An important funding structure for new ventures that likely merits more active consideration is so-called “structured exits.” Rather than relying solely on the upside from an exit, structured exits can rely on the venture’s anticipated cash flow, or percentage of milestone payments, to repay the investor. They also support a win-win scenario: For investors, they can offer reduced risk with the possibility of an upside; for ventures, they provide a new source of growth capital and less dilution.
For life-sciences companies caught in the “death valley” between seed grants and venture capital eligibility, structured exits – carefully adapted and applied – can be a new alternative or complement to bridge loans, incubators, strategic investors, and non-dilutive funding from government sources. It is therefore specifically relevant to ventures seeking to advance to a fundable stage, often with profound technology solutions that are just difficult to understand without time and capital to support their further development.
Attorney David Gitlin, Partner at Royer Cooper Cohen Braunfeld LLC, is one of the world’s leading experts on structured exits, and I recently had the opportunity to speak with him about alternative permutations.
In the first type of structured exit, preferred by Gitlin, periodic mandatory redemptions of all or a portion of the investor’s shares are tied typically to the cash flow of the company with the return to the investor capped, based on a multiple of the original investment. For most early-stage life science companies that are not expected to generate cash flow before an exit, the redemption payments can be based on a percentage of milestone, development or licensing payments. While this is somewhat “unorthodox,” as Gitlin notes, it uniquely adapts the benefits of the financial structure to the needs and opportunities of the venture and provides a previously unavailable source of capital. In the U.S., redemptions are typically taxed as capital gains rather than ordinary income.
Another alternative structure includes demand dividends that can similarly be tied to the business’s cash flow or milestone payments but the return not be capped. In other words, dividends can continue indefinitely without redeeming the investor’s equity (i.e., until the business is sold or there are no longer any cash flows) or, if capped, repaid at a progressive multiple that increases over time. While this may not clearly be the preferred solution for a company seeking to reinvest for growth, it does provide the benefit of upside to an investor and can be considered part of a careful negotiation.
A third alternative – a cash-flow based loan – is similar to demand dividends but provides greater security since the investor is a lender rather than an equity holder. However, the interest payments to the investor are taxed in the U.S. at ordinary income rates, and payments are then deductible by the company.
In addition, for investors interested in exploring structured exits, specifically in the aforementioned life sciences companies, there is substantial opportunity to gain equity kickers in the form of warrants.
Exit warrants, for example, allocate a percent of the original investment as the purchase price for a warrant that grants the investor the right to purchase a percentage of the company or set number of shares for nominal consideration. The warrant can also be structured as a right to purchase shares in the investee at an exercise price equal to the fair market value of those shares on the investment date. The warrants would become exercisable upon an exit thereby giving the investor additional returns. If the exit warrant is denominated in shares, additional issuances upon funding will dilute the warrant holder; if on the other hand the exit warrant is denominated in percentage ownership, additional funding will not result in dilution to the warrant holder.
The point is that by providing a structure that helps guarantee a return and has the promise of upside, structured exits – in between seed and full-fledged venture capital – can help bring an important new alternative to the market. They can provide needed capital for companies that might not otherwise generate angel or VC interest and help them bring about clinical innovation, as they face the many challenges posed by regulatory compliance, changing technology, rising costs, and new operating models.
Dr. Leslie E. Mitts is an anthropologist, entrepreneurship professor, and venture investor. In these roles, she combines practice with theory to teach and drive innovation for emerging technology companies. Dr. Mitts most recently built and led for nearly 15 years the high-growth entrepreneurship practice at the Wharton School. She is also former CEO of EDSi, a Fund whose mission is to incubate and invest in education technology ventures globally. Dr. Mitts earned her undergraduate degree at Bryn Mawr College and Harvard-Radcliffe College, her MBA at the Wharton School, and her Ph.D. in Anthropology at the University of Pennsylvania. She currently lives and works in Tel Aviv.
David Gitlin is a Partner at Royer Cooper Cohen and Braunfeld LLC. He has handled more than 250 M&A transactions, including over 100 cross-border transactions involving 18 different countries. He has Handled close to 100 “exits”, including those of venture backed and multi-generational companies. For the past 12 years, he has been ranked by Chambers and Partners International as a leading M&A lawyer. He is a frequent speaker on the M&A process, negotiating techniques and bridging cultural gaps in cross-border transactions. He is Former Chair of Corporate Practice and Co-Chair of Emerging Growth Practice at major US and international law firms, and is recipient of an award from the Mayors of Tel Aviv and Philadelphia for promoting business ties between the two cities. He works from Tel Aviv approximately 8 weeks per year.