4 Rules for Becoming an Investment Winner in industrial biotech

September 16, 2014 |

algae-everestIt’s hard to make a valuable molecule out of low-value biomass. And even harder to make money out of it.

What are the rules of the road, as understood by those who have dared, and done it, and lived to tell the tale?

So, the Biofuels Digest Index is up 10 percent since May, but it’s been a volatile record, with companies like Pacific Ethanol and Aemetis turning into total four-baggers, while KiOR went into the tank and Gevo has been diluted through capital-raising activity. Private companies like Genomatica have scaled up well — others have lagged. Some technologies like corn oil extraction have proven widespread winners — but not every company made money in offering it.

How do you make money in the sector? We’ve spoken with dozens of strategic investors, institutions, angels, hedge funds, private equity firms, venture capitalists, bankers, advisors, and project developers to learn their secrets. Their views have been fairly consistent — it’s all about risk. Here are the 4 that winning investors have related to us:

Rule #1. No shortcuts to the top.

Industrial biotechnology takes time, and a lot of capital — that means patient capital, and that’s not usually the kind that investors find in their wallets. Crushing the timeline is how investors win in this sector. But shortcutting demonstrations doesn’t work. Too many companies have gone by the wayside approaching scale-up steps on the basis of “1,2, skip a few, 99, 100”.

So – how do you win?

First, if you can find one for your target molecule, look for a modular technology. Where you replicate a lot of small units, rather than building the Mother of All Fermenters. You won’t always find them and they don’t always work — but they are around, and kick those tires first, Lot less blood and treasure expended on those.

If no modular solution exists, make sure you have an All-State set of scale-up partners, as in “you;re in good hands with All-State.” Scale up is tough and expensive — be with the best.

If you feel that you must invest in the R&D stage, the smart investor works on keeping a technology bottled up in university or lab research as long as possible. That’s the idea of directed research — partnering effectively with labs and national and state governments (and other grant sources) so that they thoroughly understand the commercial applications and potentials, and ensuring that research dollars are effectively channeled towards goals that will lead to winning companies and winning technologies.

It comes down to team. It’s not just who you have, it’s how well they work together. Did you get the Battling Bickersons, who will solve nothing and leave you only with a trail of unheeded email warnings and a barrowload of regret? Or, did you get the Brute Force Biology team, who will build the plant, build it again, and build it again until they have something that works — which leads to success but will cost you sums that would make Cargill weep. Or, did you get rock stars of analysis and cooperation who prevent the very problems that beset the Bickersons and the Brutes?

Rule #2. Be convertible, buy convertible.

As LanzaTech CEO Jennifer Holmgren reminds us, “never fall in love with a feedstock.”The name of the game in industrial biotechnology is flexibility. Multi feedstock. Multiple products. Flex-fuel cars. Multi-fuel pumps. So, why not flexible investment instruments, too?

In case of failure, you always want to be at the top of the capital stack. In investing, generally there’s debt, equity, and convertible debt that can switch over to equity in given situations. That latter instrument is favored by companies who want to be shielded from risk at the outset, but maximize returns should the technology prove a winner.

But why not buy convertible equity instead? That is, you are equity so long as the project is going along — giving you shareholder rights — but having the option to flip over to debt should the returns prove elusive or the company runs into trouble. Investors say that this type of vehicle is very, very tough to get — clearly, future debtholders are wary if others can join them at the top of the capital stack.

So, if you are left with no option but convertible debt — then by all means insist on a nominal amount of equity and a board seat, so that you have some of the control that equity represents.

If you can’t get convertible debt, think in terms of sweeteners. No debt or equity issue for an early stage company would be complete without a warrant offer, these days. For every dollar put in to a company, make sure you have a nice sweetener in the form of a warrant that can be executed within five years at the same price you bought your original shares at. There’s no protection there on the downside, but it helps you sweeten the returns in the case of a winner.

Rule #3. The more you have to spend, the more you’ll like projects.

For smaller investors, likely the only way you’ll be able to invest is in company stock. And the smaller your kitty, the more likely you’ll be investing in an angel round or post-IPO.

But what about institutions? If that’s where you sit, what the biggest investors tell us is: “think projects as opposed to companies”. The returns are lower — and you still have commodity risk that feedstock cost may soar and the target molecule’s price may drop. But you take a lot of technology risk out, you take some company risk out, and the timelines are comparatively short. Think 18 months from funding to completion, then 6 months to stabilize, and then the inflows start.

Most importantly, there’s no agonizing wait — compared to investing in companies, or the demonstration stage — for the IPO window to open, for a financing solution to emerge for a first commercial, or for project lenders to get in line.

Which project is right for you? Think first commercial. You can get a better return than the second commercial, because of the perception of elevated risk. If the risk is perception, not reality — you win. If the risk is real — why, that’s a sign that the demonstration really isn’t over yet, is it? And that takes you back to rule #1: No Shortcuts to the Top. And to our next rule…

Rule #4. Seek to deeply understand Technical Readiness, Hedging, and Offtake.

As they say, Warren Buffett and the shmoe down the street have the same 24 hours to work with: it all comes down to how you allocate your time.

There are a million things to put into your spreadsheet and ponder when it comes to industrial biotech. Some people focus on everything, everywhere, all the time. Buffetts focus on three items that can sink you: Technical readiness, Hedging, and Offtake.

Technical Readiness. Is the project really, really ready? Is the data robust? Does the company have world-class analytics of its pilot data? No chance of side reactions, corrosion, blockages, infections, yield-killing conditions, bottlenecks, or catalyst failure? Think again, and understand that data. Is is really, really, really, really ready? Is that design really, really right?

Hedging. What happens if your target molecule goes down, and feedstock goes up? How have the buying and selling prices been hedged? Though financial instruments, through a multi-product, multi-feedstock system? If you don’t want to be [bankrupt] VeraSun, don’t run the risk of getting upside down economics.

Offtake. 15 year fixed price offtake contracts with financeable counterparties are not going to happen in fuels. You don’t want them anyway — especially in a multi-product environment, where you give away the chance of making a more valuable molecule with fixed terms. What you need to see is: deeply committed buyers without a lot of other ways to go. Logistic advantages. Offtake structures that offer protection against commodity cycles. Nuanced production structures based around selling some of the capacity to large buyers for low margins, some capacity to smaller buyers for higher margins, and reserving some capacity to take advantage of spot market opportunities.

The Bottom Line

These are rules, not immutable laws of thermodynamics. There are exceptions.

In the end, it will not be about commodity prices, or reaction times, or titer or rate or yield, or valuation. It will be about deep reflection and about thought — and the calm that comes from having surveyed the landscape correctly.

Napoleon wrote: “In forming the plan of a campaign, it is requisite to foresee everything the enemy may do, and to be prepared with the necessary means to counteract it. Plans of campaign may be modified, ad infinitum, according to circumstances — the genius of the general, the character of the troops, and the topography of the theater of action.”

He was not a member of the French Academy of Sciences for nothing.

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