Dealing in Relationships

Joseph Schlessinger would hardly fit most people's definition of the unworldly scientist. Originally a physicist, Schlessinger has conducted groundbreaking work in identifying and characterizing molecules in the signaling pathways of receptor tyrosine kinases. Elected to the National Academy of Sciences in 2000, Schlessinger, William H. Prusoff professor and chairman of pharmacology at Yale University, has achieved the acclaim some scientists yearn for. Yet in 1991, when he set out to build a company based on scientific discoveries made by himself and his associates, the negotiations with financiers left him flummoxed. "I acted like any other scientist who was naïve on the business side," he relates. Perhaps everyone should be so green. With help from his partners, Axel Ullrich, an important early scientist in Genentech, the San Francisco-based biotechnology firm, and Stephen Evans-Freke, a former investment banker turned biotechnology entrepreneur, Schlessinger built SUGEN Inc. In 1999, the colossal pharmaceutical company Pharmacia Corp. acquired SUGEN for $720 million, even before it had marketed its first drug. Schlessinger went on to help found a second company, Plexxikon, based on the structural genomics discoveries of cofounder Sung-Yo Kim at the University of California, Berkeley, but he has learned some lessons on the way. "In order to prevent the mistakes I made in the past, I created checks and balances," Schlessinger says. Creating such safegaurds begins with negotiations for the final deal--when the scientist-inventor tries to sketch terms that supply abundant cash for development and provide the inventor reasonable profits. Many fledgling inventors end up like Schlessinger--dissatisfied with the corporate governance or beholden to market forces that financiers claim to understand better than the scientists can. "Where you end up ultimately in a deal depends basically on the market conditions and what you can negotiate," says Gary Arlen Smith, a partner at the Philadelphia-based firm, Morgan Lewis, who represents biotech companies. The deal making that distinguishes the successful inventor from what one entrepreneur calls "an indentured servant" bound by loyalty to his idea, hinges on relationships with three groups: scientific advisers who can endorse the importance and effectiveness of a discovery, legal and business advisers who can teach the inventor about business, and the people who provide the seed money until the platform or technology can earn its own way. "The chance of being successful depends on having top-quality people," says Peter Hirth, a former vice president of SUGEN who is now CEO of Plexxikon. "It's really about teams. That's the difference between industry and academia. In academia, people are pretty much on their own [with] their ideas and projects, ...while in industry, it takes many more disciplines to come together and translate ideas into products." The Essentials The first relationship to cultivate is with an attorney, which can save both time and money. "Any lawyer will get you a great deal," Smith notes. "You are not going to bamboozle the venture capitalist. Going to a seasoned lawyer in this arena will enable you to get your deal done a lot more quickly because the lawyer will know which issues are negotiable and which are not." Bob Compton, who has negotiated deals for many startups and helped see them through their acquisition, recommends interviewing the lawyer's last five clients. Compton, chairman of NoInk Communications, a company that supplies applications for wireless technologies adds, "If the lawyer won't let you do that, get out of the room quickly." The scientist should also interview the financier's former customers to find out not only how effective the firm can be, but also how the financier copes with failure. "What are they like under pressure?" says Compton. Both Compton and Smith also encourage scientists to bring at least two venture capitalists to the table to cross-negotiate. "The more venture capitalists that the company can get interested in the funding, and the more of a bidding market the company can create, the better deal the company can make for itself," Smith observes. "It's very much a bargaining process back and forth." The investors' experience with technology should parallel that of the researcher. From that starting point, the personal chemistry between parties should work out. The scientist may in the end steer the company, not toward the best deal, but toward the people who seem easiest to work with. With tight financial markets and a decline in initial public offerings, an inventor's choices may be limited, however. "It's hard to be choosy these days, you may end up having to take the money you get," says Peter McWilliams, a partner in Sanderling, a Menlo Park, Calif. venture firm that specializes in the biomedical industry. "Not everyone is lucky enough to be able to turn down money because there's not a good fit there." The Terms of the Deal Once the investor and inventor come to an agreement, they negotiate a term sheet that outlines the company's valuation, sets up its governance structure, and determines how shares will be distributed. For the uninitiated, the term sheet, sometimes no more than a page long, can be as complicated as DNA sequencing, where a seemingly insignificant alteration can dramatically affect the outcome. "The term sheet is the tool the venture capitalist uses to articulate the salient features of the deal," Smith observes. "It talks about how much money the [venture capitalist firm] is willing to invest. It describes how much of the company it will require in exchange for that money. It describes any special requirements it will impose...on the company and the principals of the company, in connection with that money." Schlessinger ended up dissatisfied with the terms of the first deal, to build SUGEN. He signed over what he considers too much decision-making power to the board of directors. "It left me with a bitter taste in my mouth--the money didn't matter really," Schlessinger says, adding that he is still co-chair of the company's scientific advisory board. "I would have liked the company to be independent until the drugs would be out." Hirth attributes SUGEN's success, in part, to its rapid acquisition and testing of its technology: the company completed four clinical trials prior to its purchase by Pharmacia. Schlessinger says he wanted the delay so the company could negotiate from a stronger position. Nevertheless, his experience with SUGEN has helped attract investors to Plexxikon, including the CW Group of New York, and the San Francisco-based Alta Partners. Schlessinger has also gained a little more decision- making power the second time around. He says, "I made myself chairman of the board." Paula Park can be contacted at ppark@the-scientist.com. The Term Sheet: A Lexicon The amount of money invested by venture capitalists is generally the first item on the term sheet, according to Gary Arlen Smith, a partner at the Philadelphia-based law firm Morgan Lewis. But other terms are critical as well: Purchase Price and Valuation: This is what determines how much of the company the founders will have to give up in order to obtain venture capital. Common Stock and Preferred Stock: In the typical venture capital transaction, the investor receives preferred stock and the inventor receives common stock. Preferred stock allows the investor to collect a 100 percent return on the investment plus a dividend before the common stockholders are paid, should the company be liquidated. The percentage of the company owned by the investor is usually thought of in terms of the amount of common stock (as a percentage of the overall outstanding common stock) that the investor may obtain upon the conversion of the preferred stock into common stock. For example, in a deal in which the investor purchases 1 million shares of preferred stock for $1 million, there are 9 million shares of common stock outstanding, and the preferred stock is convertible into common stock at $1 per share (the conversion price) then the investor has purchased 10 percent of the company. Upon conversion to common stock, the investor would have 1 million out of 10 million shares of common stock. Anti-dilution: This term is a standard part of the venture capital investment and protects the investor against the devaluation of its position resulting from the subsequent issuance of shares by the company at a lower price. Full-ratchet Anti-dilution: This phrase applies to an agreement that causes the existing conversion price to be reduced to the per-share price at which the subsequent deal is done. Weighted Average Anti-dilution: This calculation sets out the extent that the downward adjustment of the existing conversion price depends on both the subsequent per share price and the shares sold and the total shares outstanding before the new sale. It is usually more generous to the founder than is full-rachet anti-dilution. Corporate Governance: This outline defines the fiduciary responsibilities of both parties and names the board of directors. Registration Rights: Language following this term sets out who controls whether or not the company goes public; the investor often wants to drive this decision. Use of Proceeds: This section dictates how the company will use the investor's money. --Paula Park

Dealing in Relationships

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