Financing to Clinical Trials

04 November 2001

Neil Blundell

It is not possible to fund pre-clinical research and development through the public markets. This is an oversimplification of course and not applicable to those companies already publicly quoted. However, how does a pharmaceutical or biotechnology company get to IPO?

The hurdle facing such companies is that they are generally not eligible to raise money on a public market until certain milestones are met. Such milestones are either express or implicit and vary from market to market. For example, one of the criteria for admission to the Official List of the London Stock Exchange is that there must be at least two drugs undergoing clinical trial. New rules currently proposed will require significant progress on clinical development, rather than clinical trials. There are no express criteria in relation to AIM but clearly financial institutions will expect certain milestones in product development to have been achieved.

It typically takes eight to nine years to fund a drug through to product launch with a cost per drug of some £10 million to £20 million. Pre-clinical research constitutes a not insignificant portion of this. As the public markets are unavailable to new companies for these purposes, alternative sources of funding need to be sought.

One option is to seek investment from established pharmaceutical companies. Although there might initially be strategic benefits in this, it can become problematic especially when drug development has reached Phases Two and Three and the pharma is one the company's potential licensees. Under such circumstances, any significant investment (say more than 5 per cent) can lead to conflicts of interest and hamper the company's licensing strategy.

The alternatives to a strategic funding include venture capital or private placings with institutional shareholders. An institutional placing is more likely to be appropriate on a pre-IPO funding and may not always be possible in funding rounds prior to that stage. Venture capital is therefore often the most common way of funding the company through its various developmental stages prior to its final run up to IPO.

The current private equity market

The European Private Equity and Venture Capital Association has reported that last year record levels of money were raised for European private equity and venture capital funds. In all, a total of US$40.9 billion (EUR 48 billion) was raised.

Much of this money has not yet been invested since the global economic slow down has made investors much more cautious. Significant amounts are also being held back for late stage investment to support existing businesses. Nevertheless, valuations have fallen considerably and some predict that investment could return to 1999 levels. The only certainty is that whereas in recent years funds scattered their investments widely on the basis that at least one investment was likely to show high growth and therefore compensate for those which failed, the reduced growth potential of many businesses in the current market is changing the investment criteria. Funds are much more careful in making their investment decisions and due diligence is more thorough.

Identifying the right investors

This in itself presents potential difficulties for companies wishing to raise finance. There are now over 800 registered members of the EVCA. A large number of US players have also set up offices in the UK as well as in continental Europe to take advantage of opportunities here. The vast majority of these, however, will not necessarily have the expertise or desire to invest in lifesciences. As a result, a very much smaller group of more specialised investors is emerging who have the industry knowledge and understanding to support companies in the sector through the long-term development of their products.

Selecting the right shortlist of potential investors is therefore very important if critical time is not to be wasted in lengthy discussions with the wrong people. Advice should be taken at an early stage from industry sources in order to identify the most appropriate shortlist of investors to approach. Exploiting the knowledge of your other advisers, including lawyers, accountants or corporate finance advisers, can be very worthwhile. In particular, an introduction through a trusted professional will often be taken more seriously by investors.


In an industry where the protection of intellectual property rights and confidential information is so important, it comes as some surprise to many that venture capitalists have become increasingly reluctant to sign non-disclosure agreements. Whilst legally this may not be ideal, in practice NDA's can be of limited use. Whether or not an NDA exists the best way to protect confidential information is to disclose it only to a very narrow group of people and carefully restrict the amount of information that is disclosed at each relevant stage. Identification of the appropriate investors is part of this: a well-selected shortlist will limit the number of people to whom the initial business plan will need to be disclosed. In addition, most investors do not necessarily want to see a full business plan at the outset. A few well-structured pages may be sufficient to enable the investor to assess whether the investment opportunity is of interest to them.


If matters do progress, some investors may require a period exclusivity so that they are not competing with other investors and risking money and time should another investor move faster or offer better terms. Granting exclusivity may not be an issue (provided that the period is sufficiently short) if the company has allowed enough time for the funding process. Where exclusivity can be problematic is in the situation where the company desperately needs the money and does not want to tie itself exclusively to one investor who may let it down at the last minute. This is clearly not a position any company would want to find itself in, not least because time pressure will almost always work against the company and the existing shareholders in negotiating the terms of any investment.

Managing the funding process

It is currently taking up to six months (and sometimes longer) from shortlist to completion and the time consuming nature of this process cannot be underestimated. It is important that the process itself does not distract management too much away from developing the business.

Good organisation is key both in terms of allowing enough time but also in preparing for the due diligence, financial and legal, which any investor will carry out. A company and its management team will benefit greatly if there is an understanding from the outset that every aspect of the business will be scrutinised in great detail. Good business practices should be adopted from day one. Not only will a well-run company, with proper records, present a good impression but management time in answering the investors' questions will be greatly reduced, as will advisers' fees. Warranty liability (see below) will also be less of a risk if the company has always been well run. Taking early advice on key issues, such as the protection of intellectual property rights, terms of employment and corporate records will pay off in the future.

Founder/management liability

Founder shareholders and key members of the management team must expect at some stage in any funding to be asked to give personal warranties to the investors. These warranties will cover all aspects of the company's business. The personal liability attaching to these warranties will be limited by negotiation with the investors, but the investors will be keen to ensure that the potential liability is sufficiently painful for the management to take their responsibilities seriously. Warranty insurance can be obtained, but at a price. Although there are now more streamlined products on the market, the insurers may also require their own due diligence to be carried out which can extend the time involved in securing the funding. Looking forward to flotation, similar warranties will also be required from the directors and individual founder shareholders, although it is unusual for financial investors to be prepared to give warranties at this stage relating to the underlying business.

One of the key warranties will relate to the business plan. It is generally accepted that management cannot be asked to warrant the future performance of the business. However, investors will want to know that the business plan on which they have based their investment decision has been honestly and carefully prepared and that the statements of fact contained in it are correct (or at least were correct when made). Given that very few early stage businesses ever follow their business plan closely, the precise scope and drafting of the warranties relating to it need to be very carefully scrutinised.

Investors often also ask for undertakings from key shareholders and management that they will run the business in accordance with the business plan. These commitments need to be very carefully considered since they are another source of potential liability, especially if tied to default provisions which entitle the investors to take founders' shares away from them if they are in breach.

Investor requirements

If money is being raised from venture capitalists, there is something approaching a "market standard" in terms of what is currently required. The investors will typically seek shares with preferential rights on a sale or liquidation. The shares may also protect the investors against subsequent funding rounds at a lower price with the effect that their percentage shareholding may increase to reduce the average price per share paid by them. The priority nature of investors' rights was originally driven by tax requirements of US funds but it seems to have been adopted as common practice in Europe. Institutional placings may not have such rights attached although this very much depends on the existing shareholder base, the stage of the company's development and the nature of the institutions participating in the placing.

On the assumption that most investors will be minority shareholders, they will want approval rights over a wide range of decisions. There is a balance to be struck between allowing the management sufficient leeway to run the business and protecting the investors' interests. To the extent that the business plan and budgets are approved by investors, it is common for approvals only to be required if decisions are taken which are inconsistent with such plans. This probably works better in the later development stages of a company where it is more likely to adhere to its plans and budgets. In the early days, there can be very dramatic deviation as markets change and products evolve in different ways and too much reliance can be placed on such provisions. At the end of the day, it is not unreasonable for investors to require such approval. The key issue for management is therefore whether they have chosen an investor who shares their own strategic ambition and outlook.

In theory, the one veto that any company should resist is its ability to raise further capital. It is arguable that even straightforward pre-emption rights over the new issue of shares, whereby existing investors get to maintain their existing shareholdings, limit the company's ability to attract further investment from the market. It can also depress the price at which the company can seek further funding, since it prevents the company from creating competition for its shares. In practice, of course, it is unlikely that any investor would be prepared to give up this right. Management should therefore understand what the investors' attitude to future funding rounds is and to discuss with them in some detail prior to completion how future financing will be managed. If there is a sufficiently clear understanding, notwithstanding that the investor may have an absolute veto over the process, it is often worth reciting in the investment documents what the intention of the parties is for the next stages. Whilst this does not create a binding obligation, should personalities change within the investor, there is at least some formal record of the understanding on which the relationship was based.

Management issues

The board structure is obviously important. Typically, an investor will want at least one director on the board. Some investors take an active role, while others are more passive. It is probably a matter of preference as to which type of relationship the company wants. However, with a view to an IPO, it is becoming increasingly more common for board structures at the private equity stage to reflect the best practice standards for corporate governance. Investors may therefore require a remuneration committee to be established and for one or more non-executive directors to be appointed. The latter can be very beneficial to a company both in terms of establishing the disciplines that will be required going forward but also in developing relationships in the industry and/or the wider investment community. The remuneration committee will normally deal with the grant of share options within a pre-agreed option pool which is typically 10 per cent to 15 per cent of the company's equity and will also deal with the compensation of key executives and scientists. It is much less usual for audit committees and nomination committees to be established in a private equity round, although not unheard of in the context of a large institutional placing pre-IPO.

Investors will also wish to establish efficient management incentive plans. Looking ahead, one of the key benefits of an IPO is the company's ability to offer publicly tradable shares to its employees. Giving employees an early stake is therefore of fundamental importance. The range of such options is properly the subject of a separate chapter and professional advice needs to be sought as to the most suitable structure. This can be time consuming. It is generally therefore better to agree that a pool of equity will be set aside for such arrangements but to leave the detailed finalisation and adoption of any scheme until after completion.

The exit

Finally, of course, there needs to be some recognition as to the likely exit. Where private equity is raised from financial investors, there should generally be a community of interest between the investors and the founders about an exit strategy which for present purposes we are assuming will be an IPO. However, companies (and co-investors) should be conscious of potential competing interests such as a strategic investor who may have a very different agenda in relation to an exit. Whilst it is theoretically possible to provide for a wide range of scenarios in the legal documentation, there are so many uncertainties as to when and what might happen to a company that it is generally better to keep things simple. However, a statement of intention as to the end result, eg an IPO within a specified period, can be useful.

Lessons learned

Once completion has taken place, everyone hopes earnestly that the legal documentation will never need to be looked at again save perhaps prior to IPO. Matters arising from due diligence, however, can sometimes provide a useful health check. From both the company's and the investors" perspective, it is often useful to have a schedule in the investment agreement setting out actions which need to be taken after completion, including tidying up any loose ends in relation to intellectual property rights. This again will prove worthwhile when it comes to the IPO process.

First published in techMARK mediscienceTM manual 2001.