TENEX GREENHOUSE VENTURES

TENEX GREENHOUSE VENTURES

THE DILEMMA

At 6 o’clock in the evening on June 14, 2002 Frank Ruderman, CEO and co-founder of Tenex Greenhouse Ventures, was on the phone with Dr. Brady Samuelson, the CEO and founder of CardioFib, a start-up medical device company. Ruderman and Samuelson had met on several occasions over the past two weeks to discuss a potential investment in CardioFib from the Greenhouse. The conversation this evening was planned to hammer out the “nuts and bolts” of a relationship between CardioFib and the Greenhouse.

Neither a traditional venture capital firm, nor an old-fashioned angel group, the Greenhouse was a hybrid fund focusing on early stage life science-related companies. The Greenhouse offered its portfolio companies first round venture financing, access to a group of investors with deep industry experience and the willingness to work closely with growing companies, and future financing relationships for follow-on venture funding (if companies met their milestones). In return, the Greenhouse had high expectations of performance and participation from its investments. Ruderman had set aside time this evening to explain the relationship the Greenhouse might have with CardioFib and its management. If the fund decided to make an investment, he wanted to be sure Samuelson and his team knew what to expect.

HISTORY

Frank Ruderman’s career as a venture capitalist was the culmination of decades of experience in the medical and business worlds. He grew up in Wakefield, Massachusetts, and studied Biology at Tufts University, with the expectation that he would become a physician. After graduating from Tufts, and not yet ready to attend medical school, he applied to a number of graduate biology programs. While Ruderman was completing his master’s degree in Vascular Physiology at Boston University, his advisor suggested that although he certainly could complete his Ph.D. work, he might want to consider a career in the business of biology rather than biological

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research. To “buy time” while he considered his options, he took a job teaching math and biology, as well as coaching basketball, at a local business-focused junior college. Through his teaching position at the junior college, Ruderman recalled, “I met a lot of folks who told me that I was unique among research scientists. My personality was more sales and marketing than research. They suggested I consider business school.” Ruderman applied to, and was accepted at, Dartmouth College’s Tuck Business School. Reflecting back on the path that took him from potential physician to future businessman, Ruderman recalled, “I was just sort of following my nose. It is indicative of what I have continued to do since. I surround myself with good people, people who have my best interests at heart, and who can give me a read on myself.”

After graduating from Tuck in 1972, Ruderman took the first of several positions in “the corporate world”, where he would spend the next ten years working with a variety of life science-focused corporations in various sales and marketing and general management functions. (See exhibit 1 for a brief professional bio.) In 1981, he took his first early stage CEO position which launched a career in his own words, of being “a serial and serious entrepreneur.” Even with a number of entrepreneurial experienced under his belt, until 1996 he never experienced a company “cash out.” Then within one year, four of his companies had liquidity events. In February 1997 after selling and transitioning Genomyx, a functional genomics company founded at Genentech, to Beckman-Coulter, he officially retired for a while. “I bought a boat and decided to take it easy. I didn’t know what to do, so I started angel investing to redeploy some of my resources.” His “informal” angel investing eventually led to the creation of Tenex Medical Investors (see below). About a year later, he was recruited to be CEO of Berkeley HeartLab, which eventually became a Tenex Medical portfolio company. As Ruderman put it, “Before long, I was fully employed again.”

Tenex Medical Investors

After about a year of investing independently, in 1998 Ruderman participated in the founding of Tenex Medical Investors (Tenex), a forum for angels who had relevant life science experience and interest in investing in emerging life sciences companies. The concept of angels working together in a group had first arisen in 1995 when Hans Severiens and other Bay Area angels formed the Band of Angels, an angel investing network focused primarily on high tech companies. The Band of Angels worked with companies from a number of high tech industry segments, providing them with seed capital, as well as mentorship, guidance, and oversight¹.

Frank Ruderman and Tenex co-founders Alfred Mandel and Paul Quadros posited that an angel group with a vertically-focused membership on life sciences and an exclusive investment focus would have advantages over a generalist group like the Band. The deep industry expertise of its members would differentiate Tenex from other angel groups and VC firms. Furthermore, it would give portfolio companies access to what Ruderman described as “intellectual capital”, the relevant and meaningful guidance of a larger pool of angels.

¹ The founders of the Band of Angels had observed that private investing was becoming increasingly time-consuming and challenging. Identifying opportunities, screening potential investments and pulling together financing was possible for one investor acting alone, but was easier for several investors acting together. Several case studies address concepts in angel investing, including GSB Industry Note e-127 “Angel Investing” and HBS case 0-898-188 “The Band of Angels”.

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Tenex’ founders brought together over 125 other highly experienced technical and managerial professionals from the life sciences field. They established a headquarters for the group in Burlingame, California (now shared with the Tenex Greenhouse Ventures fund.) Tenex’ founders established Tenex as a “non-profit forum for entrepreneurs and investors”: entrepreneurs presented to Tenex members as a group, and then each angel made his or her investment decisions independently. The fund’s role was to facilitate this dynamic and to enable the due diligence and investment processes. Any company that became part of the Tenex portfolio had access to the intellectual capital of the whole group and also to the Tenex facilities, when required. Frank Ruderman explained that Tenex succeeded as a non-profit, because providing portfolio companies with access to the Tenex intellectual capital results in better investment decisions and more opportunities for the Tenex angels: “The angels work with entrepreneurs and bring the entrepreneur expertise to the portfolio company, but this is more than just a free service. We expect a quid pro quo in access to deals. This is an economically driven operation.”

In 1998, Tenex was contemplating an investment in a re-start of Berkeley HeartLab, a specialty reference laboratory that was repositioning and relaunching itself as a provider of advanced cardiovascular treatment informatics for secondary prevention and management of coronary artery disease. As a prerequisite to final investment interest from Tenex, the fund inserted Frank Ruderman as the relaunched company’s CEO. With his career of managing life science companies, and degrees in biology, vascular physiology, and management, Ruderman (like many other Tenex members) was an angel investor who had relevant experience and was prepared to take an active role with the company immediately. His first task was to “stabilize the ship and stop the bleeding,” as he put it. He devised new revenue models for the company to pursue, and within less than four years tripled the number of customers and grew monthly revenue to over $750,000, a greater than 5x growth rate from 1998. Ruderman explained that working so closely with portfolio companies was the essence of the angel’s job: “With angel investing, you have to get personal. You go belly to belly and you go face to face with the investments. You get into it. You’ve got to smell it, and you’ve got to feel it.” By 2001, Tenex had become the largest life-science angel investor network in the United States, with over 160 members. (See exhibit 2 for more details on Tenex Medical Investors.)

BUILDING THE GREENHOUSE

In 2000 and the first half of 2001, when a difficult and deteriorating economic environment presented new challenges for angels, as well as for professional investors, several members of Tenex, led by Frank Ruderman, teamed up to create a new investment vehicle. When the bubble burst on the dot.com economy in early 2000, Tenex’s members began to speculate whether the group’s angel investing model would still work in a deflated economy. Ruderman recalled:

Tenex was made up of high net worth individuals who had a lot of liquidity during the market’s heyday. Angels were doing a huge number of deals and there was money available. That all stopped in 2000. The public market closed, and the liquidity of the high net worth guys dropped. Fewer deals were being done. We became much more pragmatic about where and how we wanted to invest. We still had high net worth guys who had resources and were interested in investing, but they were much more scrutinizing and far more deliberate in decision making.

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Tenex’ members were concerned about the state of the market for liquidity and the availability of sufficient follow-on capital at attractive step-up valuations. They were primarily aware that the new scarcity of capital increased the likelihood of being “washed out” of any early stage investment they did make. These angels recognized the possibility that they could make a considerable investment of time, money and effort in the early stage, only to have a “crunch-down”² round from a VC wash them out. Given these insights, Ruderman and his peers saw a “strategic imperative” to adjust their current model of angel investing. Ruderman listed the characteristics of the market climate that had signaled this need:

• Less predictability of cash availability
• Tighter funding market with greater scrutiny
• Heightened fear of “crunch-downs”
• Significantly fewer deals being done with more competition for the premier deals

• Investors’ preference for co-investments and large consortiums to insure funding through subsequent rounds, if required

• Expectations of two or more rounds of financing with the initial funding

Hand in hand with this new climate was a set of demands that an investing vehicle would need to satisfy:

• Improved deal flow with focus on early stage life science deals
• Being prepared to put more than one round of funding in place
• Emotion/passion component still in place: availability of intellectual capital

• Knowledge of segment: to understand the problem and to impose an enlightened fatal flaws analysis

• Co-investing with other financial institutions
• Assisting entrepreneurs in future rounds with institutional funding

Ruderman and his colleagues believed that the answer was to create a new hybrid fund that would embody the best that Tenex already offered, along with the financial resources of at least one if not more than one venture financing institution. He and two fellow Tenex angels — Robert Leach and Paul Quadros — became the founders of Tenex Greenhouse Ventures LLC (the Greenhouse) along with Tim Mills Ph.D, a partner at Sanderling Venture Partners, which became one of the two founding venture financing institutions.

What had always set Tenex apart from other angel groups and VCs was its focus on life sciences and its members’ deep experience in the sector. Their “narrow but deep” intellectual capital improved deal flow, allowed for extensive and rigorous due diligence, and provided support for portfolio companies. The Greenhouse’s founders believed that reinforcing this with institutional-strength financial resources would allow them to continue to fund successful investing opportunities. Ruderman described the situation as they launched the Greenhouse, “We already had a path for feeding well-supported seed-round companies to institutional investors. The challenge was to institutionalize the approach, to establish a sustainable identity and to harness the intellectual capital.” The founders brought together 70 fellow Tenex angels, and established affiliations with two institutions: Sanderling Venture Partners, a biomedical-focused venture firm, and Diaz & Altschul, a late stage healthcare investment firm.

• A “crunch down” or “down round” occurs when a company receives a lower valuation in a follow-on round than it did on a previous round. As a result, the equity of investors from previous rounds would lose value.

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The founders dubbed the new fund the Greenhouse, because it was conceived as a venture capital fund that would “grow and nurture” its portfolio companies into successful life science businesses. In short, the Greenhouse would be more than just a financial investment fund. It would also reflect Tenex’ ability and willingness to leverage the knowledge and network of its members, and would draw on the financial resources of its professional investor partners. As Greenhouse president Robert Leach explained, “We capture as much of the knowledge of the Tenex angels as possible. We want to be known for providing superior returns to our investors by nurturing our portfolio companies with the vertical knowledge and networks represented by Tenex and our institutional investors.”

The Greenhouse planned to allocate the fund over three years, making about four investments per year. The group was willing to invest in companies at the seed, start-up, re-start, or spin-out stage. The average investment was $1-1.25 million, which would support the company for 9-18 months with the expectation that professional investors such as the Greenhouse’s partners or other VCs or institutional investors would take follow-on rounds, when the company needed significantly less of the Tenex non-financial resources.

Though the Greenhouse was not an incubator, it did offer additional resources beyond those typical of traditional angel groups or VCs. For example, it gave portfolio companies access to sophisticated laboratories, including wet labs, and fully furnished office facilities at its Burlingame headquarters ‘innovation center’. The Greenhouse also offered consultative management talent and administrative support for its portfolio companies. Members of the Greenhouse would actively work with management to hone business and organizational strategies, to recruit outside business and technology management, and to set up operations. In return for its investment of these non-financial resources, the Greenhouse viewed itself as a participating partner and expected a percentage, dependent on the extent of resources used, of founder’s common shares of company equity and at least one seat on the Board.

Ruderman and his co-founders selected established institutional investors with biomedical expertise and focus for partnership in the Greenhouse as a means to increase investing capital. The partnership with institutional investors strengthened the Greenhouse’s unique ability to identify and support the best start-ups in the life sciences sector. All of the Greenhouse members’ existing relationships, networks and knowledge would give them unparalleled access to opportunities and the ability to support and strengthen these companies. In addition, early stage opportunities that came to Sanderling or Diaz & Altschul could be redirected to Greenhouse. The relationship with institutional investors would also serve as a key marketing point for the Greenhouse in attracting the best investment opportunities. As Ruderman explained, “We want the entrepreneur to say, ‘Hey, I want to deal with these angels. They will work with me. They can get their hands dirty now, and they have back-end protection.’” The fund expected that entrepreneurs would value the access to follow-on financing because it would relieve them of the stress and time-demands of fundraising, and allow them to concentrate on the immediate challenge of growing the company.

Sanderling and Diaz & Altschul were eager to join the Greenhouse because it offered them interest in, and access to, pre-screened opportunities that would be supported and well-nurtured in the early stage by the Greenhouse. Sanderling had just raised a fund of over $300 million, and

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saw the Greenhouse as an innovative way to deploy some funds, while conserving its human resources. Diaz & Altschul was essentially a public hedge fund and saw its position with Greenhouse as a path to future private equity investing. In both cases, the firms saw the Tenex element as key to attracting and nurturing deals that larger funds could not easily work with. Fred Middleton, General Partner of Sanderling Ventures explained:

We were attracted to the Greenhouse because of the unique situation it presents of providing key physical infrastructure for companies when needed, and access to the experience of the Tenex Medical Investors. Through this combination, the Greenhouse brings technical, managerial, and strategic know-how directly to companies that can most benefit from these advantages, providing them with the critical resources they need to grow into successful life sciences companies.

Despite the founders’ and partners’ enthusiasm for the Greenhouse concept, the new fund received a lukewarm reception from its peers in the investing community. As Ruderman recalled, “The response was ‘We don’t see it.’ They either didn’t understand the concept of integration of angels and VCs or the uniqueness posed a competitive threat; regardless, initially there was not a lot of overwhelming support. But now, by 2002, one year after its inception, the naysayers are starting to go away.” Ruderman credited the increasing respect for the Greenhouse concept to the venture community’s pressing need for a new model:

This is more than an innovative approach to angel investing, it is an enabling approach to VC investing. How does a VC get access to early stage opportunities? How can he participate professionally in $1-3 million financing deals that are likely to succeed, but need nurturing for 12 to 24 months? If he wants to put $7-10 million to work, how does he do that within his present structure, without adding headcount or draining resources? The Greenhouse answers that question.

To illustrate the situation, Ruderman made a comparison, “We’ve sat in the church of early stage life science institutional private equity investing. We saw the pews that were available to us, but we couldn’t see the altar from those pews. We didn’t want to move out of the church, so we had to move the pews and rearrange the seating so everyone could see the stage.”

LAUNCHING THE GREENHOUSE

In October 2001, Tenex Greenhouse Ventures announced the successful completion of its $12 million fund-raising. Though it might have seemed counter-intuitive to rollout a new fund in the middle of a recession, The Greenhouse’s founders believed that even in a difficult economic environment, they were well positioned to succeed. As Robert Leach commented in June 2002, “These will be challenging times for VCs and companies for at least the next six to nine months. But a new VC firm like the Greenhouse does not have prior investments to support and to distract it. We see this as an ideal time to launch a new fund.” Furthermore, the market’s new distaste for dot.com-era companies had not negatively impacted life science companies. As the Sorrento Valley Business News reported in November 2001, “In the year 2000, the phobia against investing in life sciences by the public and by the venture community fell away as the markets opened for a very healthy window of public financing… While the performance of the overall stock market has appeared weak, this appearance belies the reality of a great deal of

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positive fundings taking place.” Also, as Ruderman explained, “The early stage life science space proved relatively immune to market vagaries, taking most of its value from technology enhancement, feasibility demonstration and market acceptance confirmation.” Nevertheless, the fund amended its initial plan to raise $18 million, and closed at $12 million. The founders decided to “seize the moment” with the funding available and move more quickly from the fundraising phase to the investing phase. The decision was motivated in part by the tight financial market, in addition to the group’s eagerness to prove the model. They knew that this could clearly be accomplished with $12 million, laying the foundation for Greenhouse II.

THE INVESTMENT DECISION

In its first twelve months, the Greenhouse had reviewed over 225 business plans and was in the process of completing three financings. To-date in June 2002, it had been consistently able to follow its preferred pathway of milestone-based trenched investments of up to an aggregate total of $1.25 million with a piece of the founder’s common equity for delivering the incremental non-financial value by being a participating partner. Ruderman expected that the fund was ready to make a decision on CardioFib within the week.

The Company

CardioFib was a cardiovascular medical device company that was developing a mapping technology for atrial fibrillation. (See exhibit 4 for more information on the company.) Dr. Brady Samuelson, a medical school professor and successful ‘serial entrepreneur, had developed CardioFib’s technology. He recognized the potential of the technology, and built an initial prototype with money raised from “friends and family.” With the company underway, Samuelson received $350,000 from the Band of Angels in October 2001. Unfortunately, as Samuelson recalled, “The money had allowed us to begin to develop a new prototype, but was really not enough to establish ourselves. So we went out again to seek financing six months later.” The CardioFib team approached the Band as well as Tenex Medical Investors, but both angel groups passed on the deal. Frank Ruderman explained that the Band had decided not to invest because of its reticence to participate twice in a single deal; Tenex did not embrace the investment because it felt that Samuelson’s goals for the company were too broad. Furthermore, CardioFib had not reached a solid fundable benchmark with their initial seed financing. Two months into this financing activity and eight months after the first Band investment, CardioFib “resurfaced” at Sanderling. Ruderman recalled:

One of the Sanderling partners had segment expertise and took a new view on the business. He thought that CardioFib should drill down on just one of the company’s four goals. But CardioFib was still too early stage for Sanderling, primarily because it needed significant guidance to make this strategic transition. The partner called me to see if Tenex or the Greenhouse would be willing to consider the deal in a new light.

This time, Ruderman’s interest was piqued. In an initial conversation with Samuelson, Ruderman realized that the Greenhouse could be very attractive to CardioFib. “They had been talking with other people, but we differentiated ourselves quickly. We showed Samuelson that we know the segment better than most investors and that we have a vision for CardioFib’s future, and the ability to support the company in the present and in the future.” Ruderman explained

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that an early stage company needs what the Greenhouse offered: “A lot of involvement from relevant intellectual capital, experienced supervision and a direct line towards follow-on funding.” In fact, as Ruderman saw it, this set of needs was always present with early stage companies, and would always give the Greenhouse a competitive advantage over other funders. He explained, “We would always be the choice over an angel group or a VC firm, except when the entrepreneur really doesn’t want someone working with him or if he can aggregate it himself due to prior successes.” The real competition that the Greenhouse faced was with the entrepreneur’s tendency to be “a control freak,” and to resist the “interference” and involvement that the Greenhouse presented.

Ruderman was particularly eager to clarify these final issues with Samuelson. Some entrepreneurs often instinctively resisted the intrusion of a team of investors involving themselves closely with the management and development of the company. The Greenhouse’s signature, however, was to work closely with the company and to provide it with the intellectual capital of its experienced members. Many entrepreneurs also resisted the milestone-based funding approach preferred by the Greenhouse. Would Samuelson do so as well, or would he welcome the insight and involvement from his investors and embrace the need to be accountable for achieving his plan?

In the case of CardioFib, Samuelson had embraced the idea of adding a new board member, but he had indicated a reluctance to accept an interim COO from the Greenhouse. As Ruderman explained,

He had established a set of milestones internally, and was working towards those goals. It’s not that Samuelson is naïve or unqualified to lead the team. We simply believe that it is prudent for the Greenhouse to participate in deciding what is best for the company given its prior history. Had Samuelson considered fully whether he was the right person to lead the company? His initial hesitation to a new COO had given us pause. We wondered if he would be unable to relinquish any control at later junctures, even if it would add value. If you’re going to put money into a new venture, then you really want to be able to partner with the entrepreneur, so that you can help him increase the probability of his success. Making major decisions is part of that partnership agreement. It sounds very basic. But it is really the most difficult concept for entrepreneurs to get into.

Ruderman pressed Samuelson on the management plan for the company. The Executive Summary did not offer insight to a management succession plan. Ruderman probed Samuelson on his current ability to lead, and his plan for the future. What was his view on succession and how would he enact his plan? Implicit in these discussions was his confidence and capability to achieve the stated milestones and ultimately his perceived value of the Greenhouse. Or was he just maneuvering for funding with minimal outside influence. Samuelson’s reaction to a discussion of leadership played out Ruderman’s concerns. “If we accept an investment from the Greenhouse, we ultimately embrace more interference from you and I’ll have less control of CardioFib. I’ve put my heart and soul into making this company run for the past 30 months. Do I want someone else to be the one to take us over the finish line?” Ruderman responded with frank honesty:

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It’s true that you’ll lose some control now. We are likely to hold you to greater accountability than other investors will. Our funding is based on milestones that we set together, and those aren’t easy to achieve. You’ll probably also be more diluted in this round than with another VC firm, but likely will need to spend less cash to achieve your goals. And it’s possible that we will recommend that your management team is shored up with other experienced leaders. But keep in mind that we help you with the heavy lifting now so that later you will have a greater probability of achieving your dream. Everyone on our team has already walked this path that you are on – several times.

By the time Ruderman and Samuelson ended their conversation, it was after 9 o’clock. The pair had agreed to speak again on Monday, and to be prepared with a final decision on an investment agreement. If the Greenhouse decided to offer CardioFib an investment, Ruderman would also give the full details of its offer. Samuelson needed to be prepared to make his final decision on his flexibility and willingness to relinquish greater managerial and ownership control.