Investors Mitigate Risk of Investing in Startups

Argolyn Bioscience Inc. recently closed a $15.8 million round of financing that will be used to advance the company's research into human clinical trials and get its product to market.

The financing round, co-led by Intersouth Partners and Quaker BioVentures, with Amgen Ventures participating, is Argolyn's first institutional financing since its founding in 2002. The added resources may be used to add staff or equipment.

"It's just good to have some resources now to execute the plan to get to human trials and get it to market," Argolyn's CEO Pearce Gilbert said. "We're ready to execute."

This investment underscores one of the key elements of funding the knowledge economy: the risk investors must weigh in determining where to place their bets. Argolyn, a spin-off company from research developed at the Medical University of South Carolina's Department of Pharmaceutical Sciences, is a privately held biotech company focused on using peptides, or human proteins, in the treatment of psychosis, pain and other serious disorders. The company also holds patents on its peptide-modification technology. The financing will allow the company to finish the pre-clinical work and begin the human trials phase.

Argolyn has ongoing grants from the National Institutes of Health, and while Gilbert said it may be "conceivable" that there might be another round of financing, "for now this will get us to a good valuation."

Investing is risky business

Investing, by definition, is an uncertain business, filled with risk. Yet risk is an intrinsic part of investing - a certainty of the business, if you will.

For Alan Craig, chairman of the South Carolina Investor Network, that paradox lies at the heart of the investor's world, regardless of the level of investment or type of investor. "Every investor, no matter whether an angel investor or venture capitalist or private investor, will do some type of due diligence that will help him get comfortable with the risk," he said. "There are all kinds of things to look into -financial factors, market factors, management factors - that will get the investor to where he feels comfortable with how the company he's looking into operates. "But in the end, it's always going to be about risk."

The levels of investment and acceptable risk run the gamut, Craig said."There's something like a food chain of investing," he explained. "First you have the angel investor, which can be an individual or group, and the angel investor usually gets involved with a very young company at the concept phase. Next is the venture capitalist, which helps the company grow in value until an exit like an initial public offering or a sale to a strategic buyer.

"Then there's the private equity fund, which is usually a firm that likes to buy out existing companies. There's a lot less risk in private equity, and they're usually looking to find under-performing companies and do what it takes to make them more profitable, build them up and then sell them off."

"In addition, he said, there are mezzanine investment companies, which can be a "hybrid" type of investment that may or may not be in conjunction with private equity companies."They are usually basing their decisions on the cash flow," he said. "They won't take collateral but they're not as risky as a venture capitalist."

Regardless of type, investors are used to dealing with risks. In a recent survey by Ernst & Young, 23% of investor respondents categorized themselves as risk averse, while 54% said they were tolerant of risk, 18% said they embraced risk and 5% did not specify.

Mitigating risk

The survey noted that "as a group, they are not predominantly concerned with trying to eradicate or completely avoid risk in their investment portfolio, but with how companies effectively mitigate risk in their financial performance. They look for ambition and aggression in the pursuit of profitable growth, but they also want to see proof that risk are under control, with opportunities and constraints in place: high levels of risk need to be compensated for by adequate upfront or expected returns. The return is the ultimate proof of concept, albeit occurring after the investment."

Angel investors, like the Charleston Angel Partners, are willing to take a much higher risk than a bank, which will ask for collateral and whose risk is dependent on the ability to liquidate the collateral," Craig said. "But then, the angel investor will take a larger equity position and expect multiple returns when it makes an exit with the company.So they risk more, but then they expect more. And if it's successful, they get more."

On the other hand, he said, angel investors also make multiple investments knowing some of those will never go anywhere."Hopefully the ones that do will compensate for those that didn't work out."

Investing in management team

Another aspect of mitigating the risk involves investing in the team that's running the company, Craig said."If you have a real star, a CEO with a great industry track record, then the risk is lessened a bit," he said. "You know you're getting someone you can trust to execute, and this allows you to hedge your bet somewhat."

Method to their madness

For those who shy away from the notion of risk, Craig said there are some good points to remember. "Keep in mind it's not like they're just rolling the dice," he said. "With most of these investor groups, there are particular industries they feel comfortable with - manufacturing, technology, life sciences. They're familiar with what the company is doing, so there's an educated risk, an understanding of the industry. And in a lot of cases, the investor is taking an ownership position. Maybe they're not controlling it, but they'll have enough insight into it to see what the company is doing. And that, in turn, leads the investor to believe enough in the company's potential to take that risk."

There are certain investment groups that deal only in certain industries, and so they have less of a learning curve when it comes to the due diligence stage, Craig said. "There's one investor I know, for instance, that I would never take an existing manufacturing deal to," he said. "I know that the company he works for invests in early market biotech and high-tech companies because they understand that. They go through a complicated model that helps them determine if they put X dollars in, what can they expect on their return. And that works for them. That's their comfort level."