Episode 126: Venture Math 101 – The Numbers Behind Funding Biotech Innovation

On today's episode, we're talking about math, but don't worry, it's the kind that makes you money. You're listening to Bio from the Bayou, empowering biotech leaders with the tools, assets, and expertise to improve healthcare outcomes.

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Serving the entire Gulf South, but recorded in the heart of New Orleans. Welcome back to Bio from the Bayou. I'm your host, Dr. Elaine Hamm, the executive in residence at Tulane University School of Medicine, and today's guest is Dr. Isaiah Reeves. He's a biomedical analyst at Solis Bioventures. And if you would like to learn more about Solis, please check out our previous episode with Isaiah's colleague, Dr. Travis Manescu. We are a big fan of the Solis Bioventures group, so we're excited to have you on the show, Isaiah.

Thank you for having me.

We're about to talk about everyone's favorite subject, math, but Good news. It's about the kind of math that helps fund our companies. We're talking about venture math. But before we get into that, I'd love to introduce yourself. What's your journey here? How did you get to Solace? How did you fall in love with venture math?

I was trained as a biologist. I did my undergrad in biochemistry, and then I did my PhD in biomedical science at St. Jude Children's Research Hospital, working in gene therapy. And I love science. I love biology. Medicine has always been a passion of mine, and I really just was wanting to get out of the lab. It was something that wasn't for me going forward. I knew I didn't want to be an academic. I knew I didn't want to run my own lab and write grants and papers for the rest of my life. So I went to a conference, LSTCon, which is a Life Science Tennessee organization here in Tennessee.

Yep.

And there was like a networking speed dating event. I'm a pretty introverted person, and I listened to your episode relatively recently about being an introvert in this kind of space, and it resonated with me very well. But I was pretty proud of myself. I went up to people in this networking speed dating, and I was just asking people for jobs. It's like, hey, I'm finishing up my PhD. It's like, what do you got?

Yeah.

And I ran into Josh Eckleberry, who was at your Bio from the Bayou event.

He was.

And I asked him for a job. He said, I can give you an internship. And I just started showing up to meetings. He gave me 2 books to read, one of them called The Go-Giver, which is just a parable story about how the more you give, the more you can receive and being a servant leader.

Yeah.

And it's just kind of the best way to do business is to serve others. And also another book called Venture Deals, which taught me basically the basics of what venture capital is, because I'd never taken a business class before. My only formal money education was in high school. I took a personal finance and economics class, which is a series of Dave Ramsey videos.

Oh God.

So like, this is an entirely new field to me. So I feel like this is good education for me to kind of get refreshed on this. And I love doing this. I love Soloist. I love the mission because it's very patient-focused. We are investing in companies that have really transformative therapies and devices. And I get to be around science. I get to see super cool science, but I don't have to do the science anymore.

Right. I love it. And you get to be on the side that writes the checks and the side not begging for— well, you know, I guess— We do beg for money too.

We do beg for money.

You are paid very well. I became a microbiologist because really the only math that we had to do was C1V1 equals C2V2. Like, that was it. I think I maybe had to take some, like, biz calc back in the day, but nothing too In fact, one of the reasons I went into venture capital myself many years ago is because I didn't understand the financing side. And hey, no better way to learn than to do, right? So, Yeah. let's, so let's dig into it. So when we talk about venture math, like what are the core numbers that we're talking about here? I mean, there's, you know, we hear some of those, you know, pre-money and valuations and that type of thing, but let's get more into the nitty-gritty of what those words mean.

I 100% agree. I think the best place to start is with valuations. We talk about pre-money, and that is basically what the agreed-upon price of your company is. When you are looking at stocks on the stock market, that is a very well-defined price. You don't have any say over the price of that stock. You say that stock is $55.39, it's either worth it to you or not because you think it's gonna go up or down.

Right.

When dealing with these startups, it's a lot more art than science. So we have an agreed-upon valuation, and it's a negotiation where in the perfect world, nobody leaves perfectly happy. It's probably a little bit lower than the founder wants, probably a little bit higher than the investors want. But generally speaking, let's take an example. You have a company, you have a drug, and we agree that the company is worth $10 million. If you have 1 million shares, that means each share is worth $10 each. It's never ever going to be that clean, but yeah, right. It's playing fantasy land.

Yeah.

And say you need $10 million to complete your IND enabling studies and get into your phase 1 clinical trial. And so on paper, you would be raising that $10 million and that would be the money as in the pre-money portion of it. And so you would think that your post-money valuation would be $20 million. And on paper that it is.

Yeah.

But usually There's another step called the fully diluted post-money valuation, and that's where an option pool or employee pool comes in after the fact. And that's— that number varies. Every company's different, every round's a little bit different, but that is for— to make sure that the team has enough incentives to keep driving, have enough shares to offer to prospective employees for bonuses for all sorts of things for hitting milestones.

Right.

And that helps protect the downside of dilution that's gonna occur in subsequent rounds. And so make sure that you keep the ship heading in the right direction.

Right.

Normally from the venture side, we get to the pre-money valuation by looking at the post-money valuation. Like we, we know it's like, okay, the math works for us at this valuation in a perfect world. If So the company's bought after this round, it would be bought based off of the multiple on this valuation because, yeah, all these shares are made up. They come up, they pop up outta the blue. And so the actual price that we're looking at is that fully diluted post-money valuation. Versus venture capital, this is a very high-risk, high-reward type of field.

Yeah.

So we are looking to see, it's like, okay, we want to be able to take a swing for the fence. Everything works out perfectly. 10x our money. That means if we put $1 million into this company, we hope to get $10 million out on an acquisition. That rarely ever happens on one, one investment. But yeah, so it usually takes multiple rounds of financing and every single round you encounter more dilution. Now, hopefully in another perfect world, the company's meeting these milestones. They're getting— they're reaching these inflection points where there's a step up in valuation. That step up can be 50, 100%, even higher.

Yeah.

Which means you're increasing the size of the company and increasing the share price of said company, which means your initial investment is going to get diluted. However, it's a smaller piece of a much larger pie. That's something we always need to keep our eye on is the fact that yes, nominally we might be owning less percentage of a company as it goes forward. If we believe in a company, we often follow on within the fund. We, we like to reserve capital, but even sometimes we, We'll do crossover rounds where we will invest into the same company in one fund and into the next fund, or even if we absolutely love it, we'll generate a special purpose vehicle, which is basically a direct investment outside of our fund.

Yeah.

Into a company that we really love. The math gets tricky, but 'cause sometimes those funds and those individual investments might be at competing odds with each other. There's different incentive structures for these different rounds. And, but we are really focused on a few key metrics. Like I mentioned it before, is the multiple that we're looking at. Yeah.

Let's talk about that. Like, what is your, like, metrics, your ideal company? Talk us through that piece.

The ideal company is—

Well, yeah, I mean, like, I, I'm more speaking from the math perspective.

Yeah.

Yeah. Like, what's your investment sweet spot?

The investment sweet spot for us is slightly de-risk clinical assets where they either getting into clinical trials or they have some clinical data. And at that point, you are looking at a company that's raising, say, $20, $30 million to do a Phase 2 trial.

Okay.

We might be looking at, say, putting in $5 million into this company. And with that $5 million, we might get, say, 10% of the company on a fully diluted basis.

Right.

And if it's a drug, drugs are higher risk. They have a much lower success rate in clinical trials than medical devices. So we are looking for potentially higher upside. You're looking at a drug, we're looking at multiples, hoping to get in the multiples of like 10. So if you have a $50 million fund and you invest $5 million into a company, that's 10% of your fund. If that comes back and you get a 10x, that company, that $50 million fully diluted company sells for $500 million. That 10% turns into $50 million and that returns the fund. Anything above that, the investors are happy they got their money back. Everything above that is where venture capital actually really makes their alpha, where we are. We're shooting for an 8 to 10x on drug deals, 3 to 5x on medical devices, obviously Hope for higher, but the premium is on these drugs because if you get an FDA approval for pretty much any market, those molecules are very valuable. A number that gets bandied about, and it is a very important metric, is IRR, which is the internal rate of return.

Yeah.

It matters because it assesses the time value of money. If I give you, if you invest $10 into a fund and in 6 months I give you $10 back, That's pretty good. That's really good, especially if you get $10, $20. If you gimme $10 and it takes me 10 years to get you $15 back, that's not a good investment. Right.

Yeah.

So technically you made some money there, but you could have put that money into the stock market and probably made, made more money.

Yeah.

It's a measure of how quickly you can make those cash returns. VC funds are kind of locked in these 10, 12-year cycles, so every year kind of kind of puts a drag on that performance. And so IRR accounts for that time value of money. There's no simple formula for it, right? But it's mostly plugins in Excel and—

Yeah.

That does the calculations. But it, what really matters at the end of the day is what, there are several other metrics, but DPI, which is distributed paid-in capital, how much money are you actually returning to your fam— to your investors?

Yeah.

There's this famous memo written by Howard Marks of Oaktree Capital fame. It's called You Can't Eat IRR. And the basic thesis is this, like, IRR is very useful, but it's an imperfect measurement of a fund because it's affected by the way that capital's deployed. If you don't deploy capital in a timely manner, you could actually still have a really solid IRR, but the gross value generated by those dollars can be vastly different because it's only on the invested capital. If you have $1,000 that you committed to a fund, but out of that, we are only calling $10 of those dollars and we turn that $10 into $20. That's doubling that investment.

That's doubling.

On paper, that looks really good. But if you contribute $1,000 and I turn that $1,000 into $1,200 or $1,500 or more, you can have a nominally similar IRR, but you're actually making more real money. That's why I think that distributed paid-in capital matters more because when the investors really do care about when do they get their money back, when do they get their principal, and then what surplus returns do they get?

Well, let's go back to probably one of the most contentious parts of venture deals, and that's valuations. The founder has a very specific number in mind and they might bring in comps if they've done their homework. If you guys have a completely different number in mind, How do you get to come to the table and agree on something that doesn't give everyone heartburn? At least.

Well, every deal dies 5 times before it actually happens. It's a negotiation. You go back and forth. You're gonna, you're gonna hear something from us that it's gonna be a complete non-starter. And then 2 days later, we come back to the table, we have cooler heads and it's like, well, maybe we have a lower valuation, but a higher option pool or vice versa.

Right.

And, um, it is really truly more art than science, but at the end of the day, we are working from that defined fully diluted post-money valuation.

Right, right.

And, um, it's easy for us to say like, don't be price sensitive because we, we are price sensitive and this is your baby, you, that you've poured your blood, sweat, and tears into. But, um, what really needs to happen is you need to focus on getting the right partners at the table that have the, have an alignment and vision, that have the right resources, bring the right people to the table. And there's the, that's the famous memo written by Noam Wasserman called The Founder's Dilemma, basically saying you're better off owning 20% of a rocket ship that actually gets off the ground as opposed to 80% of something that doesn't ever go anywhere.

Totally agree.

At the end of the day, you could own the entirety of the company, but you can't bootstrap biotech. You can't bootstrap medtech. Yeah. You, Much better to take the dilution early on because the more money you have on hand, the more capital you have access to, the more likely you are to get to a meaningful milestone, to generate an inflection point in valuation, to generate conversations on an acquisition or partnership with a large strategic partner. Good companies need to scale and develop rapidly, especially in our industry, that even once you get it through the clinical trial, you have a limited market exclusivity, especially in drugs and biotech?

So my company, Cadenza Bio, we had raised a small round a few years back, and it was a convertible note, and we oversubscribed, and we were really hesitant about taking more money than we necessarily needed. But I had a board member who's been there, done that. He's been on the podcast, Mark Corrigan, who's fantastic. He pulled me, he pulled us aside. He's like, Take money when money is being offered. Take the money.

Take the money.

Rarely will you regret taking more money because, and I'm so glad because, you know, hey, this year timelines for getting funding are really, really tight. So, I'm very glad that we oversubscribed. I probably wish I hadn't said no to a couple more investors now, nowadays.

Yeah.

But, but still, I think, you know, if money's on the table, take the money. Dilution isn't as important right now as runway.

So 100%, because everything takes longer and costs more than you think. Even the most conservative estimates, we're, we're going to be this, we're going to be this constrained on our budgets, or like everything's going to hit these timelines. You have fixed costs that if you hit one delay, those costs are constant. Then you don't want to be in a situation, especially if you have a clinical stage asset, to raise enough money to get halfway through a trial.

Yeah.

You are absolutely in the worst position possible because then you will be negotiating from a point of complete weakness.

Yeah, absolutely. Well, and something that we ended up doing, I'd love your thoughts on. So we did a convertible note and it had a cap, and I'm seeing that more and more of, it's a way of pricing a non-priced round. Talk a little bit about that, of how you guys view caps. Do you push for caps? Do you guys do convertible notes or are you more focused on Like the Series A rounds.

So we do convertible notes. We don't do convertible notes on our first investment into a company.

Yep.

And we love a cap because it protects the downside of the fact that you don't actually know what the next round is going to look like. It could be a 3x step up in valuation, and if you don't have the capital to really contribute to that round, but you have, you protect your downside and say, hey, I'm purchasing shares at this price at the maximum, as opposed to the discount plus the interest that you accrue.

Yeah. So let's talk a little bit, going back to the cap, let's talk about a different cap, the cap table.

Mm-hmm.

What are some of the things that you have seen as you guys have done diligence on companies that are absolute non-starters for you, or that you have seen destroy dilution math, you know, a few rounds later?

The worst is debt, not convertible notes and SAFEs or anything like that.

Oh, debt.

Actual like loans that you have taken out for the business. At the end of the day, especially if it's in excess of several million dollars, at the end of the day, on any sort of liquidation, the debt gets taken care of first.

It's always, and there's a lot of stuff out there that's sneaky. I mean, when you think of loans, you're thinking like, oh, I go to the bank and get a loan, which isn't often done in biotech, but there's a lot of early stage sort of, it's positioned as like, like venture funding, but it really isn't. There'll be some sort of payback or some, and it technically is a loan and that's out there. A lot of state economic development groups do those types of things, but Those get paid first and that's problematic.

Yeah. So debt at that early stage. Another thing that can be really bad, 'cause partly 'cause it sets a horrible precedent, 'cause it's going to occur every stage and it's gonna get worse every time, are preferred preferences that are participating that are higher than a 1x. 'Cause a normal non-participating preference is pretty standard. The last money in usually has the highest preference where money comes in, they get taken care of first, and then it goes down the line. But if you have a Participating preference, which for those, which this is also new to me when I was learning this, is say you have a 2x participating preference, which means you get twice the money that you invested in before anybody else gets theirs.

Yeah.

And then instead of everybody else catching up to where you are, everybody else participates and gets their share of the money and you are participating in that as well. That absolutely kills And if that's in there, the next round is, well, they have a 2x participating preference. I'm going to get a 3x participating preference. I'm going to get 4x. It's just going to compound and get worse over time. And it's going to really hurt the earliest investors, the people that believed in the company the most at the earliest stages and took the highest risk, and the founders, because it can get to the point where the common shares, even on a huge exit, the common shares don't actually receive any value.

Kind of along those lines, let's talk about some poison pills. Have you seen anything like that?

The first thing that comes to mind are cram-downs, where if you don't take your pro rata, so say you own 5% of a company going into a round, and so you have the right but not the obligation to participate in any subsequent funding. And if you don't necessarily have the requisite cash to participate in that round, in case if it's such a huge raise or the valuation's so high, Sometimes when people are writing these term sheets, they say you must take your pro rata or you must take X amount of a minimum investment or else your shares get converted to common and you're 10 to 1 dilution. So that means if you owned 1,000 shares, all of a sudden you own 100 shares and they used to be preferred Series B shares and now they're common shares.

Yeah.

And so that absolutely is a poison pill and it's, It's kind of sharp elbows in the sandbox. Mm-hmm. Again, can really hurt the earliest investors that might've put in the $100,000 when you really needed it at the beginning. That can really get hurt that way.

All right, I'm gonna make you put your entrepreneur hat on now. And you were going to a U, like, what are the things, what are the hills that are worth dying for? And what would you go, you know what, let's take the L, or let's take these terms and move this deal forward. Like what, where, You know, where should founders dig their heels in and where should they be flexible?

It's really easy for me to say, don't be price sensitive.

Yeah. Now remember, you're gonna be the entrepreneur here and you're—

No, no, no, 100%. Because I, I think that any VC that believes in you is also going to believe in what you've built and is gonna respect what you have built.

Yeah.

And will treat you fairly. It might not be the exactly the number that you feel like is fair, But don't be so married to a specific number. It's like, I need pre-money at $25 million and nothing less. I think that ensuring that your existing investors are not getting crammed down, ensuring that you do have an option pool that is being refreshed, that does protect you from dilution in these later rounds, and ensuring that you have the lead investor is able to put together a syndicate to fill out this round quickly.

That's great advice and making sure that it's someone that you want to be in a deal with too.

100%.

Even though, like we just talked about money being really important and helpful, you don't wanna just get in bed with anyone, you know? I mean, you're gonna be with them for a long time, especially in drug development. So you wanna make sure it's somebody that, like you said, respects you and respects what you're trying to do and not just trying to get their money and run. So. All right. What type of resources do you recommend? You mentioned the Venture Deals book, which I also highly recommend. I was very lucky in that I worked for a venture film firm so that I had my own Excel spreadsheets and things that I already know how to like play around with and see if this, then that, and understanding what the economics are. What are some resources that you can recommend to our audience of ways to understand venture math and being able to take with the numbers of your deal sheet and Run them through the gamut of what you think is gonna happen to your company and how you're gonna make out.

It's advice I got from my dad a long time ago. It is always strive to be the dumbest person among your friends. It is find people that you know and are willing to have a quarterly chat with and have these conversations with, whether they be peers of yours from previous endeavors that are now working in the investment space. I have several friends like that that have taught me. I have excellent mentors. I listen to podcasts like yours. Love it.

Yeah, love that especially.

It's reading and listening all the time. Obviously, we are in biotech. I listen to all the big biotech podcasts, STAT, Biotech Hangout, all those fun ones, but You have these other VC-specific podcasts as well. 20VC is one that I like to listen to a lot. Very rarely do they even touch biotech, but they talk to seed investors. They talk to founders at the seed Series A, Series B stages that have gone through the trials and tribulations and the understanding where the pitfalls are. Because I'm a firm believer that you learn more from mistakes, your own and others, more than you do from your successes.

Yeah.

So just constantly reading and listening and absorbing and not being afraid to ask the dumb questions. And there's a website called Wall Street Prep and they have really affordable courses you can get. They have free courses. They also have courses that are less than $50 of just basic Excel courses for building out cap tables. Like, hey, how do you build a cap table? This is how you turn on circular references.

Right.

It's little things like that go a long way.

Yeah. Well, and I love just going to others and hearing their dos and don'ts can be extremely helpful because it gives you real experience of like, you know, this is the one thing I wish I hadn't done when I did this type of deal. And you get the tangibles that you just, I mean, I love venture deals and lots of other resources out there, but it's better to hear it from people and get their advice of what they would've done differently. So I think that's great advice. And then to also look to We use biotech-specific bank like Chase KPMG or Silicon Valley Bank. They have resources like Carta and other things that are available for you to be able to use and try to play with cap tables and those types of things. They're normally very expensive, but definitely shop around with vendors and see like what they have in terms of resources for you as well.

And, and one thing I would add to that is for a founder, especially understanding your own cap table is incredibly important because each share class has their own incentives.

Mm-hmm.

And what a diff— a new deal is going to affect different share classes in an entirely different way.

Yeah.

So, being able to understand how it's going to affect each of your different investors will help you frame your positioning and why you need to do this raise in this particular way. And this, it needs to be on these terms in X, Y, and Z.

A million percent, especially as you're looking to get acquired or you're looking to do a big licensing deal, because once that press release hits, You bet all of the shareholders are gonna come and find you and say, okay, where's my money? And you have to know like, well, you don't get paid back until XYZ happens actually. And you wanna be able to know that, but then you might have done that deal a little bit differently knowing how the money would hit and get distributed too. That waterfall can be complicated. So, I've been down that way myself. I came into a cap table and I didn't know it as well as I should have and all of the Complicated. Well, to be fair, it was a very, very complicated cap table and just an absolute nightmare. But it was good learning experience of like, you know what, I love starting companies from scratch because then I can really understand the cap table so much better and do deals with that lens out from the beginning. So, absolutely. That's great, great advice. All right. Well, hey, thanks so much for chatting with us and for making math a little more interesting. It's always good to talk about the kind of math that gives you an ROI and helping navigate these complicated funding times these days. We'll be sure to keep an eye on what you're doing, what Solace Bioventures is doing. You know, as Travis has worked his way into being a friend of the pod, which is official now. So we're really excited to follow what you guys are working on. Thanks for joining us.

Thank you. I always enjoy listening to the shows.

Great. Well, as always, we will have Isaiah's contact information and informational links about some of the books and podcasts that he referenced in our show notes. So please check those out. And thanks again for joining us at Bio from the Bayou.

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