How Platforms Can Think Intelligently About Early Deal Structure
Before jumping in headfirst, it’s important to acknowledge relevant qualifiers:
- KdT Ventures is a seed stage venture firm and thus this article relates to seed stage companies
- This is primarily written for “platform” companies and not single asset companies
- Every company is unique and based on that uniqueness certain companies may — and some would — be best served ignoring the contents of this article
Without further ado, let’s jump in.
A typical scene in early stage science investing looks as follows:
Startup X has a novel synthesis, manufacturing, or assay technology that can credibly serve as an adjuvant to a wide array of biological or chemical processes or products. The promise is vast but as of today, there is little outside, independent validation. Believing in the promise, the founding team raises a modest amount of capital — careful not to sell too much too early, but enough to develop the platform and demonstrate some capability that reflects value inflection. Once the platform has reached that value inflection point, the company can raise significant capital on friendlier, less dilutive, terms. The key to the entire operation is devising a plan to evidence value inflection on the low calorie diet of small (seed) capital.
The first partnership is difficult to discuss in general terms. It’s impossibly difficult to convince large, market leading organizations that they should divert focus from their existing initiatives and engage you, a small start-up with no market traction and fewer than 10 employees. Additionally, there is no existing customer list you can turn to — you need the large organization to take a flier. As a result, terms and structures are often driven by the Goliath. Almost inevitably, Startup X will feel as though it is giving up too much. That’s often the price of admission. In this position, Startup X is best off trying to narrowly define the scope of the license/work/partnership — this can take the form of a shortened term, lower quantity, or a narrowly tailored scope of the license or deliverable.
It will get easier from here.
The more interesting partnerships are those that follow; the third, fourth, or fifth partnerships. By this time, Startup X is much wiser about its technology’s inherent strengths, weaknesses, and ideal applications. The world, and more importantly, Startup X’s prospective partners lack this knowledge. This information asymmetry becomes Startup X’s advantage.
The most effective way to leverage this informational advantage is to offer upfront developmental costs for increased downstream payments. In this way, Startup X is taking additional risk while also maintaining a greater upside, though most importantly, thanks to the information asymmetry, the risk is not properly priced.
Platform partnership agreements can take infinite forms but the most common is something along the lines of: BigCo pays developmental costs of Startup X, BigCo can then incorporate the new technology into their product/sales channel and Startup X receives downstream royalty payments.
[Note: It’s hard to concisely speak generally about IP ownership in this context. Sometimes ownership is shared, sometimes a license is given (exclusive or non-exclusive). It’s always best for Startup X to retain unencumbered ownership but as alluded to above, sometimes that’s a dealbreaker for BigCo and to get the first logo or two, Startup X must make concessions. This topic will be explored in detail in a later piece.]
An example will prove illustrative:
Startup X has a novel manufacturing process by which, when applied to current high-value chemicals, it can dramatically increase production and efficiency. BigCo may be willing to pay up to $1M for Startup X to apply it’s manufacturing technology to the specific chemical of interest. Additionally, BigCo may be willing to pay up to 8% royalties on all chemical sales from the new manufacturing process. BigCo explicitly states that if BigCo assumes the entire R&D cost (e.g. $1M), then it is only willing to grant a 2% royalty, but if Startup X shares the R&D costs, then the royalty may be correspondingly increased. The most important question for Startup X is: how do we balance the risks in assuming a portion of the R&D costs with the associated and inverse adjustment in royalty payments?
To help answer this question, there are two primary factors to consider:
- How strong is StartupX’s balance sheet (i.e. how many months of burn does it have assuming no additional revenue)?
- Does the marginal cost of additional R&D expenses borne by Startup X result in a disproportionate increase in downstream royalty (i.e. is BigCo mispricing the risk/reward profile)?
Question #1 is critical because companies with less runway understandably value cash more. Said another way, the financing risk of a company with limited runway is high. While retaining unencumbered ownership over internal assets is the best way to drive long term value, recall, early stage companies often need to show market validation to engage with other, larger companies, and in turn raise more capital, which then facilitates the hiring of quality teams. Conversely, companies with deeper pockets can afford to “bet” on themselves and absorb more of the R&D costs without fearing that a failed program will sink the entire company. As a framework, if the R&D costs Startup X is considering absorbing are less than ~15% of the current runway, that feels like a manageable risk, especially if the product can be implemented across multiple customers.
Question #2 is critical because this insight should determine the extent to which Startup X shares in the R&D expenses. As a framework, it’s helpful to think hypothetically about the opposite ends of the deliverability spectrum: on one extreme, Startup X is certain it can deliver on the JDA, and it should fund as much of the R&D expense (and thus obtain better downstream economics) as it can. Conversely, if practically certain it won’t deliver, Startup X should push for BigCo to fund the entire program. Where Startup X can extract value is all the in between instances where it can leverage its asymmetric information regarding the true capabilities of the platform. How does Startup X do this? It’s simple: ask.
Startup X should ask during the negotiations: if we self-fund certain amounts for R&D (reducing BigCo’s upfront expenditures) what is the corresponding increase in royalty rate we could expect. It’s a direct but eminently fair question demonstrating the belief Startup X has in itself. The answer will illuminate BigCo’s confidence in the partnership: a willingness to share the economic benefit reflects an opportunity for Startup X. Referring back to the example above, if BigCo is willing to trade $250K in upfront costs for 6% royalty rate (up from 2%), then BigCo is expressing serious doubt about the JDA. Conversely, if BigCo is only willing to trade $250K in upfront costs for a 2.75% royalty rate (up from 2%), then BigCo is acknowledging the likelihood of success. Startup X needs to be willing to finance a portion of the R&D expense where BigCo misprices and overstates the risk.
In a world where it seems BigCo is always in the dominant position, emerging companies need to leverage their asymmetric information the best they can. Frequently, the best way to do that is to bet on itself early in its lifecycle before its prospective partners fully appreciate the development and maturation of the platform. Once fully realized, platform companies will start to fund programs internally as their window to leverage asymmetric information will have expired.