Seed stage financing for life sciences ventures, presented by Mark Mirkin.

This is Mark Murkin. I'm a partner at Ramone, seated today in the Research Triangle in North Carolina, where I spend most of my time when I'm not here. My other office is down in Palm Beach County in South Florida. I've been practicing venture capital financing law for 3 decades, and these 2 locations where I practice are rather diverse and useful to the trade and will come in handy as we have our discussions today about early-stage financing for life sciences ventures. The reason for that is, as many of you know, the Research Triangle is certainly the Southeast's preeminent hub for life sciences entrepreneurship, both drug discovery companies as well as medical device companies. And Palm Beach County, on the other hand, is a rich treasure trove of early-stage money, angels, angel funds, family offices, and all sorts of other types of investors. I spend the bulk of my time representing ventures and venture capital financings, and an exceedingly large portion of that is early-stage stuff, including, you know, first-round financings, which is what we're going to talk about today. We've got a very diverse audience listening in to this webinar today from around the globe. I'm enthused about that, and a shout-out to the folks in Israel who have registered and joined us today. My wishes to all of you, of course, is that you're at home, you know, safe and sound, virus-free, and same goes for your friends and family. And we're all hoping very much that we get this situation under control and back to normal business sometime later this spring. The types of early-stage financings that we're gonna talk about today, particularly convertible debt financings, play a large role in certainly university tech transfer startups, as well as all other types of medical device and drug discovery startups. As you would imagine, over the course of the last 90 days, since the COVID-19 crisis has taken hold, there has been an enormous jump in the number of drug discovery and medical device startups all of whom are well-intentioned and designed to provide solutions, diagnostic, therapeutic, and otherwise, to the scourge that we're all experiencing. But just as in good times, the challenge is how do these startups get financed to address their business plans? Typically, Life sciences startups, as many as you know and have experienced, pursue federal government sources for grant funding. The two most popular sources at the federal level that I encounter on a weekly basis, if not daily basis, are the NIH and the DOD, which provide during good times and bad the bulk of the money for startups that have made it past the friends and family stage. However, you know, getting those monies from federal agencies is a time-consuming, cumbersome qualification and application process that just doesn't play well during this rush to solution because of COVID-19. Similarly, foundations, which provide a lot of money for startup life sciences ventures in the good times, suffer from those same administrative hassles. And in particular, disease-focused foundations are not truly geared up to, in a large way, to cover the COVID-19 crisis because that is, you know, sort of a new kid on the block and not a disease that has a foundation supporting it. SBA loans, as I wrote, as you can see on your slides, going under immense renovation in the last 60 days. But again, it's not an easy process. And as you read in the press these days, getting access to those loans, whether it's the EIDL loans or the PPP loans, has not worked as well as everybody hoped. But the traditional SBA lending process, because the SBA is slammed, you know, doing emergency things, is not working. And when you would talk about the PPP loans, which actually go through the banking system, it's worth noting that bank loans have never ever been a meaningful source of startup funding for the life sciences. And the reasons for that, of course, are that traditional bank lending requires collateral, often requires personal guarantees, and all sorts of things that the typical startup started by entrepreneurs who often are doing their first venture, you know, just can't accommodate. Not to mention the time-consuming aspect of that. So many newbies, you know, to the field anticipate that their first financing is going to involve an equity raise. If it's a limited liability company, it's an equity raise of units of beneficial ownership interest. If it's a corporation, most entrepreneurs hope that they can get away with the sale of common stock. Sometimes they're willing to create preferred stock. But the truth of the matter is, and speaking from deep, deep experience, securities offerings at the startup level of equity interests never work because that leads to a valuation discussion. Quite frankly, if you play in this sandbox, you'll know that that never works out well for the entrepreneurial company. The investors always want more of an equity interest than the entrepreneurial venture is willing to give up and vice versa. So those sorts of private placements rarely work at the early stage, which leads us to our primary topic for today. Conversation today, and that is that securities offerings of convertible debt interests are indeed the way to go. I would say that 99% of the seed financings that I'm involved with over the last decade have been structured as convertible debt offerings, and there's a great reason for that. These types of offerings are favored by all interested parties. Angels. And when I use that term, I particularly mean, you know, what we used to call the Lone Rangers, which are individual investors who either made money in the industry in which they are now looking to invest and want to help support that industry, or this is much more common, you know, simply made money the old-fashioned way doing whatever they did for a living and and now want to devote a portion of their portfolio to what I'll call risky ventures and are willing to invest in startups. Angel funds being the next category, incredible growth over the last decade in angel funds. I'll submit to you that they come in two primary flavors. One is the professionally managed angel funds which is a pool of money that comes together and hires a professional manager to make investment decisions for the fund versus the much more prevalent, and I would say almost in every community of any size in this country, the what I call the raise-your-hand funds, which are the types of angel funds that typically hold monthly meetings. Usually around happy hour, sometimes dinner, invite 2 or 3 or 4 entrepreneurs from the community to get up and show a slideshow and do a little dance and song for 10 minutes and hope that they impress people in the crowd. And some of these raise your hand funds truly are raise your hand funds where they ask people to raise their hands if they would like to invest $25,000, $50,000, $75,000, whatever, in the investment opportunity just presented to them. And the third booming area of investment capital for seed stage investment opportunities has been family offices. And as I mentioned at the outset, so many family offices are headquartered down in South Florida. These offices typically have a narrow focus tied to either some element of someone in the family, but they have become an enormously important source of early-stage funding for startups. So all those groups of investors favor convertible debt as well as the entrepreneurs. Investors favor convertible debt because, as the As the name indicates, it is a debt instrument, and these investors are essentially lenders, which means they are creditors. And creditors, as you know, are entitled to repayment of their funds before equity owners get repaid their funds in a liquidation, whatever sort of liquidation it may be. But these investors have, as well as the creditor status, the upside potential of conversion into equity securities if they like what they see. And we're going to talk about the types of conversion later on in the hour. But most investors, in fact, I would go so far as to say all investors who invest in convertible debt offerings do so hoping that this potential for conversion into equity securities comes to fruition. Entrepreneurs, on the other hand, favor convertible debt securities because they avoid that valuation war that I mentioned that is part and parcel of equity financings. They get the investment capital needed as loans, and there's no immediate relinquishment of equity ownership. That comes down the road upon conversion, but it is what those of us in the trade call happy conversion if it happens tied to what we're gonna learn about in a second is called a trigger financing. So what is convertible debt? Convertible debt, as mentioned, is in fact a loan that under certain circumstances may not have to be repaid. And that's because the principal, and usually, but not always, the accrued interest on that principal gets converted into equity securities. As I mentioned, for a limited liability company borrower, the issuer is, is in a position to issue units of beneficial ownership interest upon conversion of the debt. And for a corporation, the issuer will issue normally common stock upon conversion of the debt, occasionally preferred stock. That's one of those elements that comes down to leverage. And in these hard times of lots of startups chasing a smaller pool of money because of nervousness about the COVID-19 crisis, that leverage more than ever before is sitting in the hands of the investors, or as I've called them here in the convertible debt world, the lenders. What is the debt instrument? Like in straight debt, the loan underlying the convertible debt securities is evidenced by a promissory note. In my practice, the customary maturity for a seed stage financing and a convertible debt raise is 3 years. Lately, in 2019, I saw a bunch of 2, 1 and 2 years, but Typically, it's a 3-year note. It is typically unsecured, which means uncollateralized, so the lender is at complete risk with no security for the loss of the principal and the accruing interest. There is no backstop of a personal guarantee, which in reality for most entrepreneurs is sort of a a meaningless gesture anyway. Most entrepreneurs, especially for their first ventures, do not really have the personal net worth to make a personal guarantee meaningful. But that's OK because most lenders in these deals are not looking for that. And the repayment is customarily a balloon as to both principal and interest. So the lenders in a typical situation will wait 3 years for their principal to be repayable and the interest that is accruing along the way. The interest rate, in the last 12 months, most of the deals I've done, we've structured as prime plus 2 on the interest rate. But investors usually couldn't care less about the interest rate so long as it's north of 5, and rarely have I seen it north of 10. In the last several years. They don't care about the interest rate, nor do they care about the debt service, which is why most lenders are willing to play along with a balloon as to principal and interest. All these investors are taking the risk of lending their money to a startup, hoping and praying for conversion, which is where they're gonna get their significant return on their investment. The repayments for a seed stage financing, and you'll know I said 3 years is the typical maturity, normally involves the company taking on other debt either prior or along the way. And the standard convertible debt instrument will be subordinated to current and future debt obligations such as government agency loans. Here in the Research Triangle, the North Carolina Biotech Center does a brisk business of lending public-private money to North Carolina startups. And in every instance, those NC Biotech loans are senior to the debt provided by private investors in that convertible debt financing. So as I mentioned, conversion is the name of the game. Conversion comes in an automatic fashion, we're gonna talk about that first, and in a permissive conversion fashion, we're gonna talk about that second. The principal and the accrued interest will automatically be converted into equity in the event of an equity financing transaction or a sale of the company. The equity financing transaction, which is often called a trigger financing, is not big dollars. It's usually $1 to $3 million, usually, you know, closer to $3 in most instances. And what that means is that the company that secured— that obtained the convertible debt financing from a lender or a group of lenders at the seed stage. Oh, sorry, screen faded out. That company will then typically hit the capital markets soon enough again to advance its business mission. And if that company is able to attract venture capital investments of, say, in the hypothetical, $3 million, then the lender's money at the seed stage will automatically convert into equity securities upon the closing of that venture capital financing. And why is this attractive to the seed stage lenders? Because the conversion comes at a rather deep discount versus what the venture capital company is gonna pay in the trigger financing. I do a lot of deals where it's a 15% haircut. You know, that's the jargon that we use for the discounts. And a lot of deals where we do a 20% discount. For example, if NewCo, raises $1 million in its seed stage convertible debt financing and takes that capital and puts it to good productive use such that 2 years down the road, it is attractive to a venture capital company to come in and put in $5 million, the lenders have their principal and accrued interest. And let's say the venture capital round is priced at a buck a share. The lenders have their principal and accrued interest convert into equity at 80 cents or 85 cents per share. So those lenders are thrilled. They become equity owners in what is now a well-financed venture. The entrepreneur is thrilled because his or her venture is now well-funded and essentially the left side of the balance sheet is cleaned up, the company becomes debt-free if that was the only debt on the books. And the venture capital company funding, as in my hypothetical, the $5 million venture round, is pleased that the angels assumed the large risk of the startup. Because those of us in the game, you know, will tell you that since 2000, venture capital companies have essentially been out of the startup business and are willing to stand by and let the angel community and certainly the family office community do the, you know, the high-risk funding. And therefore these VCs don't mind the haircut that the angels receive in the conversion. Now typically this event that triggers automatic conversion will also trigger a structural change if the startup is structured as a limited liability company. And that's because most venture capital companies insist on the corporation structure so that the VCs can receive preferred stock for their, in my hypothetical, $5 million first venture raise, first venture round. However, the conversion of the convertible debt will normally not result in the issuance of preferred stock, which is what the VCs are getting in the trigger financing, but rather common stock. This again is one of those things, and we're gonna talk a little bit about that more in just a second, that comes down to leverage. Used to be, I'd say 7, 8, 9, 10 years ago, 10 years ago that the conversion of the convertible debt resulted in the issuance of the very same securities that the VCs were acquiring with their larger investments. But that's winnowed down over the course of the last 6, 7 years to standard form, at least here in the Southeast, that common stock gets issued upon conversion and not preferred stock. In other words, the VCs like their Series A preferred stock to stand alone as representative of their money and not the money that came in months or years before. Automatic conversion also happens if the company happens to be acquired, and the same haircut applies. If the acquisition price, again, is a buck a share, these lenders at the seed stage get to convert it at the 80% or 85%, meaning 85 cents a share. Before they cash out in the event of the sale of the company. The other type of conversion that attaches to convertible debt is what I refer to, I think most people refer to, as permissive conversion. Let's say the venture takes in $1 million in convertible debt financing and is unsuccessful for whatever reason in effecting a trigger financing after a year or two. In the normal scenario, the lender can compel the conversion process by having the venture go out to obtain an independent enterprise valuation from, from an appraiser, typically an investment bank. And then if the note holder approves of the valuation, it can then convert its debt, again principal plus any accrued interest, into equity securities, typically common stock, at the same discount as if there had been a triggered automatic conversion. Whether or not the equity financing transaction can occur after 1 or 2 years is another matter. Negotiation. 2 years is the typical, especially with a 3-year note. The securities laws, federal and state, apply to everything that we're talking about here. Even though it's the issuance of debt in a convertible debt financing, that still falls under the umbrella of coverage of federal and state securities laws. And what does that mean for the issuer or clients? It means that full disclosure must be provided to the investor group before the deal can be consummated. And of course, public offering prohibitions apply. No general solicitation, no advertising, just as in a private placement of equity securities. So it is prudent to have your clients who are conducting a convertible debt financing prepare a business plan in some format. Many entrepreneurs, you know, suffice it to get away with an executive summary plus access as their disclosure mechanism. I try and encourage my clients to do the traditional narrative-style business plan or or full-blown executive summary. Many entrepreneurs, especially the younger ones, simply like to get away with just a slide deck. It all comes down to, you know, what is considered, you know, full disclosure. Sometimes an executive summary and a slide deck suffices because the company is so young, there's not a whole lot of material to populate a typical 20-page business plan. In any event, the know-your-customer rules apply, and therefore it is critical to try your hardest to limit the offering, even at the convertible debt seed stage, to accredited investors. Nothing has changed in the world in the last 20 years in terms of how judges view litigation against issuers who take in money from non-accredited investors. Accredited investors, in other words, are pretty much left to fend for themselves in litigation as being capable of having the wherewithal to check out the bona fides of the venture that they are invested in, that they are investing in. And that does not apply to non-accredited investors. So as I said, at a minimum, try to encourage your client entrepreneurs to provide access to the angels, angel funds, and family offices who are being approached to invest in the convertible debt at the seed stage. Questions and answers in a written format are becoming more and more common. So what are the transaction documents? It's very simple. Again, if there's a private placement memorandum, which is a rarity, you know, that's, that's a wonderful thing. That's certainly full disclosure. Most issuers don't want to go to the time and expense of preparing a PPM, so it normally is just a business plan, but As I said, a company executive summary or a slide deck. But in terms of the debt aspect of the offering, the most important document is the convertible promissory note purchase agreement. I'm going to make available to you, and you can simply ask Nick for this when you reply to his email tomorrow, to send the sample convertible promissory note purchase agreement and other sample documents that I'm going to talk about in the next few minutes to you if you wish. The sample documents that I chose for today's talk reflects a $1 million financing. However, it's coming, if at all, to the entrepreneurial venture in tranches of $250,000 each. Not typical in my experience. Normally, I don't see tranche seed stage investments for offerings under $1 million. But this one, this deal that comes from a transaction that I handled earlier this year was extremely pro-lender transaction. So the angel, single angel in that case, tranch the deal. Not only did he tranche the deal, but he insisted on a first priority security interest in the issuer's assets, a blanket lien, first priority lien on all of its assets. Very rare, but, you know, again, comes down to leverage, and this lender insists upon it, and therefore got it. In order to part with the million dollars, he insisted on getting a UCC-1 filed on a first priority basis. Automatic conversion in the sample documents, note purchase agreement, provided that the company had to give the investor 14 days prior notice of a triggering event. And the note holder is given the option in that 14-day notice period to opt out of the automatic conversion. This is an uncommon provision. Normally automatic truly means automatic and the company calls the shots. But in the sample documents that you're gonna see, you know, should you choose to get it, you're gonna see that the investor had that 14 days prior notice period to decide to be cashed out at the closing rather than take common stock at the closing. As part of the automatic conversion. In addition, the lender negotiated for and received— we're going to talk about caps and floors— received a cap on what would happen in the event of a trigger financing that valued the venture above a certain level. In this case, in the sample, it was a $6 million cap, which means that no matter what the venture capital company that does the trigger financing uses as an enterprise valuation, which could be north of $6 million, whether in 1 or 2 or 3 years, the conversion for the seed stage lenders would be based on a $6 million valuation. Very pro-lender provision. Now, the sample document also addresses permissive conversion with a couple of twists. Again, the note holder, you know, drives permissive conversion by compelling an enterprise valuation. And you'll recall I said that normally that happens after 1 or 2 years. In the sample document, it can happen at any time. The likelihood of that happening in the first 6 months of the venture's life is minuscule, but the lender built in for itself a complete latitude on timing to compel evaluation. And again, we talked about caps and floors. The lender in the sample transaction document built in protection so that if that lender compels the company to go get a valuation and the valuation is low, the note holder in any event gets at least a 15% equity stake upon conversion. But he did agree that so long as all of the tranches, the full $1 million loan gets completed. The convertible promissory note agreement also has the customary representations and warranties that you would see in any investment transaction. Really no need to go into them because they pretty much mimic what you see in most subscription agreements or other types of investment agreements, you know, for later-stage deals as well as other types of early-stage deals. But in this particular, in the sample document situation, the tranches were not automatic. Remember I said it was a $1 million investment broken into 4 tranches of $250,000. This lender built into the deal that tranche number 2, the second hit of a quarter million dollars, only gets paid if their venture goes out and raises $875,000 by this June 30th. This is a January 2020 deal. Looks like that's going to happen, by the way. The third tranche in the sample documents, the third hit of $250,000 will be paid in if the venture enters into contracts that guarantee or at least have a commitment that the venture is making at least $100,000 per month by July 31st. That milestone has already been reached. The fourth tranche, the fourth hit of a quarter million dollars will, will get paid in if the venture raises $3 million of investment capital and hires the note holder on a consulting basis. And the consulting agreement had certain bells and whistles attached to it. By September 30th. Unknown whether the venture will be able to do that. Now, this particular company that you'll see in the sample document had some outstanding securities that were redeemable in both directions, redeemable by the company if X, Y, or Z happened, and redeemable by the investor if A, B, or C happened. So this lender built into the convertible promissory note purchase agreement a negative covenant that while the convertible promissory note is outstanding, the venture may not redeem any equity securities. And the venture went ahead and got sign-offs by the holders of its other outstanding securities to that provision. As you'll typically see, a lender in a convertible debt financing wants to be represented on the board of directors, or if it's a limited liability company, on the board of managers. The sample document does deal with a limited liability company, so this particular note holder did get a seat on the board of managers and capped the number of seats on the board of managers at 4. So his voice would be 1 out of 4. And this, that will continue so long as the convertible promissory note is still outstanding. The convertible promissory note purchase agreement also provides that the company purchase and maintain in place a $500,000 key man life insurance policy on the founder, the entrepreneur, to remain in place so long as the note is outstanding, and similarly impose a requirement that the venture purchased and maintain a $1 million errors and omissions policy applicable to the officers and the managers, again, to remain in effect for so long as the convertible promissory note remains outstanding. Attached as Exhibit A to the convertible promissory note purchase agreement that you'll receive if you wish, is the convertible promissory note itself. You'll see that the trigger financing in that particular deal was set at $3 million, which, as I mentioned, is very typical for deals that I've been working on for the last couple of years. Atypical is that the note is secured by that first priority lien that I mentioned on all the venture's assets. That did not pose a problem in this instance, but you can guess that it could pose a problem in certain other instances. But at least subordination can be in effect if there's other government loans in a typical venture's portfolio. And you'll see that there is no prepayment option. Lenders protect against this. Because they don't want the company to be able to take in their money and quickly repay it if a better deal comes along. And this is usually not an issue because the trigger financing normally covers this luxury. As in all securities offerings, as I mentioned before, it's important that the venture knows the customer. And so one of the deal documents is an investor qualification questionnaire. This is your client's backstop to assure that the investors are accredited. And I can't overemphasize the importance of making sure that these questionnaires are fully completed and signed before the venture accepts the money as investment capital. Now, in this particular sample set of documents that I'm providing, there was a twist that, very rare but smart, this particular investor built a portion of the total investments, which had been negotiated as $1,300,000, he built He subdivided that into two streams. One is the $1 million of convertible debt securities that he was acquiring, and the other was a line of credit that he would make available to the company to hedge the risk. By moving $300,000 from the risk of total loss in a convertible debt security into a credit facility gave the lender some comforts. The maturity for the line of credit is 1 year as opposed to 3 years for the convertible debt financing. The interest rate is considerably greater. It's a fixed 10% per annum, which you all know is quite a bit more than prime plus 2. The debt service on the convertible debt financing is structured as a balloon, which means the interest is payable at the 3-year maturity of the principal, but in the line of credit agreements, the debt service is monthly, so it's a higher interest rate and it's payable monthly. Lastly, the line of credit promissory note, and it's of course a promissory note that evidences the credit facility in the line of credit transaction, just the way a convertible promissory note evidences the obligation in the debt financing. This one is personally guaranteed, so the entrepreneur's attention perks up because the entrepreneur is personally liable on the line of credit agreements. So like most transactions, investors have the leverage, especially in the life sciences world, especially during these hard times, you know, the COVID-19 crisis. And that's because returns in the world of life sciences are many years out, if ever, you know, far different than investing in information technology ventures. Nonetheless, a hit can be a huge one. There's been a lot of activity in the last couple of years in the public offering space for biotech ventures. That's what all these investors are hoping for. There's been a lot of acquisitions in the biotech world and the medical device world in the last 2 years. That's another thing that all of these seed stage investors are hoping for. And quite frankly, I'm happy to tell you in my experience, which is extensive, many seed investors who invest in life sciences ventures at the seed level are not investing solely for the financial return. I see more and more just like in the foundation space and just like in the NIH space and the DOD space, they truly weren't wanting to do something good for the world. And I'm happy to say I'm seeing that quite a bit in investors coming out of the woodwork to support these COVID-19 ventures that are popping up, especially here where I sit in the Research Triangle. So that's everything that I wanted to put on the table. I'd be more than happy to field any questions. Nick, if there are questions, please let me know and I'll do my best to answer them.

I don't see any questions in the Q&A tab. If any of you do have questions, go ahead and type them in now and Mark will address them. If not, while people are typing, just a reminder, tomorrow Tomorrow you get a follow-up email with a way to respond— sorry, excuse me, something in my throat— with a way to respond with your bar number, and then you'll be emailed the certificate. It will also have a link to these slides as well as a video copy of this presentation. And then also, if you have any questions, it will have Mark's information as well. So that'll be coming out tomorrow. Tomorrow sometime. So if you don't receive it, you know, check your spam folders or anything like that. With that, I just answered that question in the questions comment. It was about the copy of the slides. With that, I think everything is done unless, Mark, you have anything else to say. Otherwise—

Nope. My phone number and email address are on the first slide if anybody would like to talk to me offline, by all means, reach out to me via email or phone, and I'd be happy to talk the thing— talk things over with you.

Perfect. Thank you all for attending. Feel free to check out our website for future CLE events. We're holding one every Tuesday and Thursday through May. Thank you all, and have a great day.