The Mantra and Myths of Capital Efficiency

26 Mar

By Danielle Silva, Director of Research, LSN

As time-to-exit has become protracted for life science investments in recent times, capital efficiency has become somewhat of a buzzword in the industry; but it seems that many firms still struggle with understanding not only what capital efficiency is in the context of the life science space, but also how to demonstrate it to potential investors. In the past, many young life science companies believed that more is always better – the more capital raised the better, and in turn, the bigger their valuation the better. Just because a firm is able to raise more capital does not mean the firm has in turn increased value for the firm’s stakeholders.[1]

It is still important for life science firms to constantly be in fundraising mode in order to keep an ongoing dialogue with potential investors, and companies still need to be cognizant of the fact that they need to raise money in order to get to the next round of funding. However, life science companies need to keep in mind the mantra of capital efficiency – doing more with less – creating more value with less capital, which is what life science firms need to focus on in order to both gain investor interest and create value for their investors.

Often, when investors refer to firms that do not have a “capital efficient” model, they point out firms that have been able to raise a good amount of capital in a small amount of time. Raising a huge lump sum is not always a bad thing – but if firms aren’t able to provide any returns to shareholders on the huge sum invested, then receiving this large allocation does prove to be problematic. Firms that aren’t able to illustrate that the investment has created any value will have trouble raising money in subsequent rounds, even if they are somehow able to show that there is a dire need for the capital.

Capital efficiency also plays a huge part in driving down the cost of capital over time – which is something life sciences firms also need to keep in mind when raising capital, considering the relatively large number of financing rounds required before product reaches marketability. Your firm needs to create more value with your cash on hand than your burn rate. If you don’t follow this rule, then subsequent financings will continue to dilute your company’s value.

The major question for life science companies, then, is how to achieve capital efficiency and how to demonstrate it to potential investors. One way to improve capital efficiency is to simply gain an understanding of the cost it will take to get to market – this includes what regulatory risks/costs may be associated with developing the technology and the firm’s target market for the product. Understanding the risks and the market will help the firm to more accurately identify if their firm is being overvalued or undervalued – again, if the firm is overvalued it will exacerbate problems with obtaining follow-on funding and raise the cost of capital in the long run.

Another useful concept that life science companies need to keep in mind is that time is money – if failure is inherent, then the firm needs to be able to quickly change their strategy and be able to identify an alternative market, indication, or application for the technology being developed. One of the most important aspects of capital efficiency is to be efficient on an operational level; firms need to leverage their existing capital base and if possible monetize their non-core assets at an early stage.

In order to prove that your firm is capital efficient, you will need to provide potential investors with financial statements, as well as outline your team. Illustrating that you have hit key milestones with a lean staff is an integral part of demonstrating capital efficiency to investors. Additionally, if your projected infrastructure expenditures or current spending to operational spending exceeds a ratio of 1:1 then this will be a huge red flag to investors.[2] Furthermore, to illustrate capital efficiency, it is important to make multiple projections for regulatory costs to show investors that you have already thought about the best and worst case scenario for getting the product to market.

If all these factors are taken into consideration by life sciences firms, it can help a company to become much more capital efficient. In the end, for life sciences firms and investors, capital efficiency is a win-win – the cost of capital is reduced for life science companies, and the return on investment is greater for investors. Thus, moving forward in order to attract investor capital life sciences firms will need to adopt the mantra of capital efficiency. If there is one thing you keep in mind – you will always need twice as much money and time as you think, and there will always be bumps in the road. Plan for it, and you are immeasurably closer to success.

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