ARCH Venture Partners: Stay in School –

It started out as a conversation between Graeme Bell, a professor at the University of Chicago, and Bob Nelsen, a managing director of ARCH Venture Partners. The topic: opioid receptors (trigger points for the body’s natural pain suppressors for those in the back of the class.) Nelson and his partners were so intrigued that they crisscrossed the country, meeting with other scientists working in the area.

Convinced they were on to something, the ARCH team wrote a business plan, licensed technology, assembled a management team, and put together a syndicate to fund their creation. The process took about 18 months, but it ultimately paid off thirteen-fold when they took their baby, Adolor Corp. (NASDAQ: ADLR), public in fall 2000.

“You have to go out and locate the craziest angel to find someone as deep in the seed- to early stage space as we are,” says Steve Lazarus, a managing director at ARCH, based in Chicago. “We are the first investor or start about 95 percent of the companies we back.”

Since ARCH spun out of the University of Chicago in 1986, a number of other firms have pursued a similar investment strategy, including Diamondhead Ventures and Redleaf Group Inc. But ARCH remains one of the granddaddies of building companies from ideas that emerge from universities.

ARCH, with 20 investment professionals and $700 million under management, follows a multi-disciplinary approach, investing in ideas centered on life sciences, physical sciences and information technology. Specifically, it targets companies focused on telecommunications, genomics, medical devices, pharmaceuticals, semiconductors, optical networking, and advanced materials.

This multidisciplinary approach allows ARCH to be a convergence investor, meaning the firm backs companies that combine a number of different technologies and sectors. “Over the last three to five years, this has been one of our intense areas of focus,” Lazarus says. “Many opportunities, especially in the life sciences, are companies that are comprised of life sciences elements along with physical science and IT aspects.”

To wit, ARCH backed Caliper Technologies Corp. (Nasdaq: CALP). The Palo Alto, Calif.-based company develops systems that combine semiconductor technology with biotechnology, simplifying many laboratory processes.

With offices in Chicago; New York; Seattle; Austin, Texas; and Albuquerque, N.M., ARCH scouts for deals nationwide and works with the 30 largest universities in the country. It also has relationships with seven of the 12 U.S. Department of Energy Laboratories.

ARCH does not enter into any formal relationships with universities. It prefers informal working relationships. “We try to be friendly and helpful with universities’ technology transfer offices, because a formal relationship requires us to look at every deal coming off of a particular campus – even if you know from day one that a certain deal won’t work,” Lazarus explains.

ARCH has done deals coming out of other research laboratories and has begun working with the research programs at large corporations to spin out technologies into new enterprises. The most successful example of this process is Boulder, Colo.-based, Array BioPharma Inc. (NASDAQ: ARRY), which ARCH helped spin out of Amgen Inc. The drug discovery company has a market cap of about $350 million, and it generated a return that was several times ARCH’s initial investment, Lazarus says.

Investing in early stage companies poses a variety of challenges. One of the most significant is the condition of the public markets and the M&A environment. “This high-risk business must be conducted, somewhat paradoxically, with an excess of caution,” Lazarus says. ARCH coped with the downturn in the public markets last year by deepening the cash reserves behind its portfolio companies. It also helps that the firm always tries to syndicate its deals to share the risk and the work involved in any venture deal. “Despite how optimistic you can be at the beginning of a deal, things often take twice as long to get half as far as you initially expect,” Lazarus says.

Among the firms ARCH frequently co-invests with are Venrock Associates, Frazier & Co., Madrona Venture Group and CW Group.

ARCH typically takes a board seat in every deal it does and it likes its syndicate partners to take board seats, too.

The firm has invested as little as $20,000 in some seed deals, like it did for opto-electronic implant maker Optobionics Corp. in 1997. It expects to commit $10 million to $15 million to an individual portfolio company over the life of a deal.

The firm’s goal is to have a 20 percent ownership stake in its portfolio companies at the time of a liquidity event. “We found during Fund I that ours was the hand on the laboring oar, so we have raised bigger funds to make sure we can maintain our ownership position where we want it to be,” Lazarus says.

Arch has raised five funds. The University of Chicago provided $9 million for its first fund in 1989. Arch Venture Fund II raised $31 million in 1992, while ARCH Venture Fund III rang up $107 million in 1996. The firm raised $180 million for ARCH Venture Fund IV in 1999. Its most recent vehicle, the $380 million ARCH Venture Fund V, closed in 2000. Fund V has done 17 deals and will likely end up backing somewhere between 27 to 34 deals, Lazarus says.

He declined to reveal the exact return for each of the funds, but he says they have been ranked in the top quartile of most published performance summaries.

Early 2003 is a likely time for ARCH to begin planning its next fund. It will probably not be very much larger than Fund V. “We feel like we need to resist getting much larger than we are,” Lazarus says. “I think $400 million is about the right size for us, plus I think all of us who have been through the flurry of 1998 and 1999 will likely invest more slowly in the future, too.”

ARCH has an industry standard 2.5 percent management fee and an 80/20 carried interest split.

Its limited partners include foundations, pension funds, universities and corporations, Lazarus says, declining to identify any LPs by name. The University of Chicago remains one of the firms investors.

To its credit, ARCH has been able to retain the core team that founded the firm Lazarus, Keith Crandell, Nelsen, and Clinton Bybee. Says Lazarus: “The cohesiveness and tightness of our relationship is a strength.”