Active VCs vs. Zombies: Dysfunctional Boards That Mess With M&A

Article By Luke Timmerman / February 22, 2016 

Investors want to know: Will Big Pharma go bargain hunting, do a little M&A? Will it lift my biotech portfolio out of the gutter?

Multiple factors are always at work. At the most basic level, pharma still needs to acquire new products to stay afloat. Little biotechs who create things need to be acquired, or go public, to reward their investors. Those facts never change.

But there’s another powerful, and dark, force creating havoc in many biotech boardrooms. People who have witnessed it don’t like to talk about it. When they do, it’s in hushed tones.

I’m talking about zombie VCs. They are everywhere. They don’t call attention to themselves, but they’re around in good times and bad. Especially at this depressing moment in biotech valuations, with three-quarters of recent IPO companiestrading below their IPO price, the creepy and desperate walking dead board members are creating a whole lot of tension behind the scenes.

Zombie VC firms, who by definition have failed to raise new funds in the last few years and have no money left to invest, often still hold board seats and wield power for years. They often use their power positions to push for a quick sale, even if it’s at a loss. That way, they can wind down their old funds, put some money in their own pocket, and hit the golf course.

Active VCs, who still have money to put to work, tend to be more willing to keep investing in that killer Phase II experiment that’s needed to reach a bigger payday. Actives tend to resist perceived low-ball offers. Sometimes, they’ll push for an additional financing round, giving them more preferred shares, which can give them the power to “cram down” a non-participating zombie firm’s existing stake into mere common shares. Sometimes, they try to elbow the zombie off the board.

These sorts of brawls may be kept hush-hush behind the scenes, but pharma dealmakers are no dummies. They can look at a small company’s board and tell pretty which VCs are active, and which aren’t. They can count the number of board seats, and do the math on just how close an old fund is to the end of its rope. They know that perhaps as many as half of all board seats in biotech are still held by zombies. If you play the long game, as a startup’s cash runs low and its options get limited, there’s a good chance the board will bite on a low-ball bid.

“The acquirers smell blood,” said Oded Ben-Joseph, a managing director with Outcome Capital, a middle-market investment bank.

Ben-Joseph and his partner Arnie Freedman told me there are still so many zombie VC funds haunting biotech boards that it will probably take another 3-4 years for all of them to wash out of the startup ecosystem. The massive contraction of the life sciences VC world has created a bulge of zombies, they say. Their Rolodex of B-round and later life science investment firms, pre-financial crisis, stretched 280 names long. Now, it’s 55, Ben-Joseph said. Many of the other 230-odd firms still technically exist, slowly winding down portfolio investments made years ago.

While the zombies continue to collect management fees, and stand to be rewarded in the event of a sale—any sale—they are creating “tremendous dysfunction” on boards, Ben-Joseph said. Zombies often try to oppose subsequent rounds of growth financing—even if it’s clearly what the company needs—because more financing will dilute their earlier stake into practical nothingness. A half dozen active venture capitalists I contacted for this article either declined to speak, or said little. Others acknowledged the phenomenon, and its potential dampening effect on valuations, even if that’s hard to quantify.

“It’s an issue for sure,” said one VC at a top-tier firm, who spoke on background. “It will get worse as the access to the public market will likely be restricted only to the strongest companies…CEOs should be wary with regard to this in selecting new investors.” CEOs would be wise to push for “pay-to-play” financing provisions that give more control to investors who can help the company, this VC said. Another alternative is to gently inquire into whether the zombie might sell his shares to someone else in a secondary offering. This must be done warily. Usually there are few or no potential buyers in the private market anyway. Zombies also have egos, and it’s hard to get them to bow out gracefully. Many amble around in denial, and will bare their fangs if anyone dares speak the truth about their walking dead status. “We all know their flesh-eating tendencies,” this VC said.

“What you see sometimes with zombie funds is that the partners are not really paying attention, almost a malaise of sorts, and that is the worst thing,” said Mike Powell, a general partner with Sofinnova Ventures, an active VC firm.

CEOs often find themselves mediating between warring boardroom factions, Ben-Joseph said. Often, the zombie VC is simply checked out mentally and no longer that interested in putting time and energy into helping the company.

Janelle Anderson, a partner at CTI Life Sciences Fund in New York, said she considers herself lucky to have avoided such situations. That’s mostly because she says she’s relatively new to her fund, invests in Series A (before things usually get messy), and has had successful syndicate partners. “That’s probably the trifecta for zombie avoidance,” she said.

True zombies take time to evolve, and only undergo their transformation years after it becomes clear they can’t raise new funds.

Here’s what Anderson when I asked her about today’s tensions between actives and zombie VCs:

VC timing and fund cycle plays a major role. Given a standard fund life of 10 years with the first 5 years being the active investing period, the last 5 years become problematic if the fund has not had the discipline to hold reserve for its earlier investments, and/or if it is unsuccessful in raising the next fund. Even around year 4 and 5, a VC may be getting itchy for returns and start pushing their portfolio companies to go for an acquisition (less so IPO these days) that may leave value on the table.

There will always be this effect at play, even at steady state. However, if there is a particular surge of zombies coming into prominence right now, it implies we had a disproportionately large amount of capital in funds now roughly 5 years old. That would make sense, as it implies a raise around 2011 – after the economy was bouncing back from the 2008 financial crisis and subsequent venture capital desert. It may also point to difficulty in raising next funds right now, but I find that harder to explain. I would agree with the conclusion that in 3-4 years this surge of zombies will wash out. But before they have, it stands to reason there could be some M&A bargains for big pharma – in companies that shouldn’t be distressed, but are drawn into selling themselves to serve their zombie masters.

You can practically hear the CEOs pleading for a little more time and money from these zombie masters. In more genteel language, this is what VCs often refer to as “syndicate risk.” This is a big reason why they want to invest with the same old pals. It’s partly because they want to know that fellow investors will be able to keep investing until the time is right to cash out. They’re terrified of being in bed with someone whose interests diverge, with someone who starts working against the company.

The zombie dynamic becomes especially pronounced in a downturn, as people get stressed by disappointing valuations, and the more limited strategic options. Consider the degree of dysfunction in the medical devices field. Hardly any active VC funds are left standing in that grim market, where investment returns have lagged for years. Big device companies like Medtronic, Johnson & Johnson, and Abbott Labs may still need to purchase innovative little companies, but they know they’ve got the little guys over a barrel. There’s no IPO market, and no venture capital left to bankroll an independent course. They see a lot of zombie venture capital firms looking to zero out their positions.

That leaves a whole lot of entrepreneurs in the lurch.

“It’s a big problem,” said Thong Le, CEO of Accelerator Corp., a venture-backed startup and a former VC with WRF Capital. “It’s frustrating. If you’re in the seat of an entrepreneur, you’re not in it for a quick flip. Most people, when they start a company, they put their heart and soul in it. They try to create the most value they can. The people who invest in you are supposed to be backing you, they are supposed to be there for you in thick and thin…the problem is with the way VC incentives work, and the time frames they work on. It’s not always aligned with the best interest of the company.”