Venture Capital and Venture Debt in Life Sciences

This article examines some of the key issues encountered in life sciences VC transactions, focusing on sources of finance, deal structuring and the key terms that are often negotiated. By understanding these issues, founders and investors can successfully navigate the fundraising process.

How do early-stage life sciences companies obtain funding?

Raising capital is vital to the long-term success of early-stage companies who are generally unprofitable and, therefore, require significant investment to fund their research and development (“R&D”) activities and create value.

Earlier-stage companies can obtain funding from a number of areas. While financial VC funds typically invest in early-stage companies, companies can also obtain funding from other sources, including:

• Grants – Grant funding, which typically comes from government agencies, private organisations or charities, plays an important role in helping early-stage businesses raise capital and commence R&D. Grants are also appealing because there is usually no requirement to issue equity and consequently dilute shareholders. The application process for grant funding is usually rigorous and requires the company to produce a viable business plan explaining how the funds will be used.  The review process is also equally thorough, and funders will expect the results of R&D to be presented. Successful grant applicants can facilitate companies seeking VC funding as it provides both non-dilutive funding and the award of the grant itself will act as a form of validation, especially where it is from a body which is known to have a rigorous grant awarding process. The UK’s main provider of grants to early-stage companies is Innovate UK and UK researchers can also apply to Horizon Europe, an EU research and innovation programme, for grant funding.
  
  
• University funding – Universities often take equity stakes in companies where IP is  spun-out from the university, typically by way of a transfer or licence of patents and other IP to the company. Sometimes, universities have investment arms which can also invest funds to further facilitate the process.  
  
  
• Corporate venture capital (CVC) – CVC essentially started in the pharmaceutical sector and is now commonplace in most industries. Funding comes from large corporates, either on-balance sheet via the corporate itself or via a dedicated fund with its own investment mandate established by the corporate. CVCs generally invest in companies which align with the priorities of the parent group. As with traditional VC investors, a corporate investor takes an equity stake in the investee company. However, whereas VC funds are primarily focused on achieving a financial return for the investors in their fund, a CVC will also look for a strategic fit. 
  
  
• Venture debt – As life sciences start-ups generally generate little or no revenue to enable them to service debt and are focused on R&D activities, they are not usually well suited to debt financing. However, as companies grow, the ability to raise debt can become a viable option, especially if they start generating revenues and profits which may be used to service the debt. There is an increasing range of specialist venture debt providers operating in the life sciences sector. Lenders typically base their lending criteria on a number of factors including the scope and potential value of a company’s intellectual property and any applicable regulatory approvals, test results and milestones. For life sciences businesses that often incur significant R&D costs and which may take a significant amount of time to bring a drug to market and achieve profitability, venture debt can be a useful source of non-dilutive finance as they often have a period of interest only payments of typically between 12-18 months prior to repayment of principal beginning. A venture debt financing will usually involve an equity element, either in the form of convertible debt or an equity ‘kicker’ in the form of warrants to subscribe for shares in the future. Given the high-risk nature of venture debt from a lender’s perspective, the loans are usually secured over the borrower’s assets, which for life sciences companies will generally mean its intellectual property rights.

How are fundraisings structured?

Early-stage companies rarely follow a standardised fundraising process and may undertake successive rounds of financing. Successful companies will often be acquired by larger companies who can use the company’s product to fill a gap in their portfolio and can fund the significant costs of later-stage drug development such as clinical trials  or undertake an IPO  to raise larger amounts of capital. If a company fails, then it will be liquidated or dissolved, and any remaining funds are returned to shareholders.

A seed round is typically the first round of financing undertaken by a company and the investors in this round are  close connections to the founders. In some cases, they’ll be high net worth angel investors but could also be a university seed fund or earlier stage VC fund. Once a company has used the money raised at the seed round to carry out its initial R&D activities, the next step in its life cycle usually involves raising a more substantial round of capital from larger VC funds. Companies that show promise in their R&D activities will seek to raise increasingly larger amounts of capital as they focus on advancing their program (for example, proof of concept, first dosing in clinical trials etc.). These later rounds of financing are typically named by progressing through the alphabet (Series A, Series B, Series C, and so on) for each subsequent round. The commercial terms of each round vary in terms of the nature of the investors and the amounts invested. 

What are the key areas of diligence that an investor needs to undertake?

Due diligence is an important part of any VC transaction and the thoroughness of an investor’s process will vary depending on the stage of the fundraising. For earlier stage fundraisings, the level of due diligence is generally fairly light and focuses on key areas like corporate structure, IP, material contracts and service contracts for founders.  Where investment amounts are larger and the company has a longer trading history, the level of due diligence is typically more comprehensive. 

Intellectual property is a key element as it generally constitutes the majority of the company’s value. Therefore, an investor will want to determine the ownership, scope, and enforceability of the company’s IP rights to ensure that the company owns or has the exclusive rights to use all of the IP required to operate its business. This will involve examining patents, trademarks, trade secrets, proprietary technologies and the company’s contractual arrangements. An investor will also want to assess whether there is any litigation in progress or risk of potential litigation, especially regarding the company’s IP and key contracts. 

The other key areas include the employment contracts and incentivisation arrangements of the founders and management team.  Investors will want to ensure the employment contracts contain robust provisions, such as IP protection, and restrictive covenants. 

The above examples are typically the key areas of focus for an investor’s legal due diligence but these are by no means exhaustive.  Other areas such as the company’s tax position, finance arrangements and compliance with applicable laws and regulations are also important.

What are the key legal documents used in a typical VC fundraising?

Term sheet

The company and investor will generally negotiate a term sheet as the starting point. Term sheets are usually entered into once the key terms are agreed but before undertaking detailed due diligence and drafting the transaction documents. The content and level of detail of a term sheet depends on the preferences of the parties. If the term sheet is sufficiently detailed, this can help the parties identify any deal breakers or points requiring negotiation at an early stage and reduces the risk of protracted negotiations or the deal aborting at a later stage.

A term sheet is usually non-binding, so it does not legally require the parties to complete the transaction on the terms set out in the term sheet or at all, although term sheets do contain certain binding provisions such as exclusivity and confidentiality provisions. The parties may also include a binding provision allocating fees and expenses for the transaction, which are typically borne by the investee company on behalf of the lead investor.

Subscription agreement

The subscription agreement is entered into between the investors and the company and relates to the share subscription by the investors. The founders may also be party to the subscription agreement if they are required to give warranties.

The subscription agreement will include investor protections in the form of warranties, which provide an investor with a contractual claim for damages if a warranty is breached. The subscription agreement will also contain provisions which limit the liability of the warrantors in the case of a warranty claim. For example, a warranty claim may only be brought within an agreed time frame following completion of the investment and the amount that may be claimed for breach of the warranties is typically capped. In the case of the company, the liability cap will usually be the total amount invested and, in the case of any founders, the liability cap will usually be equal to a multiple of the founder’s annual salary (typically 1x).

Shareholders’ agreement

The shareholders’ agreement is usually entered into between the founders, existing shareholders, the investors and the company, and covers the day-to-day operations and governance of the company. 

The shareholders’ agreement is not a publicly available document and usually includes the following governance provisions:

• Consent matters – These are specified matters that the company is restricted from taking without investor consent. The matters are usually split between material matters that require the consent of an investor or group of investors and more operational matters that require the consent of a director appointed by the investor to the company’s board. 
  
  
• Restrictive covenants – Covenants are designed to protect investors by imposing restrictions on the founders’ ability to compete with the company if they leave, such as by setting up or working for a competing business or soliciting customers, suppliers or employees away from the company.  As the courts generally interpret such restrictive covenants strictly, they are also often contained in both the shareholders’ agreement and the services agreement between a founder and the company. This can provide greater protection as the covenants in the service agreement may be enforceable even if the covenants in the shareholders’ agreement are not.
  
  
• Business undertakings – Undertakings are given by the founders and the company to the investors to provide comfort that the company will take positive steps to run the business in a way which maximizes value.  A failure to comply with such undertakings would enable the investors to bring a claim for breach of contract. These usually include broad undertakings – such as disclosing newly-created IP to the company and then taking the necessary actions to ensure the IP vests in the company. However, undertakings may also include those matters that an investor has identified as being of particular concern following completion of their due diligence. 
  
  
• Information rights – These are rights to receive financial and other information that are provided to investors on a periodic basis to enable them to monitor their investment. The scope of the information rights will vary depending on the size and nature of the company. For example, smaller companies not legally required to prepare audited financial accounts will not be required to provide audited financial statements, but larger companies will be required to prepare and disclose these to investors.

Depending on the nature of the investor or the jurisdiction in which they or the investors in their fund are based, an investor may also insist that certain bespoke provisions are incorporated into the shareholders’ agreement. Increasingly, investors require additional provisions dealing with compliance with anti-bribery and corruption laws, tax laws and Environmental, Social and Governance (“ESG”) matters.

Articles of association

The articles of association regulate the internal affairs of a company and form the basis of a statutory contract between the shareholders and between each shareholder and the company.  They set out the rights attaching to each share class and also contain provisions relating to board and shareholder meetings, directors’ powers and duties, dividends, transfers of shares and issues of new shares. Unlike the shareholders’ agreement, the articles of association are publicly available and therefore, any sensitive information that the parties do not want to be publicly available is generally only included in the shareholders’ agreement.

Convertible loan notes (CLNs)

CLNs are debt issued by a company to an investor that may be converted into equity if certain trigger events occur, such as a subsequent equity funding round or an acquisition. CLNs are often used prior to an expected equity funding round or as a form of ‘bridge financing’ between funding rounds. They are an attractive way for a company to raise finance relatively quickly as the documentation is generally easier to agree than the documents involved in an equity financing. 

From an investor’s perspective, CLNs give them the benefits of both debt and equity financing as the investor will earn interest on the principal amount of the loan notes until the debt is converted into equity. An investor also usually has the option to be repaid the principal amount of the loan notes together with a redemption premium on one of the conversion trigger events or on the maturity date (which is typically 1 to 3 years from the date of issuing the CLNs). 

Importantly, no valuation is set for the company at the time of issuing the CLNs. So, by investing prior to the next equity funding round, the investor will usually benefit from a discount (typically between 10% to 30%) to the price paid in the next round valuation when the CLNs convert into equity.

Other documents

The main supplementary documents on an equity financing include: 

• A disclosure letter which sets out the matters that qualify the accuracy of the warranties in the subscription agreement;
  
  
• IP assignment agreements which assign the key IP rights from founders to the company;
  
  
• Service agreements for the founders and any key employees where existing service agreements are non-existent or not sufficient (for example because they do not contain restrictive covenants or an appropriate IP assignment clause); 
  
  
• A business plan which is usually prepared by the management team of the company and agreed with the investors prior to completion of the investment; and
  
  
• An option plan which may be put in place as part of the broader financing to incentivise key employees.

What are the key terms that are typically negotiated in VC transactions?

In the UK, the British Private Equity & Venture Capital Association (“BVCA”) has produced model documents including a subscription agreement, shareholders’ agreement and articles of association which contain a set of market-standard terms used in VC transactions. 

The large majority of early-stage VC investments will use the BVCA model documents as a starting point, which generally saves both the time and costs associated with negotiating agreements from scratch. As companies advance through funding rounds, the terms contained in investment documentation generally evolve in an increasingly bespoke manner, depending on the requirements of both the company and its investors. 

When negotiating the transaction documents, the following key points will need to be addressed:

Valuation

There is no prescribed way of valuing an early-stage company and some of the traditional techniques such as discounted cash flows can be problematic as they require the investor to make assumptions on the future profits of the company. Investors often apply a risk-adjusted net present value approach, which takes into account the probability that the predictions on future cash flow will occur. Investors will therefore consider the potential of the technology being developed and how it compares to what is on the market or under development by competitors, the likelihood of success/failure as well as how much capital has been invested (for example, via grants and equity funding). 

Funding

To mitigate risk, investments are often made in multiple tranches.  Each tranche is made following the satisfaction or waiver by the investors of milestones, typically  a mix of R&D, regulatory and operational. However, founders should be aware that they can lead to disputes if the milestones are not carefully structured and worded – they should be clearly defined and linked to objective criteria. 

Similarly, companies will want to ensure all investors are required to fund if there is tranching and the milestones are achieved. So called “Pay to Play” provisions are also often included which require an investor to invest subsequent tranches where milestones have been satisfied. Failure to fund then has a negative impact on the investor, including losing the right to appoint a director and the automatic conversion of any preference shares into less attractive ordinary shares.

Warranties

The BVCA model subscription agreement includes a customary set of warranties which are then usually amended following completion of an investor’s due diligence. The purpose of the warranties is to flush out any issues regarding the company’s business which need to be disclosed by the warrantors. If a warranty is breached, it will enable the investor to bring a contractual claim for damages against the warrantor in connection with the loss that the investor has suffered as a result of the breach. From the company’s perspective, it should ensure that the key employees who have sufficient knowledge of the company’s business are involved in reviewing the warranties and providing any disclosures that qualify the accuracy of the warranties. 

Board composition

An investor will often want to appoint a director (or, in some cases, multiple directors) to the board to enable them to monitor their investment and have some oversight and input into the running of the business. However, from the founders’ perspective, they will want to maintain control of the board for as long as possible. Therefore, where there are multiple investors in a funding round, the parties will need to agree on both the appropriate board size and which investors should be given the right to appoint a director. This is typically determined by reference to share ownership following completion. Investors may also require a founders’ right to appoint a director to be conditional on them holding over a certain number of shares and being employed by the Company. 

Investors may also want to appoint an observer to attend and speak at board meetings. However, observers do not have the right to vote on board matters. Again, companies will generally want to avoid too many observers being appointed so that the running of board meetings does not become unnecessarily burdensome.

Liquidation waterfall and liquidation preference

The liquidation waterfall sets out the order in which any proceeds of a sale or any surplus assets held by the company on a liquidation will be distributed to shareholders.  The default position for a company is that all shareholders receive capital back pro rata. However, investors almost always negotiate a so-called liquidation preference.  This refers to the amount of money that an investor will receive on a sale or liquidation of the company before any proceeds are then distributed to holders of ordinary shares such as the founders and employees. The liquidation preference is usually expressed as a multiple (usually at 1x) of the original amount invested (i.e. on a sale of the company, the investor will receive £1 for every £1 invested). However, in riskier circumstances or in adverse economic climates, investors may insist on interest accruing on the invested capital (e.g. at a rate of 8% per annum) and/or on a higher multiple (such as a 1.5x or 2x liquidation preference). 

Investors may also request that their shares have a ‘participating preference’. This means that on a sale of the company, an investor receives its liquidation preference and then also participates in the remaining proceeds to be distributed between the investors and the other shareholders according to their percentage ownership. This is investor-friendly, and it is more common for an investor to have a “non-participating preference” instead, which ensures that after the liquidation preference has been paid, the surplus assets will only be distributed to the holders of ordinary shares (i.e. to the founders and employees). In these circumstances, an investor can choose to convert their shares into ordinary shares prior to the distribution if it would result in them receiving a greater return. 

Anti-dilution protection

Investors typically require protection from dilution of their shareholdings as a result of the company issuing shares in a ‘down round’, which is a share issuance at a price per share that is less than that paid by the investors in the current round. There are different methods of calculating the number of anti-dilution shares issued to investors in these circumstances. Some methods  are more company friendly (i.e., fewer anti-dilution shares are issued) and some more investor friendly (i.e., more anti-dilution shares are issued). If these provisions are triggered, then investors are issued with further shares on completion of the ‘down round’, thereby diluting those shareholders that do not have anti-dilution protection.

Pre-emption rights 

Investors typically receive a right to purchase a pro rata portion of any new issue of shares by the company to protect their shareholdings from being diluted. If a company has lots of investors, these pre-emption rights may only be limited to “Major Investors” that hold over a certain percentage of the shares in the company. The pre-emption rights are designed to apply only to bona fide financings and, therefore, do not apply to an issue of shares following the exercise of options by an employee and they may usually be disapplied by a majority of the investors to facilitate a future funding round. 

Vesting

Investors will want to ensure that the founders and key employees are appropriately incentivised to grow the company. Therefore, founders’ shares and option awards are typically subject to vesting provisions which are based on continued employment with the company. Vesting is usually on a monthly or quarterly basis and typically lasts for three to four years. The first twelve months of vesting is delayed until a year after the vesting commencement date, which is usually the date of completion of an investment.  Longer or shorter vesting periods can be appropriate depending on the business plan of the company.

If a founder leaves the company during this period, some or all of their shares will usually convert into deferred shares with no voting or economic rights depending on the circumstances in which the founder leaves. If the founder is a so-called ‘good leaver’ (for example, they resign due to ill health), only unvested shares usually convert into deferred shares. If the founder is a so-called ‘bad leaver’ (for example, they are dismissed for fraud or gross misconduct), all of their shares that are subject to vesting usually convert into deferred shares. 

Once shares have vested, they have in effect been earned by the founders who are then free to deal with those shares subject to any other transfer restrictions that may apply in the company’s articles of association. Founders and key employees can often negotiate better vesting terms particularly at later stage funding rounds where it is acknowledged that they deserve credit for the time that they have already devoted to growing the business. For example, founders will often argue that only a portion of their shares should be subject to vesting arrangements. It is also common for vesting to be accelerated prior to a sale of the company or IPO and for shares that have been acquired for value to be excluded from vesting provisions. 

Given the financial impact vesting provisions can have on key employees’ overall remuneration, there is often extensive negotiation between companies and investors on both the vesting schedules and the definitions of what constitutes a ‘good leaver’ and a ‘bad leaver’.

Drag and Tag

Drag-along provisions facilitate the sale of the entire issued share capital of a company by enabling a pre-determined majority of shareholders to force the minority shareholders to sell their shares. The purpose of the drag-along provisions is to prevent a minority shareholder from blocking a sale of 100% of the company. Typically, investors with larger shareholdings will also want the right to trigger the drag-along provisions to protect them from being forced to sell their shares. Sometimes, it is negotiated that a drag will only operate if a minimum valuation has been achieved.

Shareholders usually also have the right to tag-along to a sale of the company. The tag-along rights are usually triggered when a buyer makes an offer to acquire a controlling interest (i.e. more than 50% of the voting rights) of the company. In these circumstances, the buyer must also make an offer to buy the shares held by all of the other shareholders at the same price per share.

What other considerations need to be taken into account in VC transactions?

In addition to the points referred to above, there are a number of other considerations that will need to be considered when negotiating VC transactions including the following:

National Security & Investment Act 2021 (“NSIA”)

Investors will need to determine whether their investment is caught within the NSIA regime and, therefore, conditional on receiving approval from the UK government. We considered the NSIA process in Merger Control and Foreign Direct Investment in Life Sciences in the EU and UK. 

Currency controls

In a small number of cases, an investor may be located in a jurisdiction which is subject to currency control requirements.  Although rarely an issue, as the majority of investors in the US and Europe are not subject to such requirements, this may impact investments from investors in certain overseas countries. It generally impacts the process and speed with which an investor can transfer funds to the company once documents are agreed.

Tax

As the VC market in the UK has evolved in recent years with increasing amounts coming from international investors, companies may be requested by such investors to comply with additional tax requirements. Commonly, US investors require the company to provide certain tax information and confirmations to ensure that the VC fund can comply with US tax laws.

What are the key terms of venture debt transactions?

A venture debt loan agreement is generally a simpler document than a loan agreement based on the UK standard setting Loan Market Association documentation. When negotiating venture debt transactions, the following key terms will need to be negotiated between the company and the lender:

Loan Amount

The key point is the total amount of money the lender is agreeing to provide to the borrower, and the conditions on which that amount of money may be drawn down. For example, a loan agreement could stipulate that the loan facility is £10,000,000 – with £5,000,000 being available for drawdown upon signing the loan documentation, and the remaining £5,000,000 being available based on the borrower achieving certain financial or operational metrics.

Interest Rate

The interest rate of the loan may be a fixed rate throughout the life of the loan, or a variable rate based on the current base rate plus a certain percentage (often with a floor).

Term and Maturity Date

Venture debt loans often begin with an interest only period, during which the borrower does not repay the principal amount of the loan. Although negotiable, this is generally between 12-18 months. Following the interest-free period, the borrower will then repay both principal and interest, typically over a period of 30-48 months.

Warrants

Lenders often receive warrants, which give them the right to subscribe for shares in the borrower at a predetermined price. This provides the lender with potential upside if the company performs well and increases in value.

Covenants

The loan agreement often includes financial and operational conditions that the borrower must adhere to at all times. These so-called covenants include maintaining certain financial ratios and/or a minimum level of cash, and restrictions on incurring additional debt. These typically involve some level of negotiation and will depend in large part on the company’s business and expected financial performance.

Security

Venture debt is almost always secured by the assets of the borrower group. In the UK this would usually be achieved by way of an all-assets debenture. Lenders typically do not take a share pledge over the shares of the holding company, but often look to take share security over its subsidiaries. For life sciences companies, a lender will want to ensure that all material IP has been captured by the security net, given that the IP is the most material asset of the borrower. 

Prepayment

Borrowers are usually permitted to repay the loan early. Whether the borrower is allowed to prepay in part (not just in whole) and the financial terms on which they must prepay are often negotiated points.

Fees and expenses

There are usually a number of fees and expenses associated with a venture debt loan in addition to the interest that is paid. There is often a fee due by the borrower to the lender upon signing the loan documentation and on the date that the final repayment is made. Also, the borrower is often responsible for the legal costs of the lender in preparing and negotiating the loan documents.

Reporting obligations and information rights

The loan documentation also usually includes information rights for the lender, allowing the lender to assess the ongoing financial health of the borrower (for example, delivery of monthly management accounts and other financial information, and/or the requirement to deliver to the lender all materials shared with the board or shareholders). A lender may also negotiate a board observer right (rather than a board seat) so they may attend all board meetings.

Conclusion

Venture capital fundraisings in new and growth biotech companies has become a key part of the overall biopharma ecosystem. Successful companies then raise further capital, often in subsequent venture capital fundraisings and sometimes by way of an IPO.  At other times, successful companies may end up being acquired by big pharma, especially where they are developing a product which may help the acquiring company replenish their pipeline of new products. 

VC fundraisings are increasingly complex transactions and therefore it is key for founders and companies to understand what investors expect. There are a myriad of contractual obligations in the investment documentation that investee companies will be required to navigate on a day-to-day basis. Therefore, having legal counsel who are well versed in negotiating these deals is key.