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TL;DR: Biotech startups are revolutionizing fields like medicine, life science and environmental science, but they face significant legal hurdles when seeking funding. Key legal considerations for funding biotech startups include choosing the proper corporate structure, distributing and documenting founder equity, building a solid team and IP portfolio, developing a strategic funding approach and preparing for due diligence and investor meetings. Addressing these legal aspects early on is crucial for attracting investment and setting your biotech startup on the path to success. Engaging experienced legal counsel can be invaluable in navigating these complexities.
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Biotech Startups – Key Legal Considerations When Seeking Funding
Biotech startups are at the forefront of critical innovation that helps improve lives and drive advancements and discovery in medicine, life, agriculture and environmental science. However, navigating the path from concept to commercialization involves significant legal complexities, particularly when seeking funding. Biotech startups usually require significant outside investor capital, which can be raised from angel investors, venture capital firms and/or strategic corporate partners. Preparing for future financing rounds is crucial for the success of a startup biotech.
As a corporate law firm with extensive experience representing startup biotech companies and biotech investors, we understand the unique challenges these biotech startups face.
We outline below vital legal considerations that your biotech startup needs to consider when seeking funding from early-stage biotech investors.
1. Choose the Right Corporate Structure
Delaware C-Corp: Selecting the right legal entity for your biotech startup is critical to your company’s success. For most biotech startups, forming a Delaware C-corporation is preferred over a limited liability company or S-corporation, or other entities formed outside of Delaware. Both startups and investors favor a Delaware C-corp due to Delaware’s well-established corporate governance laws, corporate law case history and efficiency. Also, many of the investments structures and related documentation (e.g., SAFEs and NVCA preferred stock financing documents) are tailored to work with Delaware C-corps.
Solid Foundation: Establishing the proper corporate structure from the start will ensure you have a solid legal foundation for the future. Your biotech startup needs to be set up the right way in order to take in investment efficiently; this funding stage is not where you want to be creative or unique, especially if your biotech startup will require follow-on financings. A false start as a LLC or other entity can be costly to fix and delay essential funding for your biotech startup.
QSBS: Qualified Small Business Stock (QSBS) can provide significant tax advantages for founders and early investors in a biotech startup, potentially saving each qualifying stockholder up to $10 million of capital gains from federal taxes if specific holding periods and other requirements are met before the startup equity is sold. QSBS is only available for C-corporations, which is one key reason investors want to invest in biotech startups that are set up as C-corps.
Governance Structure: You should set up your biotech startup with corporate officers and executives to run day-to-day operations, and a Board of Directors to oversee the officers and management of the startup. Early-stage biotech startups will usually have simple governance structures, with the founders likely serving as both officers and directors. As you bring in outside investment, your corporate governance structure will likely change as lead investors request seats on the board and as you appoint additional corporate officers to help you run the company.
2. Distribute & Document Founder Equity
Who Owns the Company: One of the most critical aspects of forming a biotech startup is determining who owns the company and how much equity each founder should own. Breaking down ownership among founders often is more art than science and usually case-specific. To start, you should consider each founder’s relative role and expected scope of contributions now and in the future to determine how much equity such founder should own. A misalignment of ownership among founders can cause resentment or disagreements among the team down the line, which may impact your biotech startup’s ability to raise money from investors.
Ownership Documents: It is essential to establish clear agreements among the founders addressing equity splits and vesting schedules from the beginning; do not wait until you need to produce these documents in diligence, which may be too late. This upfront structuring will help avoid potential disputes in the future and help ensure that everyone involved has a clear understanding of their ownership stakes in your startup.
Stock Vesting: Each founder should be subject to customary stock vesting terms, which will helps ensure that each founder continues to “row the boat” in the same direction on behalf of the biotech startup. Their stock will “vest” as they continue to serve and contribute to the company. If they stop pitching in as contemplated, the company can step in to repurchase their unvested shares so that they end up with an ownership percentage, if any, that more closely reflects their actual involvement and contributions. Failing to implement stock vesting among founders can lead to significant disputes in the future as duties and responsibilities change and as the value of the Company’s equity increases. It can also lead to so-called “dead equity” (i.e., stock held by inactive founders), which can cause problems when seeking venture capital investment.
Cap Table Maintenance: Your biotech startup must maintain an accurate and up-to-date capitalization table from day one. This ownership attention to detail will help you attract future investors and eliminate many due diligence issues as investors kick the tires on your startup. Your cap table should be clean and concise; again, this is not where you want to use your creative talents.
3. Build the Right Team
Offer Letters: As you assemble a strong team to drive your biotech startup forward, draft clear employment offer letters and other contracts for your team to establish solid working relationships and set expectations.
IP Ownership & Confidentiality: To ensure that your biotech startup owns all of the “secret sauce” and essential inventions your team is creating, you will need to put in place Proprietary Information and Invention Assignment Agreements (often referred to as PIIAs). These agreements are vital to documenting your company’s ownership of its IP and protecting company confidential information. It is best to sign these documents on (or before) Day 1. Do not wait until your prospective investors ask for them in diligence.
Consultants & Advisors: In addition to employees, you may bring on consultants, advisors and other team members to assist you along the way. Each relationship must be documented with an appropriate contract, whether through a consulting agreement, advisory board member agreement or independent contractor agreement. These agreements should contain appropriate provisions regarding the protection of proprietary information and assignment of inventions (unless the consultant or advisor also signs a PIIA).
Stock Incentive Plan & Options: Most people that go to work for a biotech startup will expect some form of equity compensation, which is often a good way to conserve cash. Accordingly, you will likely need to compensate your employees, consultants and advisors with equity incentive awards, typically structured as stock option grants. To offer valuable equity incentives to your team, your biotech startup will need to adopt and properly administer an equity incentive plan to issue equity incentives in a tax-efficient manner and maintain a clean equity cap table.
Rinse & Repeat: As you build your team, you will need to ensure that you document each relationship accordingly. Failing to secure IP ownership from your personnel or to document an oral equity promise could derail or delay your efforts to raise money from biotech investors. Use onboarding and document processes effectively to ensure that these items are addressed when they arise, rather than rolling the dice and waiting until they are required to be produced in diligence.
4. Build a Strong IP Portfolio
What the Company Owns: Intellectual property, including biotech patents, trade secrets and proprietary information, is often the most valuable asset of a biotech startup. Therefore, it is essential to document what your company owns from the start and on an ongoing basis. You will also need to be prepared to demonstrate to investors that the company owns, or has appropriate rights to use, the IP that it relies on. In other words, investors want to ensure that your company has “clean title” to its IP, which they will verify through legal due diligence.
Patents & Trademarks: Your biotech startup should work closely with patent and trademark counsel to secure patents and trademarks necessary to protect your proprietary technology and research.
IP Policies & Protection: In order to safeguard your most valuable assets, your biotech startup should adopt and enforce IP policies and strategies. This involves managing IP ownership and contributions among founders and other personnel and implementing best practices to protect and secure confidential information.
IP Licenses: If your biotech startup needs technology or other IP from a third party, such as a university, research institute or big pharma, then it is important to negotiate, document and secure those rights early on. Investors will scrutinize your company’s key IP licenses to confirm that your company has a clear path forward to develop and commercialize the licensed IP as required to support your business plan and goals.
5. Develop a Funding Strategy
Funding Options: Biotech startups typically go through various funding stages, from pre-seed to Series A and beyond. Understanding the nuances of each stage is vital for securing the necessary capital to grow your company. Biotech startups often use grant funding, SAFEs and convertible debt for early-stage funding. They later move to priced-equity rounds (e.g., Series A preferred stock and up the alphabet). Most established companies also have the option of seeking venture or commercial debt to further support their capital needs.
Check out our Ultimate Legal Guide to Seed Startup Funding Part 2: Key Structures, Terms and Legal Issues for more in-depth information regarding the various funding options available for biotech startups and how you should prepare for your upcoming round.
Key Terms: Key terms and conditions for each funding round should be carefully considered and negotiated in order to align the financing with your company’s long-term goals. We recommend using a term sheet as a way to focus initial discussions with investors. The term sheet phase is your one opportunity to ensure that you are securing the deal you want – it is challenging to negotiate better financing terms for your startup as part of the investment documents if you have already settled an issue in the term sheet. Also, consider the creeping effect of key terms over time. Investors tend to build upon what is already in place, so consider the implications of setting a precedent for future rounds.
Dilution & Investor Rights: Understanding how dilution and investor rights will affect your company is important. This involves modeling out the financing to understand how the ownership of your startup will change post-funding. Keep in mind that dilution is not always a bad thing, and it may be inevitable; the goal here is to limit unnecessary dilution. After all, you would rather own a relatively smaller piece of a valuable company than owning more of a company that is worthless.
One strategy is to raise your earliest capital without committing to a specific pre-money valuation, using the funds to hit milestones, de-risk the investment and increase the value of your startup for a future priced-equity round (a priced-equity round has a specific pre-money valuation). Many startups use SAFEs or Convertible Debt for their earliest capital-raising activities in order to avoid committing to a pre-money valuation. These instruments are also useful for bridge capital in between priced-equity rounds.
6. Prepare, Prepare, Prepare
Due Diligence Data Room: In diligence, as in life, first impressions matter. Our clients often hear us say, “You don’t want to show your home to potential buyers with dirty dishes in the sink,” and this principle also applies to raising money for your biotech startup. You need to put your company’s best foot forward in due diligence. Preparing a thorough and well-organized data room will ensure your startup is ready for investor scrutiny.
Red Flags: As part of due diligence, investors and their counsel will closely review your company’s corporate and other documents. They expect your startup’s records to be up-to-date and complete and will red-flag any issues they spot. Avoid due diligence headaches by prioritizing corporate housekeeping and good governance and recordkeeping practices early on.
Investor Materials & Meetings: To set the stage for productive discussions with investors, your biotech startup will need to prepare a solid business plan, executive summary and pitch deck. This is your chance to really sell the opportunity to investors, so make sure that you have mastered your elevator pitch, and be prepared to discuss your company’s vision, market analysis, commercial opportunity and financial projections. You should also anticipate and prepare for the tough investor questions headed your way.
For more guidance on preparing investor pitch materials, check out From Seed to Success: The Ultimate Legal Guide to Seed Startup Funding.
Conclusion
Navigating the legal complexities of biotech startups is challenging, but with the right guidance, building a strong foundation for success and future funding is achievable. By proactively addressing these key legal considerations, biotech entrepreneurs can position their companies for growth and attract the necessary financing to bring their innovations to life. Seeking experienced legal counsel early in the process is essential to avoid costly mistakes and help ensure that your biotech startup is on the right track from the beginning.
Consult with a startup attorney today!
Clients Also Ask Us:
How much money will my biotech startup need to raise?
The amount of money your biotech startup will need to raise depends on various factors, including the stage of development, the costs associated with research and development, clinical trials, regulatory approvals and go-to-market strategies. We recommend creating a detailed financial plan that outlines your biotech startup’s milestones and funding needs at each stage to determine the appropriate amount to raise. Engaging with investors early on can also help gauge realistic funding targets based on market conditions and investor expectations.
How successful are biotech startups?
Biotech startups have the potential for significant success, particularly when they bring to market groundbreaking therapies or technologies. However, success often depends on factors like funding, regulatory approval and market demand.
Are biotech startups risky?
Yes, biotech startups are inherently risky due to the high costs, intense competition, lengthy development timelines and regulatory hurdles involved, but the potential rewards can be substantial if they succeed. As you engage investors, you will need to be prepared to address the risks of your biotech startup and how you plan to overcome them.
