreneurial Studies at Ross.
Recent Trends in Venture Capital: Does the VC Model Work?
With The New York Times reporting significant declines in first-quarter fundraising by venture capital funds and moves by pension funds, endowments, and foundations to cut back permanently on investments in what some see now as a risky asset class, it's difficult to remain upbeat on the venture capital industry. Over the past 10 years, returns have taken a nosedive, mergers and acquisitions have slowed precipitously, and venture-backed initial public offerings have literally ground to a halt. But it helps to put things into historical perspective, said Jonathan Seelig, who specializes in investments in IT and clean tech at Globespan Capital Partners.
"We've seen this movie before," he said. "We've been through this cycle where people have said innovation is dead, there's nothing new that's going to be built, and there's no point in investing in startups because the returns won't be there. We've said it before. We're saying it now. It wasn't true then. And personally, I don't think it is true now."
Looking at the cycle of venture capital returns, Seelig observed that in 1999 to 2000, things were in a free fall. However, he predicted that once the industry begins to emerge from its deep trough, returns will improve considerably. "People who are putting money to work and building companies today are doing it at what we will historically end up viewing, in retrospect, as a spectacular time to be a business builder or an investor in startup companies."
To deliver outstanding returns, Seelig said, venture capital firms must have five qualities: operational experience, entrepreneurial experience, technology understanding, venture capital experience, and global perspective. He cautioned venture investors about standing on the sidelines until conditions improve. "The best capital investment firms out there recognize that in the toughest of times, you have an opportunity to build in a thoughtful, rational, unfrenzied way very real, sustainable businesses that can be very good companies for the long term," he said. "But the best firms also understand that you don't wait on shore to catch the next wave. Even though the waters are calm and you don't see tremendous opportunity, if you are not in the water, you're not going to get there in time to catch that next wave."
Some of areas where venture investors might find opportunities are digital syndicated media, biotechnology, biopharmacuticals, information technology, and clean technology. Looking ahead, Seelig predicted VC funds will become more conservative and recalibrate the number of deals they are able to do.
The Impact of the Stimulus Package on Healthcare
The healthcare industry stands to benefit substantially from the new stimulus package, a panel of medical experts and venture investors said. The American Recovery and Reinvestment Act of 2009 provides $20 billion in healthcare technology-information funding to advance the widespread implementation of electronic medical records in physicians' offices and hospitals. It also pumps $10 billion into the National Institutes of Health, which funnels grants dollars to university researchers and other scientists who are pursuing new drug discoveries, developing innovative medical devices, and investigating cutting-edge technologies.
Many venture capitalists are encouraged by this new spotlight on healthcare, but others are sounding a note of caution. "There are going to be a lot of dollars thrown at healthcare IT, but you must choose carefully," advised Peter Shagory, a partner at Baird Venture Partners. "It's not an overnight gold rush." In the current environment, he noted, "every investor has taken one step to the right" by investing in drug and medical-device companies at a later stage where there is more clarity in the regulatory path and less risk.
"There is frenzy in academia and small companies because $10 million is a big chunk of money," said Dr. Gilbert Omenn, professor of internal medicine, human genetics, public health, and computational medicine at the University of Michigan. But he observed that because the money is front-loaded over two years, grant recipients have very little time to hire a research staff and open new facilities.
The debate over healthcare reform, universal insurance, Medicaid expansion, and cost containment has created uncertainty for venture investors. "We have to pay attention to this," said Nicole Vitullo, a partner at Domain Associates. "It has caused us to look harder at the kinds of companies we're investing in." Innovative companies that can demonstrate their drugs or devices offer huge benefits over existing products are more likely to receive funding from VCs and to gain quicker approval from the safety-conscious U.S. Food and Drug Administration, Vitullo added.
The Good and Bad News for Entrepreneurs
Current trends in the venture-investing landscape may make it increasingly challenging for entrepreneurs to procure funding for new startups, a panel of VC veterans said. The venture capital industry is undergoing massive consolidation, and pundits predict that half of today's firms won't be around in five years. Industry observers have seen a flight to quality and greater interest in more capital-efficient models. On the whole, trends are moving toward lower returns on investment and longer times to exit. Still, there are those who believe this is the time to cherry pick the winners and run with them.
"Money is flooding to the coasts, so our job is to convince our limited partners that there is tremendous opportunity in the mid-continent," said Ned Hill, managing director of DFJ Mercury. He advised entrepreneurs to "make sure you have truly disruptive technology with a big potential market" and to think about ways to validate new technology using as little capital as possible. Picking like-minded investors who can offer advice as well as capital and demonstrating "scrappiness" also are crucial strategies for success. Strong management and team-building capabilities are essential. "We also want to see customer traction and an opportunity to hit break-even at a low revenue number," Hill added.
John Rice, managing partner at Triathlon Medical Ventures, said he prefers to work closely with a founder in a university laboratory setting to keep initial research and development costs low. He also looks for ways to get valuation and proof-of-concept step-ups early on.
Matthew McCall, managing director at Draper Fisher Jurvetson Portage, advised entrepreneurs to "do their homework" in determining where a venture fund is in its life cycle and how much "dry powder" remains for doing deals. He noted that exit values are falling and that expectations about returns should be realistic.
Different Ways to Think about Financing Business
As the venture capital industry retrenches, entrepreneurs need to think out of the box about how to finance their startups and growth companies. "There are a lot of angel groups in Michigan," said Thomas Kinnear, professor of marketing at Ross and executive director of the Zell Lurie Institute. Angel investing tends to be localized to a particular area and sometimes is syndicated. The best way to approach an angel investment group, Kinnear noted, is through an organizational or individual mentor who can provide an introduction. Having a comprehensive business plan and making a well-rehearsed presentation are two important factors that entrepreneurs sometimes overlook.
Another financing alternative is to procure non-dilutive funding through a Small Business Innovative Research or Small Business Technology Transfer Research program at one of the many participating federal agencies, including the Department of Defense and the Department of Energy. "This funding is for research and development, not business development," explained Michael Kurek, a partner at Biotechnology Business Consultants. Monies are awarded in tranches over six to nine months with milestones attached, rather than in one lump sum at the front end, so the timing may not be well-suited to fast-moving entrepreneurial ventures. Several large federal agencies, such as the National Institutes of Health and the DOD have started their own programs to accelerate commercialization, Kurek added.
Greg Main, who recently returned to Michigan to take the helm of the Michigan Economic Development Corporation (MEDC), said that despite Michigan's auto-related woes and weak housing market, the state offers great opportunities for innovation in such areas as advanced battery technology and renewable energy. The Michigan 21st Century Investment Fund already has made a number of investments in life-sciences, medical-device, and software companies. It is part of the overall 21st Century Jobs Fund initiative, which was announced in 2005 by Governor Jennifer Granholm. Under this 10-year initiative, the state government decided to allocate up to $1 billion of proceeds from Tobacco Settlement monies to strengthen and diversify Michigan's economic base. Other venture-funding options include the Michigan Pre-Seed Capital Fund and the Venture Michigan Fund.
Although a number of venture capital funds have taken root in Michigan, the state's entrepreneurs still face fierce competition for funding dollars. "There still are significant gaps in our capital structure," observed the MEDC's Main. "I don't think the venture community has the sense of urgency I'd like to see. They need to step up and look at deals."
Leadership in the Locker Room and the Board Room
Former University of Michigan Head Football Coach Lloyd Carr admits he knows very little about the venture capital business. But he does know a great deal about leadership.
"First, a leader has to define reality and be brutally honest when he assesses it," said Carr, who is now associate athletic director. "Next, a leader must accept accountability. A leader must work hard every day to build the kind of culture he wants. And a leader has to know what it takes to win."
Like his counterparts in business, Carr attributes much of his success during his 13-year career as head coach to the people he hired and the players he recruited. "You have to understand in your organization whether you want the team concept or the star concept," he said. "Every leader has to be willing to cut loose disruptive people and to set the tone and core of discipline. You want a culture where everybody is giving his best every day." Organizations weakened by the "disease of me" or the "fellowship of the miserable" are doomed to failure. "You've got to master the fundamentals, because 80 percent of the games are won by the team with the fewest turnovers," Carr added. "Better to have died an early death than to have fumbled a football."
When things go bad, the coach told his audience, our worst instincts tend to come out. Yet, smart leaders don't place blame, they accept it. "Expect nothing," he advised. "This game can make you rich and famous, but if you want respect and championship, you've got to earn them." In tough times, leaders can expect to endure criticism, second-guessing, sabotage and being maligned and castigated – "and those are the good things." To prevail, leaders must trust in themselves and treat triumph and disaster equally.
Carr concluded with one final observation on leadership. "The last responsibility of a leader is to say thank you," he said.
Trends in Healthcare Investing
The convergence of several major trends is transforming the healthcare industry and opening up new avenues of opportunity for investors and entrepreneurial companies, said Dr. Douglass Given, a partner at Bay City Capital. The pharmaceutical industry's growth rate is expected to slow as the patents on many blockbuster drugs approach expiration. As a result, large-cap pharmaceutical firms are seeking to acquire, via in-licensing and mergers and acquisitions, innovative products from smaller biopharmaceutical companies to fill dwindling pipelines. "Small companies have an opportunity to become part of the solution," Given said.
Biologics, which spans a wide range of medicinal products, such as vaccines, gene therapy, and recombinant therapeutic proteins, offers many opportunities for innovation and growth, according to Given. New therapies for treating cardiovascular disease and cancer are also prime candidates for replenishing empty pipelines. Diabetes, which affects millions of Americans, represents another "unmet" medical need with great potential.
Today, the aging population in the U.S. offers a ready market for new drugs and medical devices. However, Given noted, pharmaceutical companies still face headwinds, including declining FDA drug approvals, limited access to capital, pricing hurdles, and the emergence of "biosimilars." Government efforts to rein in the burgeoning cost of healthcare also will have an impact on the industry.
Although biotechnology traditionally has been a "safe harbor" for investors, Given reported that small and mid-cap biotechs suffered in 2008. He attributed their poor performance to inhospitable capital markets, lack of liquidity, and lack of FDA transparency. M&A activity, which provided investors with healthy returns, was the "only bright spot." More worrisome, Given said, is the cash crisis facing the biotechnology sector. He reported that 60 percent of biotechs and emerging companies trade at less than 18 months of cash, and 15 percent trade at or below cash. "Some say that as many as half of these companies could go out of business this year," Given said.
As a life-sciences venture-investment firm, Bay City Capital looks for portfolio companies with sustainable, innovative product generation, strong intellectual property and an experienced management team. Given said investment targets also must demonstrate exploitable market opportunities, balance-sheet strength, economic participation in core assets, and continuous development. Venture capitalists, he explained, are embracing a new paradigm, which brings together venture, innovation, and pharma partners in the early stage, followed by commercial or product proof of concept and finally, acquisition.
Cross-Border Investing: Partnering with Canadians
More U.S. venture capitalists and investors may be singing "O Canada" in the future. With its strong banking system, experienced labor force, advanced research and development capabilities, and favorable immigration policies, America's northerly neighbor is drawing more than casual attention from players in the U.S. venture investing and private equity sectors. "We think it is Canada's time to shine," said panelist Sunil Sharma, senior trade commissioner for venture capital at Canada's Department of Foreign Affairs and International Trade. "I'm struck by similarities between this region and Canada, but we don't know enough about each other," he added.
Canada's generous tax credits and incentives, combined with low labor costs and government-paid health benefits, have been effective tools for accelerating innovation at the pre-seed stage. However, there aren't enough big deals in the Canadian market to make the kind of returns limited partners want to see. Therefore, savvy venture capital firms need to use their leverage wisely. Peter van der Velden, president and CEO of Lumira Capital, said he takes a broader North American perspective to venture investing that entails building co-investor syndicates with sufficient capital and cultivating relationships with local investors. "You could have a Canadian CRO (contract research organization) do clinical trials and core development," he explained. "But the challenge in life sciences for funding the later stages is that large capital is not available in Canada."
U.S. general partners looking to invest in Canadian companies must navigate through considerable red tape, including the infamous section 116 of the Canadian revenue code. "It's not a problem getting money into Canada, it's getting it out," said Jeffrey LaBine, a principal at the law firm of Miller Canfield. "The two legal systems are so close, but the areas of difference can be a big problem." The Canadian government, he noted, is attempting to smooth out some of these legal entanglements to promote more cross-border investment.
The Role of Government Spending
The $787 billion stimulus bill passed by Congress will not quickly solve the historic problems besetting the economy, but it does offer new funding options for research, business creation, and jobs-related initiatives in hard-hit states such as Michigan. Among the biggest winners are the National Institutes of Health, the academic research community, and the clean tech industry, a group of panelists said.
"In Michigan, the big emphasis is on green technology," reported Amy Banninga, an economic recovery coordinator for the Michigan Economic Development Corporation. Key areas of opportunity in the clean-tech space include water technology, advanced battery technology, transportation electrification, upgrades to smart grids, and the broadband superhighway that will one day crisscross the entire state. Banninga also said that creating green jobs is a priority in Michigan, which is investing heavily in job-force training through its No Worker Left Behind program.
Portfolio companies that have been squeezed by tightening in the capital markets are benefiting from the stimulus package, said John Neis, managing director at Venture Investors. "We're in a very difficult time. The availability of these grant dollars is a godsend." The challenge, however, is the short time line for submitting grants.
Nick Tzitzon, a government policy adviser for Dykema, advised entrepreneurs to create a profile on the website grants.gov in order to find and apply for federal grants. Banninga said Michigan businesses and communities seeking stimulus dollars could find more information about opportunities available through the American Recovery and Reinvestment Act on two websites: michigan.gov/recovery and michiganadvantage.org/recovery. "We want to make sure people come out of the woods and that the state gets our fair share," she added.
"The significant increase in government spending on science and technology is really encouraging," Neis said. "From a venture capital perspective, this is the worst of times and the best of times. There are a lot of good investments out there, and it's a good time to be investing. Yet, it's very difficult to build syndicates because everyone is battening down the hatches to support their existing portfolios."
Venture Capital Myth Busters
The economy has put pressure on the venture capital community, and VC funding has slowed noticeably, a panel of experienced investors agreed. But their opinions diverged over whether the traditional VC model is "broken."
"A lot of venture funds have built portfolios on a belief of multimillion-dollar valuations -- that's broken," said Beau Laskey, managing director of Steamboat Ventures. "We're not sure the returns will be there." George Arida, managing director of Venture Investors, observed that tough economic times have forced companies to become more disciplined and capital efficient. "You have to manage the math to make the multiples work," he said. Although venture funds typically have favored companies on the coasts, investors said they were willing to travel to underserved capital markets, such as Michigan and the Midwest, to find good investment opportunities.
Entrepreneurs who are seeking funding should look for the "right fit," Arida suggested. "You want investors who are familiar with your sector and can add value. You might check out coastal investors, but if there are investors who have done deals in your neighborhood, that might be better."
The panel laid out dos and don'ts for raising money. "Know your audience and what's in their portfolios, and get an introduction from someone," advised Laskey. Alain Rothstein, a principal at Vicente Capital Partners, said entrepreneurs need to know their company's historical financials, show persistence, and be prepared to answer questions about the amount of capital and time it will take to reach break-even. "Investors are looking for proof of your value proposition and forward-looking revenues," commented Albert Kim, vice president of technology at Investor Growth Capital U.S.
When asked for predictions about the future, the panelists again diverged. "The venture capital industry will see contraction," said Arida. "With fundraising down, fewer companies will be funded." On the positive side, he predicted that government stimulus funding would help venture-backed companies. Laskey predicted the S&P 500 would retest its lows and that conditions in the housing market would continue to worsen.
Rothstein said he anticipates a stock-market dip, with the Dow retesting the 7000 level. However, he ended on an optimistic note, saying there is an opportunity to invest in sound companies with a time horizon of four to seven years. "It's a great time to build great businesses," he added. "But they need to have a plan to make their cash last."
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