Bioentrepreneur Pitfalls to Avoid: Capital Structure & Dilution

10 Jun

By Danielle Silva, Director of Research, LSN

As any emerging life science entrepreneur knows, just getting on an investor’s radar is an extremely arduous task. What many biotech firms do not realize, however, is that initiating a dialogue is only the beginning of a relationship that must be managed and maintained over time, and there are still many things that can cause a prospective deal to go south. To help prevent future headache, or even losing a deal during negotiations with potential investors, entrepreneurs should make a concerted effort to avoid some critical errors from the very start.

One thing that often raises a red flag for investors is an issuing company’s capital structure. Are the existing investors difficult to deal with? Is there risk associated with unfavorable terms from previous financings? How much risk of dilution is there due to existing convertible loans, etc.? Some key ways that entrepreneurs can avoid sabotaging future deals is by thinking strategically about how and from whom you raise your first seed capital. Make sure your investors are partners that will be easy to work with past the check-writing stage, and that the terms won’t deter future investors.

One effective method of ensuring a more favorable set of deal terms from the onset is via a non-participating liquidation preference. Here’s a hypothetical situation: If an angel investor invests $1 million in a company and negotiates a simple 1X non-participating liquidation preference, and then the firm is sold for $4 million, the angel investor will get $1 million and the remaining $3 million will be divided amongst the firm’s common shareholders. Obviously, some investors may have a higher multiple preferences, but negotiating non-participating liquidation preference with early investors can mitigate the risk that more institutional investors will not invest due to concerns over a firm’s equity dilution.

Another important component of a company’s capital structure is the capitalization table. A capitalization table is a cash-on-cash analysis of the percentage of ownership for investors and founders, the value of equity for each round of investment, and equity dilution. Some firms may have a large number of small investors that could cause issues for the companies owners or investors down the line. This is one of the issues that crowdfunding can cause, as it can attract large numbers of “unsophisticated” investors. If the entrepreneur should ever go down the road of “herding cats,” it is important to show prospective investors a clear strategy to repurchase as much equity from these “micro-investors” as possible, and convert any of the remaining preferred equity holders to common stock. Often just having a clear answer to an investor concern is helpful in itself.

Showing potential investors that you are business savvy and strategically-minded can be just as important as illustrating how compelling your product is. Avoiding these missteps proves to investors that you not only benefit yourself and the other stakeholders of your firm, but also that you have the ability to run a business.

These mistakes should be avoided at all costs when going through the due diligence process with investors. If you are an entrepreneur who is in the due diligence process with an investor, and do happen to have such setbacks, don’t be alarmed. Acknowledging that you have made these mistakes and speaking with your potential investor about how to resolve these issues will help show them that they are not just making an investment, they are forming a partnership, and that you are doing everything possible to generate a return on investment for themselves and future investors.

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