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Friday, August 26, 2011

Dilution and Investment - An Answer You May Not Expect

You may remember the Dot.Com bubble which burst around 2000-2001 timeframe.  Prior to the burst, investment and valuations were out of control.  It seemed that all anyone had to do was write a business plan to get money and high valuations.  The stock market reflected the degree of excitement especially in technology.  The trends of looking at revenues and investing at PE ratios in the 10-20 range went out the window.
Biotechnology has been trough several cycles of investment where excitement centered around the sizzle not the steak.  Maybe you remember, there were several intervals in the late 1990s where biotech was the major new investment for many.  Many millionaires were made in the biotechnology space (same for technology space) and it was always interesting to see what Genetic and Engineering News posted quarterly for the new millionaires being added to the list.
The past is the past! Investors occasionally learn from the problems and losses they made in the past, and they take longer before they believe the same problems will not happen next.  In 2000, I met a hedge-fund manager that had done rather well.  He had hired some really smart young scientists that reviewed public biotech companies and advised on the biotechnology investments for the fund.  Interestingly, they decided to look at biotech companies running late stage clinical trials.  The fund shorted the stock in nearly all they chose to invest in.  Biotech stock prices almost always fall when the data from a clinical trial is not satisfactory to gain an FDA approval.  So the fund just guessed that most of the companies would miss the endpoints, shorted the stock, and made lots of money.  The returns in the fund were greater than 60% per year for a 3 year period!  The companies with low prices either had to dilute investors in a financing, had enough to survive, or went out of business.
After 2001 and 9/11 (I was actually in NYC at 5th and 40th when the planes hit), the investment in technology and biotechnology was extremely difficult.  The markets had hit bottom and some described it like the nuclear of fund raising.  It certainly seemed so.  Deals were much more difficult and investors became much more careful. They demanded more and there were fewer funds as many had gone under over the following years.
In 2007-2009, the situation turned bad again.  VC funds were hard hit and could not raise capital.  One investor group that placed investments in VC funds informed me that they were dramatically limiting which VC funds they invested in.  They believed there were too many and selected only those that had been around for the longest time.  Many of the traditional funds had redemptions and their capital fell off and they made only limited investments.  Complicating things was the large number of companies seeking capital.  This made it a BUYERS market for the funds and difficult times for the companies.  A company really had to look stellar and have prospects of short-term exits or valuation inflections to attract attention.
Getting deals with large corporate partners were also a major issue.  The corporations were cherry picking.  They had many opportunities to choose from, so only the very best got the deals. When a deal was consummated, the large corporations could not raise capital to do additional development and they could not borrow from banks.
Why bring up the past?  In developing a startup, it is critical to plan ahead.  Having cash in the bank is sometimes the only way you can survive when the “Black Swan” events occur.  You can NOT predict the future.  You do NOT know when financing windows will close.  So when you consider the Dilution Effects of a financing, remember the following advice delivered by many old timers; “It is Better to Have 10% of a Lot of Money, than Have 100% of Nothing.”  You don’t want to dilute the investors too much, but you want enough funds to ensure you can weather any storm and that you will not run out of money. Running out of money at the wrong time Leaves You With Nothing.

Taffy Williams is the author of:  Think Agile:  How Smart Entrepreneurs Adapt in Order to Succeed to via Amazon