By Gabor Garai
Until recently, venture-capital firms tended to focus on achieving high returns by investing in risky early-stage companies across a broad range of industries. As competition for attractive investments has become more intense within certain industries, such as biotech, VCs have become more specialized. Whereas the conventional wisdom had it that experienced VCs were prepared to assess the promise of any startup within any industry, the thinking in the last few years has undergone a change that now favors specialization.
This change has important implications for entrepreneurs in search of funding. Increasingly, they must target VCs with expertise in their particular industry, and sometimes even within a particular niche of that industry. Biotech -- "life sciences," as it is increasingly known -- offers an interesting case study.
DEALING WITH THE FEDS.
A growing number of VC firms now specialize in funding life-sciences outfits, mostly as a way of differentiating themselves in the competition for the best companies. There are even funds that specialize within the industry. For example, one firm targets medical-imaging ventures. The founders of these specialty funds tend to have been industry analysts and scientists who once worked for VC firms with more general interests, where they helped assess life-sciences startups.
By being able to speak the language of the scientists who often head life sciences startups, specialty VCs have a head start in winning the confidence of those outfits' founders. Moreover, the specialist VCs can then offer opportunities that might not be as readily available through more generalized firms -- connections to distributors, vendors, specialty consultants, strategic-partnering candidates, even to management-team candidates.
Positioning themselves as industry experts, the specialty VCs also enjoy a leg-up in marketing themselves to the pension funds and other institutions that provide investment capital. The VCs argue that access to key university faculty and an understanding of the Food & Drug Administration's (FDA) approval process enable them to gain access to the likeliest big winners in life sciences.
In addition, the specialty firms argue that they are best positioned to pick winners. They point out, quite rightly, that being able to anticipate in advance how life sciences companies differ in their development from other kinds of ventures enables the firms to structure financing to maximize the chances of success. For example, life-science companies typically have a much longer development cycle and a different range of intellectual-property issues than software companies.
The differing growth cycles influence VCs' investment strategies. One VC firm specializing in life sciences might distribute stock immediately after a company goes public, while another VC outfit specializing in software companies may make such a distribution nine months to a year after an IPO.
The reason behind such differences: life-sciences stock may languish for several years after an IPO, as the lengthy FDA approval process unfolds. By contrast, a software player well be expected to increase over the first year as it uses public funds to expand manufacturing and distribution, hike sales and profits, and attract a growing following to the stock.
WEBS OF CONTACTS.
These changes in the VC marketplace require entrepreneurs to think again how they go about attracting funding. As industry specialization takes hold in more areas, including even such nontechnical areas as retailing, financial services, and human resources, it makes sense for entrepreneurs to seek out specialty venture firms.
For a young life-sciences company, a small specialty VC firm can often provide a quick decision about funding. If it is interested, the specialty firm may well be able to recruit larger general funds to become involved, based on the specialty firm's recommendation. If a specialty firm becomes involved, its ongoing presence may lead to important additional introductions to potential backers, customers, partners, and professional service providers -- all of whom appreciate the special requirements of life-sciences startups.
Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.