DEFINING BUSINESS SUCCESS

Traditional biotech companies consume effort and money for the first 5-10 years or more, offering in return to their shareholders only the promise of downstream profits. Stock is an IOU that entitles the bearer to a portion of a company's assets and profits.

Popular notions of what it means to be a successful entrepreneur are misleading. It's not about building a company and taking it public or increasing a company's valuation day-to-day. It's not about creating jobs or even improving society. Successful entrepreneurship is about building a sustainable, profitable business -- everything else is derivative of that simple axiom.

Successful biotech entrepreneurship is less about biotech and more about good entrepreneurship. Whether it is a grocery store or a pharmaceutical company; any business must justify its consumption of resources with profits.

Those of us in the biotech sector who have grown accustomed to measuring success by metrics other than profits, e.g. patent filings, PhDs on the payroll, venture capital financings, may find it worthwhile to review these fundamental principles of business that most everyone outside of biotech finds obvious.

Return on Investment

When valuing an investment opportunity, consider how much profit one could generate with an alternative investment of capital. If an entrepreneur bought a small store, would a few percent profit (percent of total capital invested) per year be considered a good return? Probably not, seeing as the entrepreneur could buy US Treasury Bonds and earn several percent each year without any effort or risk.

But what if the entrepreneur generates a nice profit each year because he has not hired a staff and is doing all the work himself? He could have kept his savings and found a job that paid equally well managing someone else's store. Therefore, when evaluating a business opportunity, we should also value an alternate investment of the entrepreneur's time.

Opportunity Cost

The merit of an investment should be weighed against how much money you could make by investing elsewhere. An adult earning $70K annually who then goes to business school full-time incurs not only direct expenses (tuition, room & board, books, etc) but also the opportunity cost of forgoing $140K in salary during those two years. An investor who puts $1M into a startup only to receive $1.6M five years later when the company is acquired may appear to have gained $600K profit but, in fact, may have lost the opportunity to make an extra $400K if reasonable investments in the stock market would have conservatively returned $2M during that period.

THE TIME VALUE OF MONEY

While different businesses have different risk factors, the risk of time is common to all ventures. Time-to-profits is a critical variable in calculating the merits of an investment. What if the entrepreneur needed to spend three years developing the products? A lot can go wrong in that time, and the only sure thing is that the entrepreneur will spend a lot of his money. The opportunity cost of forgoing other investments of money and effort for three years would be high. Only the promise of huge profits down the road would motivate any rational person to take such a risk.

ENTREPRENEURIAL EFFICIENCY

Entrepreneurial efficiency is based on three variables: (1) invested capital, (2) time to profits, and (3) profits. The relationship between all three is graphically represented in Figure 2. The black area between the Expense and Revenue lines is the total amount of capital a company burns before achieving breakeven. If revenue growth outpaces expense growth, the company will rely less and less on investors' capital until it is finally profitable and can theoretically start to give back value to investors. The larger the black area on the graph (accumulated losses), the larger the white area (accumulated profits) must be before you can consider the company a success. Therefore, the company whose performance is described in Figure 2B is more successful than the one in Figure 2C. Unfortunately, most biotech companies resemble Figure 2C and fail before reaching breakeven.

SUCCESSFUL ENTREPRENEURSHIP

To be considered successful, an entrepreneur must start a business that honors its promise of rewarding shareholders for the risks they have taken. These financial rewards are gleaned from the profits a company earns by selling products. Without current or future profits,

> Figure 2. Simple Profit and Loss Model. Keeping expenses low and generating revenue early allows a company to achieve breakeven sooner (shown in B), resulting in lower net consumption of investors’ capital (black areas) than if company has higher expenses and takes longer to start generating revenues (shown in C).

companies are akin to Pyramid Schemes, vehicles for moving money from one set of shareholders to another.

Some unprofitable companies with valuations in the billions may appear to be successful businesses considering the handsome returns enjoyed by their founders and early investors. While these companies have indeed been successful investments of effort and money, they are not yet successful businesses. At best, you could say that these companies are on their way...

An entrepreneur should not be satisfied that a few early investors profit from the willingness of later investors to pay a higher price for their stock. The company should have a track record of increasing profits, rewarding each new investor with a consistently appreciating share price.

The Ponzi Pyramid Scheme

| In 1919, an Italian immigrant named Charles Ponzi discovered that one could purchase a coupon for US postage stamps in Spain for only one-sixth of their value. By buying $1 coupons in Spain, redeeming them for $6 worth of stamps in the US, and then selling the stamps to customers, he figured he could make a killing. Ponzi bragged about his get-rich-quick idea, attracting investors who gave Ponzi their money in exchange for IOU notes promising a 100% return in 90 days. People poured into Ponzi’s office, arms filled with cash to invest, until the authorities stopped the operation to perform an audit (to which Ponzi submitted willingly for some inexplicable reason). The audit revealed that there wasn’t enough money to even pay back current investors’ capital let alone give them the profits they expected. | There was no stamp business, and there were no customers. The cost of dealing with various bureaucracies made arbitrage unprofitable. Ponzi socalled business was simply to sell more and more IOUs to new investors to pay off the old ones. It was a classic pyramid scheme. Pyramid schemes are inherently a zero-sum game; money trades hands without any value being created in the process (i.e. no revenues from sale of products). If there were infinite investors, Ponzi could have continued forever. As it were, these promises were destined to be broken because the universe of investors is a closed system and therefore finite; eventually a set of new investors would turn out to be the last, and their tremendous losses would equal all the gains of the preceding investors and Ponzi himself. | | :--- | :--- |

An entrepreneur may profit from selling the stock of a company whose value later plummets when the company is shown to have unrealistic revenue projections. While this can sometimes happen even to the most competent of buyers, if the company's impending failure should have been obvious, then the entrepreneur was fortunate to have sold stock to a "fool". While the often nonsensical gyrations of the stock market may lead one to believe that there are and always will be naïve investors willing to overpay for anything, an entrepreneur should not count on this. The entrepreneur's strategy should assume that investors will know everything about the company and will never pay more for a share than it is worth (e.g. as calculated by discounted cash flow).