E is for equity investment
2020 and 2021 were both bumper years for venture funding but the spotlight was firmly on the life sciences sector. In 2021, £4.5 billion was raised by UK biotech and life sciences companies, through both public and private fundraisings - 60% more than in 2020. Therapeutic platforms and biopharma have continued to lead the way both in terms of quantum of investment and the number of funding rounds, closely followed by diagnostic tools, medtech and digital health therapeutics.
Historically, PE investors have shied away from life sciences as a sector, preferring instead to focus on industries where there is a faster return on investment. The drug development process can take up to 15 years, there is uncertainty around product success and extremely high costs in bringing a drug to market, so investors need to have deep pockets to avoid being priced out of future funding rounds.
For corporate investors (eg. pharma companies), taking a minority equity stake in a start-up can be a lower risk segue into an eventual acquisition, giving the opportunity to conduct more detailed diligence, and have some control over the IP and business plan, whilst understanding the strengths and weaknesses of the management team "from the inside", at the same time as creating additional revenue streams through early-stage collaboration.
Here, we take you on a whistle-stop tour through seven key areas to think about in respect of minority equity investments in the sector.
- Investing in life sciences companies typically carries an even higher degree of risk (and greater potential upside) than investing in other sectors, where the company is often required to clear regulatory hurdles in order to become revenue generating.
- Tranche funding is common in the life sciences industry as a means of risk sharing – rather than giving the company access to the full funding upfront, the company's ability to make further drawdowns will occur on the occurrence of key milestones, such as results of pre-clinical trials or the achievement of regulatory approvals.
Warranties and due diligence
- Diligence in the sector will often focus predominantly on IP, being a key asset for any life sciences company, at whatever stage of growth, and on tax (e.g. R&D tax credits).
- Early-stage funding in the life sciences industry will typically require a suite of warranties which focus primarily on IP, with other warranties being fairly limited, reflecting the simplicity of the company's corporate history and lack of trading.
- As the company grows (in both size and inevitable complexity), the suite of warranties demanded by later stage investors will also grow.
- Investors will sometimes push for warranties to be repeated on completion of subsequent tranche funding.
Shareholders' Agreement vs Articles
- The Shareholders' Agreement typically includes provisions relating to: scope of business, financing requirements, capex policy, non-compete covenants, exit provisions, information rights, certain minority protection rights, including board reserved matters and shareholder reserved matters and deadlock provisions.
- Articles (which are publicly available) typically include provisions relating to: rights to appoint and remove directors, quorum provisions at board and shareholder meetings, procedure for board and shareholder meetings, pre-emptive provisions relating to share issues, pre-emptive provisions relating to share transfers, drag along/tag along rights, rights attaching to different share classes.
- Shareholders will typically want key rights to be incorporated into the Articles as this provides greater comfort: (i) if certain shareholder rights can be established as class rights, then any variation requires class consent; and (ii) whilst directors of the Company are not bound by the Shareholders' Agreement, an act breaching the Articles is void.
Investor consent matters
- Typically, a minority investor will want as an absolute minimum a right to veto specific, material business decisions, pre-emption rights on a transfer of shares by other shareholders, a right to veto any change to the Articles, and a right to veto the removal of any of their nominated directors.
- The list of minority protections (or Shareholder/Investor Reserved Matters) can often run to several pages and will be one of the key areas of negotiation.
- In practice, the increase in "red tape" and process, is one of the most significant changes for any company and its management, after taking on external investment.
- Depending on the percentage or quantum of equity acquired, an investor will often expect to have representation on the Board and, potentially, a list of Board Reserved Matters that require the approval of the Investor Director in order to be passed.
- Alternatively, an investor may settle for the right to appoint a Board observer, who will not have the right to vote but will have the right to attend and speak at board meetings.
- The key difference between Board Reserved Matters and Shareholder/Investor Reserved Matters is that an Investor Director will need to make decisions in line with their fiduciary duties, whereas an investor can withhold consent on a Shareholder/Investor Reserved Matter regardless of such constraints.
- VC and PE investors will typically require anti-dilution protections in the equity documents to protect their investment against "down rounds" (where the company issues shares in the future at a lower valuation).
- Often, investors will have the right to be issued with additional shares for nominal value in the event of a down round. The formula to calculate the shares received by the investor will be subject to negotiation; there are several different "standard formulations".
Right of first refusal, drag and tag
- A ROFR (right of first refusal) requires a selling shareholder to first offer their proposed sale shares to the other shareholders before selling to a third party. The Articles will set out the detailed process that must be followed by the selling shareholder.
- Having a ROFR in place can impact liquidity of the shares, as it makes it harder for a selling shareholder to negotiate with a third party buyer who knows that their offer may be overridden by existing shareholders.
- A drag along right is a useful provision for majority shareholders and typically provides that, once the ROFR process has been followed (and assuming no take-up), the majority shareholders can choose to "drag" the minority and therefore sell the entire issued share capital to a third party buyer – this has the advantage of improving liquidity for their shares, as the option to acquire 100% of a company may be attractive to third party buyers. A minority investor is likely to push back on a drag being exercised in situations where they do not receive a minimum amount in cash for their shares, and is also likely to resist giving any warranties to a buyer.
- If the majority shareholders choose not to use their "drag" right, it would be typical for the minority shareholders (investors) to have the right to "tag along" and sell their shares to the third party buyer on the same terms.
- Early-stage investors often place considerable importance on the strength of the company's management team and may therefore want protections in place to prevent founders for a lock-in period and/or are likely to want ROFR protections, and the ability to "tag along" with a sale by any key members of management.