DTx Pharma’s FALCON™ SOARS to NOVARTIS ACQUISITION
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This is a condensed version of a case study we provided to our investors.
Case study of an ExSight portfolio company exit
On Monday, July 17, 2023, DTx Pharma announced that it was being acquired by Novartis. We posted a congratulatory note to the team, including CEO and founder Artie Suckow, former COO and early investor Jeff Friedman, and Cam Gallagher. The credit is to the team for accomplishing a significant milestone as they joined forces with Novartis, a global pharmaceutical industry with capable resources to bring DTx’s work to patients and ultimately realize the technology’s promise.
VCs are criticized for taking too much credit when companies succeed and quickly deleting references to failures. We aim to stay off the excellent VCs Congratulating Themselves (@VCbrags) Twitter/X. That said, exits are the currency that venture investors (LPs) need to see to invest with us. In part, LPs judge venture firms against their peers by measuring the ratio of distributions to paid-in capital (DPI). While early-stage investing is by nature a long game where exits can take many years to develop, you need to return capital to your investors at some point. While ExSight had one prior exit (RetroSense) in 2016, the DTx exit is the first time we have had a liquidity event on behalf of our investors.
DTx provides an instructive case study by which to revisit our investment strategy and thesis. We will look at our experience with DTx through several steps of the typical VC investment process.
Deal Sourcing and Origination
Initial Screening
Due Diligence
Deal Structure and Terms
Investment Committee Approval and Investment
Post Investment Support
Monitoring and Reporting
Exit Strategy
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Deal Sourcing and Origination
Venture capital is highly competitive, with many firms and investors actively seeking the best investment opportunities. VCs build deal flow through networking, industry event attendance, thought leadership, entrepreneur submissions, and relationships with other investors, accelerators, and incubators. Co-investor relationships can be fruitful, particularly when both parties have shared a previous co-investment. Each investment is a multi-dimensional, dynamic group of connections.
Shared co-investments are a great way to learn what each party brings to the table, e.g., thorough diligence, ability to lead later rounds, introductions to strategic relationships, or value-add expertise. The goal is to provide these many resources to each portfolio company. Startups are incredibly challenging; the more parties providing value add experience, the better. Additionally, introductions from other investors are a meaningful screen with low-quality introductions leading to lost credibility. Consequently, introductions from previous co-investors are one of the best sources of deal flow, both for the investor and the entrepreneur.
In this way, we were first introduced to Artie on June 14, 2017, by Cam Gallagher. Cam was a board member and Chief Business Officer at RetroSense Therapeutics (acquired by Allergan), ExSight's first investment. Cam knew us for our particular interest in ophthalmology opportunities. Though a platform technology, DTx's initial focus was ophthalmology, wet-AMD. In this instance, our deep domain expertise and investment strategy were the reason for the introduction despite our minimal check-writing ability.
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Initial Screening
Even after a warm introduction from a knowledgeable contact and co-investor, VC firms conduct an initial screening to assess if the startup aligns with their investment thesis and criteria. This phase often involves quickly reviewing the business model, market potential, team, and other vital factors. Though we focus on early-stage ophthalmology, only some companies that fit that criterion pass our first review.
Often these companies fail for one of the following reasons:
Lack of novelty: While we may be interested in the underlying promise of a specific opportunity, there may be a dozen other companies with competing technology. Each technology must be differentiated to pass our first review.
Transformative technology: our investment strategy relies on any single investment's ability to return the fund, where one investment will return the total amount committed by that fund's investors. Consequently, the technologies we invest in need to be genuinely transformative to justify that type of return.
ExSight's initial screening process typically entails an introduction, the company providing some non-confidential written materials (so we can make sure it passes the novelty and transformative tests), an initial call with one of the team members, and short notes from each of us to our deal flow database. We typically filter each opportunity through our investment thesis as part of our initial screen.
Our thesis states in part, "The eye's unique anatomic features make it an ideal proving ground for breakthrough technologies. The eye is easily accessible, facilitating the testing of novel treatments…The retina is a model for diagnosing and treating the central nervous system because it is part of the brain." In one of our first internal notes about DTx, Michael stated, "DTx is [a good fit] since they hope to prove their concepts using 'local' treatment of the eye due to its 'unique anatomic sequestration' (also possibly local treatment to the CNS)."
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Due Diligence
Due diligence is a comprehensive investigation into the startup's business, technology, market, financials, legal aspects, etc. Due diligence helps identify potential risks and opportunities associated with the investment. In the case of early-stage life science companies, there is typically only foundational science to analyze.
The process typically includes meetings with the startup's founders and advisors, rigorous analysis of the science, market analysis (e.g., patient population, reimbursement), regulatory and intellectual property considerations, clinical development strategy, financial analysis, operational capabilities, manufacturing feasibility, risks, and mitigation strategies, and an exploration of various exit strategies.
ExSight's early-stage focus on biopharma opportunities means there are often limited pre-clinal studies and publications for our scientific and technical review. Accordingly, we look for other signs of progress and typically follow companies for months and years before we make an initial investment. This review period allows us to get to know the founders and watch as they meet (or miss) their milestones. We place a high value on two critical milestones: the ability to attract top talent and win non-dilutive funding awards. These are essential validating factors for technologies often many years away from clinical trials and even further from Phase 3 approval.
We engaged with DTx early in the company's history, even before their first financing. Engaging early on allows us to watch the company progress. In this case, DTx was accepted into JLABS (Johnson & Johnson Innovation's global life science incubator network). Incubators like JLABS serve a vital role in the life science ecosystem by vetting companies and providing them access to expensive lab space and equipment, networking opportunities, pitch practice, and investor introductions. These incubators also lessen the cost burden by removing the need to rent and build out expensive lab space. DTx company continued to expand its IP estate during this time.
Artie was also able to engage other investors and advisors during this time. Jeff Friedman, then with TechCoast Angels, invested and joined the company as an advisor. We knew Jeff as he was also involved with RetroSense (it's a small world!). TechCoast Angels ended up backing DTx's seed round.
This initial diligence process extended for over a year, allowing us to observe the company's ability to execute, de-risk, and gain traction. Reviewing our many notes during the period makes clear that the company was politely persistent with their updates and outreach while patient with our diligence process. Ultimately, we passed on the seed round because we were between funds, and it was still very early relative to other opportunities we were pursuing. In hindsight, we missed out on an even bigger win by not participating here. Hindsight is 20/20, and it was the right decision for our investors at the time. Nonetheless, Artie and Jeff (who had joined as COO, further validating the company's promise) were understanding and stayed in touch, continuing to share updates and facilitate our extended diligence process.
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Deal Structure and Terms
The terms of the investment are negotiated and determined upon successful completion of the diligence process. These terms include the valuation of the company, the amount of funding to be provided, the portion of the company the VC is purchasing, and any additional terms such as board representation, liquidation preferences, and protective provisions. The investment round's lead investor negotiates these terms.
In our case, we could not lead the Seed or Series A rounds with DTx and could only decide if the terms fit our investment parameters and goals. The typical fundraising for biopharma follows a reasonably predictable pathway. The standard financing pathway for venture-backed biopharma companies involves several rounds of funding, each with (hopefully) increasing valuations and varying amounts of equity sold to investors. Seed rounds typically fund early-stage development, often advancing proof of concept and initial research. Funding seed rounds via convertible note or SAFE is standard, where the instrument will convert into subsequent financing at a discount. Valuations are typically in the single or low double-digit millions with wide variance in the percentage of the company sold.
Median valuations serve as an essential benchmark for investors and companies. Silicon Valley Bank's recent mid-year report tracked the Median Seed/Series A Valuations and Deal Size.
Source: SVB.com, Healthcare Investments and Exits: Mid-Year 2023 Update
Silicon Valley Bank's recent mid-year report tracked the Median Seed/Series A Valuations and Deal Size. The implication based on the H1 2023 median pre-money valuation of $12M with a deal size of $8M is that the company sold 60% of the equity in a Series A financing. SVB added, “Investors are looking for Series A candidates that can draw lines between palatable valuation, runway through meaningful inflection milestones, and realistic exit prospects that do not rely upon the IPO window opening in the next 12-18 months.”
The DTx rounds were attractively valued and relatively standard. Straightforward terms are more manageable for VCs to process because they model their portfolios based on these assumptions. DTx raised $2 million in convertible notes that converted at a 20% discount to the Series A price per share. In other words, the convertible note purchased Series A shares for 20% less than the Series A per share price.
The goal of each financing is to develop data and advance the program to a point at which additional investors will gain interest and invest at an increased valuation. Again, DTx Series A milestones were fairly common for this stage of development and included:
Advance 2 candidates up to IND-enabling studies
De-risk technology in higher species (NHP) for local and systemic applications
Close pharmaceutical partnerships
Others: hire key people, move more quickly, and expand infrastructure to support partnerships.
ExSight looks for companies that are sufficiently capitalized to hit these milestones while leaving enough meat on the bone to keep founders and executive teams motivated in the financial outcome. Finally, we will also look to the post-money valuation to ensure companies can raise future financings at a stepped-up valuation if they hit the milestones. Step-ups minimize the dilutive impact of future capital raises on founders and investors.
While valuation and runway rightfully take up the lion’s share of the discussion of terms, there are plenty of other terms that comprise a standard term sheet. Many volumes and full blog posts have been dedicated to the topic, so we will only mention those we think are most important. First is our pro-rata right, which gives investors the right to maintain their ownership in future rounds. The pro rata right is one of the most important tools we have to mitigate one of the biggest risks of investing at an early stage, the dilutive impact of future financings. Each round of future financing can diminish our ownership stake if we don’t have pro-rata rights, which can lead to divergent investment outcomes for companies, management, and later-stage investors. The second is the composition and structure of the board of directors. Properly constructed boards can have a significant positive impact on early-stage companies. Contrastingly, poorly constructed boards and corporate governance can hinder a company’s growth.
Term sheet negotiations are an important part of the process for both companies and investors. In our experience, these terms should follow established norms and focus the negotiation on the issues that matter most, those that optimize for successful outcomes for all parties. We had no role in the DTx negotiation of terms but they easily met these standards.
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Investment Committee Approval and Investment
Venture capital firms typically have well-defined investment committee approval processes to ensure thorough evaluation and effective decision-making when considering potential investment opportunities. These processes can vary from firm to firm.
The investment committee typically comprises senior partners or critical decision-makers within the venture capital firm. They review the investment proposal and engage in discussions about the opportunity. These discussions often involve critical questions, concerns, and potential challenges associated with the investment. The committee's role is to ensure that the proposed investment aligns with the firm's overall strategy and risk appetite.
After thorough deliberation, the investment committee decides on whether to proceed with the investment. The decision could be an approval, rejection, or a request for further information. Committees base decisions on combinations of due diligence findings, strategic fit, risk assessment, potential return on investment, and overall alignment with the firm's portfolio and objectives.
Firas, James, and Michael make up ExSight's investment committee. We are (somewhat) unique in that we conduct our initial screening process as a team. The team screening process differs from many firms, where a partner or associate will bring a company through the diligence process and present it to the investment committee. We have decided at our outset to operate as a team to ensure buy-in and thorough analysis. This leads to a more rigorous diligence process while striving for unanimity in sentiment. All ExSight investment decisions must be unanimous. Unamity was a principle we agreed to very early on because we believe the best venture capital firms are true partnerships and not collections of different investments. Additionally, it ensures we will collectively continue to support each portfolio company.
Consensus builds over time with shared participation from the outset. Nonetheless, at least one of us will adopt the "devil's advocate" role where we attempt to poke holes in the investment thesis. Many potential investments have failed at this stage.
DTx failed this process twice before we finally achieved a unanimous "yes." The first time it failed was the seed round where we assessed the company too early. The second time the investment failed to get approval was during the initial close of the Series A. It was still "too early," and we could not get confidence that we had the requisite expertise to diligence the cutting-edge, breakthrough science and research that underpinned DTx's technology. However, following the first close (and the successful close of our second fund), Artie and Jeff continued the conversation. They ultimately facilitated additional discussions with leading experts in the field, at least one of whom eventually invested. These conversations finally gave us enough confidence to get to a unanimous "yes."
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Post Investment Support
Venture capital firms often have a post-investment monitoring process to actively support and advise a portfolio company after the investment. Support can involve regular updates, board representation, strategic guidance, and assistance overcoming challenges.
VCs can play a crucial role in adding value to their portfolio companies beyond just providing capital. Their expertise, industry knowledge, network, and experience can significantly contribute to the growth and success of these companies.
Here are a few ways VCs can add value with their expertise to portfolio companies:
Strategic Guidance: VCs bring a wealth of experience and knowledge about the industry, market trends, and competitive landscape. They can provide strategic guidance to help portfolio companies refine their approach, target indications, and clinical development strategies. Where a company may know of a few competitors, VCs have often seen hundreds or thousands of companies. They can draw on that experience for the benefit of the portfolio companies.
Operational Expertise: Many VCs deeply understand operational best practices and can help portfolio companies optimize their operations. They might advise hiring and building the right team, structuring internal processes, setting up key performance indicators (KPIs), and improving overall efficiency.
Access to Networks: One of the most valuable assets VCs offer is their extensive network of industry contacts, potential advisors, partners, and other investors. They can introduce portfolio companies to potential strategic partners, vendors, and talent. These connections can help portfolio companies accelerate development, secure new business opportunities, and hasten their pace.
Business Development: VCs often have a strong understanding of market dynamics and can assist portfolio companies in identifying and pursuing business development opportunities. These opportunities include strategic partnerships, distribution agreements, joint ventures, or mergers and acquisitions aligning with the company's growth objectives..
Fundraising Support: While the initial investment is a significant step, many startups require additional funding rounds as they grow. VCs can help portfolio companies navigate subsequent fundraising efforts by leveraging their knowledge of investor preferences, market trends, and valuation considerations.
Product and Technology Guidance: VCs with expertise in specific industries or technologies can provide insights into product development, technological advancements, and innovation. They might offer guidance on the lead indication, clinical trial design, and development roadmaps to help portfolio companies build optimized treatments to meet unmet patient needs.
Board Representation: In some cases, VCs take a seat on the board of directors of their portfolio companies. Board roles allow investors to have a more direct influence on company strategy, decision-making, and governance. Board members can provide the company's leadership team with mentorship, oversight, and accountability. A board observer role can also accomplish this function.
Crisis Management and Problem-Solving: Startups often face challenges and setbacks. VCs can offer guidance during difficult times, providing insights into crisis management, regulatory and clinical trial setbacks, and navigating unforeseen obstacles.
Scaling Expertise: As companies experience rapid growth, they often need to scale their operations, teams, and infrastructure. VCs with experience in scaling startups can provide advice on managing growth effectively and avoiding common pitfalls.
Exit Strategy and M&A: VCs help portfolio companies plan for potential exit scenarios, such as mergers and acquisitions or initial public offerings (IPOs). They can provide insights into market dynamics, timing considerations, and positioning the company for a successful exit. A founder or CEO may go through this process a few times in their career. A VC will experience this process dozens of times and have the requisite relationships.
ExSight's early-stage focus and small checking writing capabilities mean these other contributions are more critical for us as our investment will neither complete a round nor sustain the company through multiple financing rounds. We were introduced to Artie because we had expertise in what was then the company's priority indication, anti-VEGF therapeutics, an ultra-competitive class of therapeutics with a high bar for efficacy. Our feedback may have resulted in the company's pivot to retinitis pigmentosa. We were also happy to facilitate introductions to other investors and strategic relationships. Firas had Artie on the OIS Podcast to help raise the company's profile (see below). We also participated in several scientific advisory board conversations about developing DTx's FALCON platform for patients with retinitis pigmentosa. This is just a sampling of ways in which VCs can add value.
From our perspective, DTx was an exemplary company that was a pleasure to work with, even if they didn’t require much help. We were in an active and ongoing conversation with them around Series B financing strategy when we got the news that RA Capital was going to lead the company’s $100 million Series B. The team’s ability to hit their Series A milestones contributed to their successful Series B financing.
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Monitoring and Reporting
VC firms keep a close eye on the performance of their portfolio companies. Regular updates, financial reports, and meetings with the startup's management team help the VC firm assess the company's progress and make informed decisions about further funding or exits.
ExSight requests that our portfolio companies complete a quarterly questionnaire of high-level business update questions. This pace of reporting coincides with our investor reporting. However, this is a minimum requirement. We prefer to have more frequent updates. An open and ongoing dialog can help avoid unnecessary errors, provide valuable input to the company, and instill confidence that the company is executing and being transparent. Importantly, communication avoids nasty surprises. Moreover, ongoing dialog helps expedite the decision-making process when considering critical business and investment decisions, such as whether to make a follow-on investment.
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Exit Strategy
VC firms typically aim to exit their investments within a specific timeframe, often through acquisitions by a larger company or an initial public offering (IPO). The acquisition/IPO price and ownership at exit directly impact the returns the VC firm receives from its investment. Consequently, firms look at development timelines and valuation during their due diligence process to ensure that their portfolio companies can meet their targeted investment returns both on time and in the face of increasing dilution with each financing.
In our case, ExSight's “8th Line” family of funds are small proof-of-concept funds with shorter life cycles than more standard early-stage dedicated life science venture funds, five years vs. ten years. Consequently, we look to companies that can exit before completing a costly and time-consuming regulatory approval. The timeline was one of the reasons we were initially reluctant to invest in DTx, while it was in the earliest stages of development. We partially overcame this when the company laid out a clearly defined development plan with multiple value inflection and exit opportunities. Moreover, numerous examples of RNA therapeutic companies exiting well before regulatory approval existed as a precedent.
Exit strategy also factors into how we model our targeted investment returns. We model each fund such that anyone portfolio company can return the fund. Additionally, we invest ~50% into any one portfolio company and reserve a proportionate amount of our allocation for follow-on investment. This risk mitigation strategy allows companies to develop and for us to participate at the fund level in later rounds. In the case of DTx, 8th Line II invested $250K in the Series A and the same amount in the Series B.
Hindsight is 20/20 and it would be easy to sit here today and say we should have invested the $500K in the Series A. However, there is no way to have known then what we know now. The technology could have easily flamed out, leaving our investors down the entire $500K rather than half that amount. We employ this technique to protect against concentration and downside risk, even though we may have to pay more in later rounds to maintain our pro rata in de-risked technologies. That said, the results on an upfront basis are remarkable and underscore the extremely attractive valuations available to early-stage life science investors.
8th Line II received $2.69 million in total commitments. Our initial $250K investment represented 9.294% of total committed capital and 11.62% of total investable capital (net of fees). Once the company hit its Series A milestones and we made the determination to follow on, these percentages rose to 18.587% and 23.23%, respectively. This tracks to the five portfolio companies and would have had a higher concentration had we been able to secure a larger follow-on allocation.
Even so, our initial distribution of proceeds returns up to ~94% and 188% if the predetermined milestones are met. It is worth mentioning that we have four other portfolio companies in the 8th Line II portfolio.
After many years, three funds, and multiple side car investments, this is our first exit where we are returning capital to investors - it is a very proud and happy moment. Moreover, the exit validates our model.
We extend our deepest gratitude to our investors for their trust, commitment, confidence, and patience.
We would also like to express our heartfelt congratulations to Artie, Jeff, and the team at DTx Pharma for their dedication, accomplishments, and for attracting an excellent partner. Novartis is well-suited to advance DTx's FALCON technology. We eagerly anticipate momentous clinical advances we hope they can deliver to patients.
Back to work!