The Three Ways to Invest in Early-Stage Biotech

Beaker and stock chart

We are entering the Decade of Biotech as powerful technologies begin to bear plentiful fruit. Many of these technologies will be accessible to academic founders working in shared lab spaces and funded by angel investors. Angels can invest in these early-stage biotech companies in three main ways, (1) directly on the capitalization table [the list of who owns what in a startup], (2) via a special purpose vehicle (SPV) sponsored by a platform or an experienced angel or (3) via a fund. These three approaches are explored here.

(1) Investing Directly: People who work full-time as angel investors typically invest in this way. The investor deals directly with the startup and appears in its list of investors (the capitalization table). The investor receives updates directly from the company and is periodically asked to sign documents related to subsequent financings.

Angels provide a whole lot more than just money. They provide other resources such as connections to potential customers and possible hires as well as specific and general advice including being a sounding board. The most time-consuming aspect of an angel’s work is the due diligence that must be performed before the angel invests. Startups frequently ask early investors to sign off on future fund raises, as well, which can be time consuming if you have a portfolio.

Full-time angels often belong to angel groups that allow them to lower the burden of due diligence by collaboration within angel groups and between angel groups. The check size for angels is typically $15,000 and up, although some startups, particularly well-performing ones, have minimum investments of $25,000 or even $50,000.

When an investor invests directly that investment is typically documented either as:

a)  Preferred Stock, meaning the investment has some preference over common stock held by the founders and employees. This is typical for later stage deals. Learn more about preferred stock here:

b) Convertible Note, which is a promise to pay the investor back a certain amount in a future date that usually bears interest. There’s typically a provision for the note to convert into preferred stock at an advantageous price if a certain amount is raised in the future. This type of document is pretty typical for early funding because they are simple and do not require that a value be placed on the company. Learn more about convertible notes here:

c) S.A.F.E or (Simple Agreement for Future Equity)

Bottom line: Investing directly is both more time-consuming and more rewarding than other ways of investing. It should be the goal for most investors who have the time and the means to do it. I consider other forms of investing as on-ramps to full-time angel investing.

(2) Investing via an SPV: An SPV (special purpose vehicle) is an entity (typically a limited liability company) setup just to invest in a single startup. Investors become members of the LLC and sign on to an operating agreement which governs how the SPV is run. They pay their contribution into a banking account in the name of the SPV. Once all investor funds are collected most of the funds are paid to the startup in which the investment is being made. The SPV’s investment in the startup is evidenced by preferred stock documents, a convertible note or a S.A.F.E. (see above). A small amount of the funds paid into the SPV is usually held back to pay for the annual expenses of the SPV which should typically be no more than $1,000.00 per year to be shared by all the members of the SPV. The SPV shows up in the startup’s capitalization table, not the individual investor. Communications with the company are typically done through the SPV.

Investors may find investing via SPVs beneficial because they get to invest in a deal that is already vetted (although investors should always do some due diligence on their own), they can write smaller checks and thus diversify more, and have less responsibility to be responding to documentation requests that are common in early-stage investing.

Diversifying is important because the risk of complete loss from investing in any one startup is high compared to the risk of investing in public companies. This risk declines as the number of investments increases. Diversification also increases the chance of investing in a startup that might have a disproportionate impact on the return of the portfolio. Most angels I know consider that it is necessary to invest in at least 20 companies to get the effects of diversification. There are, however, some highly engaged angels that have success by investing in just a handful of companies and pouring a lot of effort into them (podcasts on the two sides of this question: Ben and Sal Mostly Pro Diversifying, Fred Bamber and Sal Pro Diversifying, Jeff Arnold Somewhat Pro Concentration, Frank Ferguson Pro Concentration )

SPV’s do not charge annual management fees (typical of funds), but they do charge a “carry” which is a percentage of the gain from investments, typically 15 to 20%. This carry is charged when the investment pays off through an acquisition or an IPO.

Startups like SPVs because it allows them to reach out to more investors without greatly increasing the burden of investor communication.

Bottom line: SPVs make life easier for investors who are starting out, who don’t have the time to be full-time angels, or who prefer to write smaller checks.

(3) Investing in a Fund: A fund is an entity that receives money from many investors and then invests these funds in several different investments. The person or the company that makes investment decisions is called a “fund manager”. When funds are set up as partnerships, the fund manager is called the “general partner” and the individual investors are called the “limited partners”.

Funds are usually the least demanding of an investor’s time. The investor does the initial due diligence about investing in the fund. From that point on the fund’s general partner makes all the decisions. The general partner or fund manager provides periodic (typically quarterly) reports on the progress of the companies in which the fund has invested, i.e. its portfolio. Once all the investments of the fund are turned into cash (or, alas, deemed worthless) the fund is closed.

Funds typically charge an annual “management fee” (1-2%) plus a percentage of the appreciation of the assets in the fund called the “carried interest” or “carry.” The carry can range from 10 to 20%. There are also fund expenses which are shared by the partners typically covering fees for a third-party custodian (an independent entity that holds the assets for the fund), lawyers and accountants. Funds usually require investments in “units” of no less than $50,000. Frequently the unit size might be $100,000 or even $500,000.

Bottom line: funds are the least demanding way for investors to have exposure to early-stage companies in a diversified portfolio. They cost more but, if chosen well, have the benefit of experienced management with good deal flow.