Editor’s note: Matt Megaro was president and CEO of Quill Medical, Inc., a medical device company that he co-founded in 2000 in Research Triangle Park, N.C. The Company achieved profitability in 2006 following the successful commercialization of a series of minimally invasive cosmetic surgery devices. Quill was sold to Angiotech Pharmaceuticals in 2006 in a $200 million structured acquisition. This article is the latest in the Entrepreneurial Spirit series produced in partnership through the Council for Entrepreneurial Development and WRAL Local Tech Wire.

This is the first of a two-part article. The second part will be published on Tuesday.

RESEARCH TRIANGLE PARK, N.C. – One of the most important things on the mind of any entrepreneur in the late-stage developing their business is exit strategies. Exiting can be a very risky process and it is hard to know sometimes whether or not your company is ready for it. If so, how can you be sure you are following through with the best deal? Matt Megaro has extensive experience in starting and developing biotechnology and medical devices ventures and shared his thoughts with us on current trends in life science exits.

Share some trends in life science exits you have witnessed during the course of your career.

My career in bio-med goes back about 24 years or so, so there have been several ice age-equivalents in that time frame in terms of shifts in the dynamics of the biotech market. But going back to the very beginning, biotech was brand new and there was not a sophisticated investor group out there to evaluate deals. I don’t think investors then really understood what they were buying. The analysts that worked for the major sell side brokerages like Paine Webber and Kidder Peabody were all Ph.D.s who appeared to be oracles in their understanding of this complex technology, if only because they knew at least a little bit more than everyone else, who knew essentially nothing.

As a result, these analysts would recommend a stock, a stock would become popular, and a company could go public and raise a lot of money and create an exit for its original investors. At times, there was an active almost frenetic pace of stock offerings in spite of the complex nature of the technology. This is because the analysts would distill these very complex subjects down to simple sound bites of “here’s why I like it” and “here’s why you should own it.” Investors usually did not need more than this level of understanding mainly because biotechnology was an exciting way to speculate – really, to gamble.

A guy names Stelios Papadopoulos who is now the head of investment banking for biotech with Cowen and Company put it best. Stelios’ comment when he took Athena public, back in 1990-1991, was “there ain’t nothing like a bull market.” And that’s the point. When the market was strong, bullish and positive, 20 years ago, you could float anything. So every few years you would have these episodic openings of an IPO “window” and everybody would rush out and go public – a lot of capital was raised and for the company and early investors would make money – there is no denying that those were fun times but I doubt anyone appreciated at the time just how artificial many of these offerings were.

Many of those companies shouldn’t have been public, though, they just got caught up in the wave of the bull market. Yet, they raised a lot of capital. Some of them put it to good use and survived and flourished. Many squandered the capital on buildings and infrastructure and most of these ended up floundering. But the point is that there was a receptive market for everyone then, which is probably more important than just about any condition for a company seeking an exit strategies such as an IPO’s or an acquisition.

I think the best example of Stelios’ wisdom can be found in the 1990s when Saddam Hussein invaded Kuwait. All the markets shut down completely. Our team got into a limousine at John F. Kennedy airport to begin our road show and the limousine driver picked up our bags and he looked at us and said “Hey! Are you guys on a road show?” When we told him that we were, he responded, “Aw, man I haven’t seen a road show in ages!” And that told us it was going to be a long, hard fight. It was very difficult offering and we raised a fraction of what we were looking for that year. Then, a year later, while our story hadn’t really changed much, the war had been won and the markets we happy and robust and Stelios took Athena public in what turned out to be the second hottest Biotech IPO for 1991. So, what happened? Favorable conditions – Stelios’ fabled “bull market”.

I think that the exit environments will always go through these cyclical periods where they are more or less receptive to technology deals, but I don’t think we are going to see the same wild swings that we saw once just because I think we’re smarter investors, smarter businesspeople, bankers, etc. Of course, we will continue to see IPO’s as an exit for many companies, but far fewer that in the past and these offerings will be for much better composed ventures, with solid management and tight business strategies. These are the sorts of companies that can manage the challenges of being public anyway where severe penalties are levied for missteps.

The obvious shift now for exit opportunities is to the venue of mergers and acquisitions. The reason for that is two fold: one, IPO’s are a lot less accessible for most small companies, because, frankly, most of these companies are mature enough to be traded publicly. I think the market has wisened up to that. The second reason is that big Pharma and big medical device companies have now accepted reality, which is that they don’t innovate very well overall relative to their resources and their opportunities. There are a lot of complex reasons and some very simple ones for why they don’t innovate, but at least they realize this limitation and they have responded by being very active with their strategic license and acquisition deals with smaller emerging companies.

If you look at the numbers at the moment, the return rates for small company investors (private stage investors such as venture capitalists, private investors, angels, etc.), are much higher for companies that succeed in an M&A exit, maybe 5 or 6-fold of investor capital, as opposed to the return for those who mange to going public, which is maybe less than two fold. So, if you invest a dollar and get back two or less in the IPO venue, as opposed to getting back five or six in the M&A venue, then clearly you see what is driving the phase shift in exit strategies to the M&A solution.

I don’t see that going away. In fact, I see most little companies who face very large future development costs and capital requirements, increasingly positioning their businesses for a most favorable acquisition or merger opportunity. M&As should dominate future exit strategies. In fact, as I read current business plans for emerging companies, I increasingly see “M&A” replacing “IPO” as the intended exit path forecasted to prospective investors.

Can you explain why partnerships between large pharmaceutical companies and biotechnology companies are such a big trend? How long do you think this particular trend will last?

Well, let’s define what a partnership is. You know, when I was doing this 20 plus years ago, the deals of the day were “collaborations.” We’d often call them partnerships, but they really weren’t that equilateral. A collaboration was, “ok, we’ll pay some of your research costs, make an equity investment and some milestone payments along the way and you get a royalty once the product gets to market.”

The royalties would vary from anywhere from 2-7 or even 8 percent. On a very rare occasion, you saw 10 percent royalty. So in those days a small company would say “okay, well lets go out and do two, three or maybe four deals like this and even though the royalties aren’t big, our future revenue stream will be in the hands of these really well- recognized big companies and this will make us look good to public investors. That’s what was once called “window dressing” in order to go public. For a long while, this was fine, until investors learned that these deals took a long time to mature and the royalty rates did not have the prospect for substantial growth in company value.

If you accept that the trend is now away from IPO’s as an exit strategy, then companies should no longer focus on these sorts of “window dressing” deals that are, in the end, pretty lousy value builders. I hate to see little companies today say, “hey we have done this deal with this big-name company,” and then they don’t have much to say about the actual terms of the deal. They may have received $5, $10, or $20 million up front, but they are going to spend that – It’s gone from the perspective of value growth. The only sustainable value, the only thing that seems to grow franchise value over time is a share of the action. And that’s driven by the size of the royalty. And in the case of a partnership, it’s the share of the profits. Now the deal that we did at Trimeris, was driven by a desire to see significant 50/50 profit sharing, with Roche taking all the product development burden on, finishing the clinical trials, and taking the product to market. If they could do that and drive the product to a high profit, then Trimeris would receive half of the profit from their effort and this made our little company look like a good bet for value growth. If all that had been achieved was 6 or 7 percent royalty, it would not have excited anybody in the public markets for very long and Wall Street would eventually have said, “That’s not much of a growth prospect – we’re bored with this story; show us something else.

So I think the partnership trend is here to stay. I think it’s the only way that small companies, in a waning IPO market, can hold out the promise for an IPO, is to address the value growth desires of Wall Street with high value partnerships. These deals also create a chance for a favorable acquisition. If the product shows promise, the partner will start calculating how much this deal is going to cost them over time and will likely try to buy out the deal now and this could mean an attractive exit for the start-up. Clearly, the more share they have to buy back, the more they are going to pay; so getting the right partnership terms now is critical. I typically trade away up front and milestone payment for more share of the revenue or earnings – again, the main value driver. So partnerships do two things: they catalyze prospective M&A prospects for you, and they also enhance your value with Wall Street. So I guess that high value partnering deals keep both acquisition and IPO squarely on the path of the company’s exit strategy.