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The term venture capital (VC) is typically used to describe the provision of development or working capital to a company, which is not linked to or dependent on the acquisition of another company or business. By contrast, the term private equity is usually used to describe the provision of equity financing in connection with an acquisition or management buy-out. This article focuses primarily on VC investment.

According to the recently published British Venture Capital Association (BVCA) report on VC investment activity in 2005:

• UK technology companies (communications, computer, electronics, biotechnology and medical) received more VC investment than any other industry category. GB£681 million (about US$1.3 billion) was invested in 644 companies (compared to GB£678 million (about US$1.29 billion) in 657 companies in 2004).
• Of this GB£681 million, GB£130 million (about US$248 million) was invested in 138 pharmaceutical and biotechnology companies (representing 10% of all UK companies receiving investment in 2005).
• Investment in biotechnology companies alone was GB£58 million (about US$110 million) in 67 companies, a reduction of 19% compared to the GB£72 million (about US$137 million) invested in 82 companies in 2004.

Against this background, the first part of this chapter examines recent trends in VC investment in UK life sciences companies, which may help explain the decrease in investment in 2005 compared to 2004. The second part of this chapter explains a typical deal structure and discusses some specific issues which arise in VC investment in life sciences companies.

Recent Trends

Who is Investing?
There are a number of VC and pseudo VC investors investing in life sciences. These include:

• Business angels. High net worth individuals who typically invest at start up or the early stage of company development.
• University/research institutes seed capital funds. These typically provide early stage or start up capital to spin-outs from their own university or institute.
• Specialist healthcare/life sciences funds. These invest at all stages of the fundraising cycle and lead funding rounds.
• General VC funds. A number of these funds have specific amounts earmarked for investment in healthcare and the life sciences. These funds invest at all stages of the funding cycle and lead funding rounds.
• Corporate venture funds. These are captive funds of large corporates, typically investing in later funding rounds (not usually in start ups except where the start up is a spin-out from the corporate affiliated to the fund) and usually will not lead funding rounds.
• Corporate venturers. These are typically large healthcare or pharmaceutical companies who may invest in life sciences company equity as part of a strategic alliance or commercial collaboration with that company.

Different investors have different motivations. VC funds are focussed on making substantial returns on investment. Corporate venturers may primarily be looking to access technology and view cash investment for equity as a cost of such access, although it gives them a stake in the development of the company generally and perhaps influence over its research and development (R&D) policy.

Historically, universities and research institutes and their seed funds were primarily interested in generating income to fund their R&D activities and building the research reputation of their institution. However, universities and research institutes are now increasingly approaching investments (whether a technology or intellectual property (IP) rights transfer, or cash) in their spin-out companies on a similar basis to traditional VC funds. In addition, a number of universities and research institutes have established collaborations or partnerships with VC funds or financial institutions with the aim of (among other things) increasing their returns from spin-out companies and securing greater access to external funding. A recent example is the joint venture Babraham BioConcepts established in September 2006 between life sciences VC fund Avlar BioVentures and the Babraham Institute, to form and fund new early stage life sciences companies associated with the Babraham Research Campus near Cambridge, UK.

Low Level of New Company Formations
The recent trend of low numbers of new company formations and start ups seems to have continued. The main factors contributing to this seem to be a shift in what investors are looking for and the concentration of funding in follow-on or later stage investments nearer to exit (driven in part by the current stage in their life cycle of certain funds investing in the sector).

What are Investors Looking for?
The obvious answer to this question is the highest financial return possible. However investors differ on which companies or sub-sectors of the market offer the best opportunity to make the highest returns. The pay back period for investment in classic early stage drug development companies has been long compared to the usual pay back period for VC investors in other sectors. There has been a recent trend of investors focusing more of their investments on opportunities with shorter pay back periods and a lower risk profile, for example:

• Medical device/equipment companies where regulatory hurdles to product approval are lower compared to drug development companies but where there are still significant barriers to market entry.
• Spin-out businesses from large pharmaceutical or biotechnology companies to create start up companies with near term products and revenues and a much more developed business compared to a "greenfield start up".
• Services businesses, that is, companies providing services to the drug development industry (often businesses based on a combination of software and clinical expertise).
• Consolidation plays, that is, investments in vehicles formed specifically for the purpose of making acquisitions to consolidate parts of the sector and build a significant business (for example, the recent creation by Advent Partners of Speciality European Pharma to acquire, develop and market specialist pharmaceuticals in Europe).

Some well-known VC funds have moved out of the early stage and drug development area altogether. This seems to have created a new "equity/financing gap" for early stage start up companies, which has contributed to the low level of new company formations. High quality drug development companies whose product candidates are targeted at substantial markets that are currently poorly served are still attractive to investors and are being financed. However, investors are generally looking more sceptically at classic drug development opportunities.

Fund Life Cycle and Focus on Exits
VC funds are typically limited life funds with an investment period of usually seven years. Inevitably, this leads to highs and lows in the amount of available funding at different points in time. Currently, a number of funds, particularly specialist life sciences funds, are at the stage in their life cycle where uninvested funds are now only available for follow-on investments in existing portfolio companies. In addition, a number of these VC funds are looking to raise new funds, and have recently been focused on exits and later stage investments in companies close to exit, to demonstrate returns to existing investors and potential investors in new funds they are seeking to raise. Consequently, less funding has been available, particularly in the early stage and new company formation area.

The Rise of AIM
The Alternative Investment Market (AIM) of the London Stock Exchange is targeted specifically at emerging growth companies. In 2005, 509 companies joined AIM. It is popular with life sciences and emerging healthcare companies seeking a listing in the UK because of its relatively light regulatory regime and because a company need not be revenue generating to list on AIM. Pharmaceutical and biotechnology companies are one of the top ten sectors represented on AIM by market capitalisation. The last 12 months has seen a significant increase in the number of life sciences and emerging healthcare companies listing on AIM (for example, Plethora Solutions, ReNeuron and Intercytex, on all of which Morrison & Foerster, London acted for the company).

In some cases, an initial public offering (IPO) on AIM is seen as an alternative to a further round of VC funding and the existing VC investors often make an investment in the IPO alongside new institutional investors. Given that they will be restricted from selling stock for (typically) 12 months following an AIM IPO (lock up period), a number of VC funds see an AIM IPO as an alternative to a series C or D financing round. An added advantage is that they are sharing the investment risk with new investors and are closer to an eventual exit because, on expiry of the lock up period, they are free to sell shares on the market.

The constitutional documents of VC funds (as distinct from private equity funds) often restrict the fund from investing in public equity, although typically this does not prevent VC funds from investing in an existing portfolio company on, or just prior to, an IPO. However, typically these funds will be restricted from following-on and taking up pre-emptive rights on subsequent follow-on financings by a listed company. To address this issue a number of funds are amending their constitutional documents, to allow a limited exception under which they can invest in follow-on offerings by portfolio companies in which they were invested pre-IPO. The trend of life sciences and emerging healthcare companies raising finance by listing on AIM, in part as an alternative to VC funding, is likely to continue, subject of course to stock market conditions.

Typical Deal Structure

Set out below is an overview of the typical structure of an investment in a life sciences company by a VC fund, emphasising the issues relevant to life sciences investment. The overview is necessarily general, as each VC fund has its own specific investment criteria and requirements.

Equity Structure
The VC investors will subscribe cash for new shares (or debt convertible into shares) in the life sciences company (Newco). The shares subscribed by the VC investors will usually be a different class of shares to those held by management and will have certain preferred rights. However, as Newco will typically be loss-making and cash burning, the VC investors' shares will not always carry preferential income or dividend rights (which would be normal in a VC investment in other sectors). In investing in Newco, the VC investors will be looking to make a substantial capital return on an eventual exit (typically an IPO or trade sale of Newco). VC investors would not expect to receive cash dividends from Newco but the shares they subscribe may have preferred dividend rights, as such rights can help provide the VC investors with their expected rate of return on investment (the accrued unpaid dividends would usually be converted into additional shares on an IPO or sale, which would give the VC investors a greater share of any IPO or sale proceeds). Management will usually have a shareholding in Newco. The valuation of Newco and consequent shareholding split between management and the VC investors is, not surprisingly, usually the subject of lengthy negotiation. Valuation of privately held life sciences companies is particularly challenging given their lack of revenue and profits, and there are often significant differences in the opinions of VC investors and management on valuation.

Share options are widely used by life sciences companies as incentives for management and employees and to align employee interests with those of shareholders. Making options widely available to employees enables life sciences companies to preserve cash by not paying excessive salaries to attract the best talent. Typically, options are only exercisable on a realisation of value for shareholders, usually on an IPO or trade sale of Newco. The exercise price of an option is usually the market price (as evidenced by the price at which the VC investors invest) at the time the option is granted, so the employee gets the benefit of the uplift in value of Newco between the date of grant of the option and the date of sale or IPO, As share options dilute the VC investors' shareholding, it is usual for the VC investors to impose limits on the aggregate number of shares over which options can be granted.

Documentation
The main documents setting out the rights and obligations of the VC investors, Newco and management are the:

• Investment and shareholders agreement.
• Bye-laws/articles of association of Newco.

In addition, there may be technology transfer agreements under which Newco acquires the technology and IP that its business plan is based on, and which it intends to develop using the funds provided by the VC investors (for example where Newco is a university spin-out). All relevant documentation will be signed and completed or adopted on completion of the investment (that is, when the VC investors actually invest cash in Newco).

Investment and Shareholders Agreement
The purpose of the investment and shareholders agreement is to regulate the arrangements between the VC investors, Newco and management. It sets out the principal commercial terms agreed between the parties (including the amounts and timing of the investment, which can be provided in tranches subject to Newco's performance against agreed milestones). It also sets out how Newco is to be managed and its business carried on post-completion of the investment.

VC Investors' Requirements
VC investors will require certain rights in relation to the management of Newco to protect and monitor their investment. These typically include:

• The right to appoint a director(s) to the board of Newco and any subsidiaries.
• The requirement for regular (often monthly) board meetings.
• The right to receive financial and other management information on a monthly basis.
• Veto rights, under which certain actions by Newco require the prior consent of the VC investors or a specified majority (usually by reference to shareholding) of the VC investors (which is often provided via the directors appointed by the VC investors).

For further details of the information and veto rights for VC investors often included in the investment and shareholders agreement, see box, Typical VC requirements.

In relation to access to Newco's business and confidential information, when one or more of the investors are corporate venture funds or corporate venturers, Newco will be cautious about sharing confidential information with them (particularly information relating to its IP or the core operational aspects of Newco's business such as clinical trials). This is because corporate venturers or corporate venture funds may have competing projects or relationships with actual or potential competitors of Newco. Consequently, it is not unusual for corporate venturers or corporate venture funds to have a more restricted right to receive information compared to other, non-corporate affiliated investors.

Giving VC investors veto rights over the way Newco carries on its business clearly has the capacity to restrict management's ability to run Newco on a day-to-day basis. The aim is to create a balance between where it is fair that the VC investors have input into the decision-making process and the need to allow management to run Newco's business effectively.

A particular issue arises in life sciences investment in relation to IP rights. Typically, VC investors expect to have a veto right over the acquisition, sale or other divestiture by Newco of its assets. In a life sciences investment, this would typically include IP rights. However, Newco and management will not want the VC investors to have a veto over every dealing by Newco with its IP rights (including licences in and licences out), given that IP rights are core to the business of most life sciences companies. The parties will therefore compromise and agree a position appropriate to the particular nature of Newco's business. This can range from setting threshold values above which consent of the VC investors is required to pro forma licence agreements or parameters for licence agreements, so that such deals do not require consent unless they depart significantly from those parameters or terms. Disposals (whether by sale or licence out) or acquisitions (including licences in) of substantial IP assets (in value or strategic terms) usually require VC investors' consent.

Warranties
The investment and shareholders agreement provides for warranties to be given by Newco's management and, usually, by Newco itself to the VC investors. Although the VC investors will undertake due diligence on Newco and its management, they are subscribing for shares in Newco on the basis of information provided by management and therefore require warranties.

The warranties given in any particular transaction will be negotiated between the parties although certain warranties are common to all VC investments irrespective of industry sector (for example, warranties as to the accuracy of audited/management accounts, tax position and there being no litigation). In a life sciences investment, the VC investors' due diligence and negotiation of the warranties will focus in particular on Newco's business and development plan and the associated risks, its IP position (including ownership of the relevant IP rights and Newco's patent position compared to other companies in the same or related areas) and, to the extent Newco has undertaken pre-clinical or clinical trials, the results and integrity of those trials (including whether such trials comply with the relevant regulatory standards and any adverse events). As part of their due diligence, the VC investors can instruct patent agents and/or scientific consultants to investigate and report on Newco's patent and other IP portfolio, its research programmes and potential products. Often, Newco and management will be asked to warrant that they agree with the factual content and conclusions of experts' reports.

Restrictive Covenants
Typically, the investment and shareholders agreement includes an undertaking by senior management that they will not compete directly or indirectly with the business carried on by Newco for a specified period of time (both during and post-employment).

Management will usually undertake not to solicit employees, customers or suppliers of Newco post-termination of employment. The restrictive covenants included in the investment and shareholders agreement are usually given directly to the VC investors and are therefore enforceable by them. It is also usual for similar restrictive covenants to be given by management (and all other employees above a certain level of seniority) to Newco itself in the relevant individual's employment/service contract with Newco.

Bye-laws or Articles of Association
The bye-laws or articles of association of Newco set out in detail the different classes of shares in Newco and the rights attaching to those shares, including as to dividends, return of capital, attendance at meetings and voting and rights of transfer or sale. The VC investors usually own a different class of share to management (see above, Equity structure). The VC investors' shares have certain preferred rights, which usually include the right on a return of capital (on a liquidation or otherwise) to be repaid at least the subscription price for such shares (and, if relevant, any arrears of preferred dividend) in priority to all other classes of share. In addition, the VC investors' shares may carry the right to receive a preferred dividend which, subject to the usual legal restrictions on payment of dividends, must be paid in full before any dividend can be paid to other shareholders. Typically, both the VC investors' shares and management shares will have one vote per share, although if the VC investors' preferred shares are convertible into ordinary shares at a ratio greater than one to one, then the preferred shares can, in certain circumstances, have additional voting rights on an "as converted'' basis. The VC investors' aim is to retain management at Newco using incentives to create value and disincentives to leave.

In addition, the VC investors usually require control over the timing of any IPO or trade sale. Various provisions are typically included in the bye-laws or articles of association to address these issues.

Typical VC Requirements
Financial and other information supplied to the VC investors will usually include:

• Monthly management accounts (with CEO commentary or analysis).
• Annual business plan.
• Audited accounts.
• General right to inspect Newco's books and accounts.
• Board minutes and agenda.
• Comparisons with business plan and forecasts on a monthly or quarterly basis.

Matters requiring the consent of the VC investors will usually include:

• Change to Newco's capital structure.
• Grant of share options above certain aggregate limits.
• Acquisition and/or disposal of subsidiaries and undertakings.
• Change to Newco's bye-laws (or articles of association).
• Change in the nature of the business.
• Winding-up.
• Borrowings above specified levels.
• Declaration of dividends.
• Capital expenditure or disposals or acquisitions of assets above specified limits.
• Change to directors' remuneration or dealings with directors. 
• Making of loans.
• Change in auditors, bankers or accounting reference date. 
• Conducting material litigation.
• Appointment of further directors to the board. 
• Entering into material contracts.

Pre-emption Rights
Newco's articles of association will typically include pre-emption rights on transfer of shares. These provisions usually provide that any shares in Newco which are to be offered for sale must first be offered to the other shareholders holding shares of the same class, then to the other Newco shareholders holding other classes of shares and finally to a third party. If the purchaser of the shares is a third party it is typically a requirement (usually of the investment and shareholders agreement) for such third party to enter into a deed of adherence agreeing to be bound by the terms of the investment and shareholders agreement. It is normal for certain exceptions to the pre-emption provisions to be included in the bye-laws/articles of association. Usual exceptions where pre-emption rights on transfer of shares will not apply include transfers:

• By management shareholders to close family members or family trusts.
• By corporate shareholders to companies in the same group.
• By VC investors to investors in their funds or to other VC investors' funds managed by the same investment manager.
• To anybody with the consent of the holders of a substantial percentage of the voting shares in Newco (often 95%).

Mandatory Transfer
Newco's articles of association will usually provide that an employee/management shareholder who ceases to be employed by Newco (and all its subsidiaries) must, if requested to do so by the board of directors, offer for sale his shares in Newco. Typically, the number of shares to be sold and the price at which they must be offered to other shareholders varies according to the duration of employment and the reasons for leaving. It is usual for an employee who left on amicable terms to be able to retain some or all of his shareholding and, in relation to the shares to be sold, to receive a sale price equal to fair market value. By contrast, an employee who is dismissed for cause or who has voluntarily resigned without the agreement of Newco's board is usually required to offer to sell his entire shareholding in Newco at a sale price equal to the lower of fair market value and the subscription price actually paid for such shares. The aim of this provision is to encourage management to remain with Newco and to build value.

Forced Sale/Drag Along Provisions
VC investors will be investing in Newco to make a substantial return on their investment. Consequently, it will be important for the VC investors to have control over the timing of any exit, whether by way of an IPO or trade sale. In relation to a trade sale, VC investors who decide to sell to a third party purchaser will want to be able to sell 100% of the entire issued share capital of Newco to such purchaser (because the purchaser would not want to acquire less than 100% of Newco and the price obtainable on the sale of the entire issued share capital of Newco could be substantially more than on the basis of a partial sale). Consequently, Newco's bye-laws or articles of association will typically include a provision that if a certain percentage of Newco shareholders (usually between 51% and 90%) accept the third party offer to acquire Newco, then the dissenting shareholders must either purchase the shares held by accepting shareholders on the same terms as the third party offer, or sell their own shares in Newco to the third party purchaser on the same terms.

Tag Along Provisions
Newco's bye-laws or articles of association will usually include a provision that if a third party acquires a controlling interest in Newco (usually specified as more than 50% of the voting shares in the company) then the third party must offer to purchase all other Newco shares on the same or similar terms (including as to price). This type of provision is designed to protect shareholders against certain groups of shareholders obtaining an exit which is not offered to a significant minority of Newco shareholders.

Sale Preference and Ratchet
In relation to a sale of Newco, the price paid by a third party purchaser may not always provide the VC investors with their anticipated rate of return or even full recovery of the amount invested in Newco. It is quite common for the bye-laws or articles of association to provide that, if a normal operation of the sale provisions would provide the VC investors with a return of less than their original investment (plus, often, a minimum rate of return), then the proceeds of the sale are reallocated between the shareholders, so that the VC investors receive back their original investment (plus any agreed minimum rate of return), and any remaining balance is divided between all shareholders in proportion to their shareholding.

Newco's articles may include a performance ratchet. Generally, the ratchet is designed to reallocate the proceeds of an exit as between the VC investors and management to provide previously agreed returns to each group of shareholders. For example, a ratchet may provide that if the sale or IPO value of Newco provides a return to the VC investors of above a certain agreed benchmark, then the sale or IPO proceeds are reallocated between VC investors and management to provide a larger share for management beyond their actual percentage shareholding in Newco. This is typically achieved by the redemption at a low value of the relevant proportion of the VC investors' shares, or conversion of such shares into non-participating non-voting deferred shares (with a consequent increase in the percentage of Newco's equity and therefore the sale or IPO proceeds for management).

Anti-dilution
Newco's bye-laws or articles of association will usually include an anti-dilution provision. Under this provision, if, post-completion of the VC investors' investment, Newco issues further shares at a lower price than that paid by the VC investors, then the VC investors are entitled to additional Newco shares at nil or low cost to average their subscription price per share down to the later lower issue price.

Exit/Realisation of Value
VC investors and management will both be focused on realising value from their investment in Newco (both in terms of cash invested and efforts in building the business). Typically, the investment and shareholders agreement will include a provision that the parties intend to achieve an exit by way of an IPO or a trade sale within a specified time period, typically three to five years. Historically, in the UK at least, the typical exit in relation to investments in life sciences companies has been via an IPO. However, this requires receptive and stable stock market conditions and may not allow VC investors or management to fully realise their investment. This is because management and VC investors will usually be required to enter into lock up arrangements to provide reassurance to new institutional investors, under which they agree not to sell all or most of their shares in Newco for a specified period following completion of the IPO. In addition, an I PO is a very public process with a lengthy timetable. By contrast, a trade sale is likely to be achieved more quickly and is a much less public exercise. Ultimately, the relative valuations achievable on an IPO and trade sale are likely to determine the decision as to which exit route to take, as will the desire (or otherwise) of Newco's shareholders to retain a continuing interest in the future fortunes of Newco.