January 1, 2012 (Vol. 32, No. 1)
Peter N. Townshend
Monique Y. Ho
Daunting Prospects Demand a Variety of Creative Financing Strategies
The current economic climate is not an easy one for any type of start-up company. But life science startups, even those that have progressed beyond the true start-up phase, but have yet to reach profitability, are having an even more difficult time securing venture capital funding than their high-technology counterparts.
The limited partners that invest in venture capital funds have less capital available to deploy and want a quicker return on investment than in prior years, but most life science startups require substantial funding and have lengthy paths to liquidity. Moreover, the Food and Drug Administration (FDA) is under pressure to make changes to the regulatory pathway of certain types of products that would further lengthen and complicate the regulatory process.
As a result, life science startups find themselves in the dangerous predicament of needing both more capital and more time—which flies in the face of current trends in venture capital. To the extent that life science startups are getting funded, it is those that have an easier and faster regulatory pathway or that find a way to establish value without going through the full regulatory process.
Limited Partners Have Less Capital to Invest in VC Funds
Like most investors, pension plans, college endowments, corporations, extremely wealthy individuals, and other typical investors in venture capital funds were hit hard by the stock market crash of 2008 and continue to be affected by the volatile financial markets that have been prevalent since then. Their wealth has been significantly impaired, and, as a result, so has their ability and willingness to participate in high-risk investments like venture capital.
A release published by the National Venture Capital Association (NVCA) and Thomson Reuters on October 10, 2011, reported that venture capital funds raised the smallest amount of capital in a quarter since the third quarter of 2003, as the venture capital industry suffered along with the volatility of the broader economy—52 funds raised $1.72 billion in the third quarter of 2011, compared with 53 funds raising $3.5 billion in the third quarter of 2010.
Limited partners’ ability and willingness to invest in venture capital funds has also been negatively impacted by the stagnant initial public offering (IPO) market.
According to a release published by the NVCA and Thomson Reuters on October 3, 2011, just five venture-backed companies went public in the third quarter of 2011, down 77% from the second quarter of 2011 and 64% from the third quarter of 2010. Without the liquidity afforded by a healthy IPO market, limited partners have less available capital and less incentive to invest in venture capital funds.
In the October 10, NVCA-Thomson Reuters release, Mark Heesen, president of the NVCA, cautioned that “Until we begin to see a steady and sustainable flow of quality IPOs that return cash, limited partners will remain on the sidelines and the venture industry will continue to contract.”
Life Science Startups Are Attracting Less Capital from VC Funds
Life science startups are drawing less of the depleted capital available from venture capital funds. According to a release published by the NVCA and PricewaterhouseCoopers on October 19, 2011, venture capital funds invested a total of $6.95 billion in 876 deals during the third quarter of 2011, with the most investment going to the software sector (a 10-year high for that sector) while the life science sector (biotechnology and medical device industries combined) experienced a marked decline.
During the quarter, venture capital funds invested $1.1 billion in 96 deals in the biotechnology industry, which constituted a decrease of 18% in terms of dollars and 20% in terms of deals relative to the prior quarter, and $728 million in 74 deals in the medical device industry, which constituted a decrease of 18% in terms of dollars and 21% in terms of deals relative to the prior quarter.
Life science startups’ long investment horizon, which stems from the long and uncertain regulatory process for their products, has contributed to their waning popularity among venture capital firms. According to a recent survey of venture capital firms by the NVCA and the Medical Innovation & Competitiveness Coalition, 39% of the 156 venture capital firms that participated in the survey (which accounted for $10 billion in investment in healthcare companies over the past three years) reduced their investment in healthcare companies during the past three years, and the same percentage of participants expect to reduce their investment in healthcare companies over the next three years.
The survey also showed that within the healthcare sector, venture capital investment has shifted away from biopharma and medical devices during the past three years—61% of the venture capital firms that participated in the survey cited FDA regulatory challenges as the top factor affecting their investment decisions.
Life Science Startups Have a Long and Expensive Gestation Period
The approval process for new drugs and high risk (Class III) medical devices is expensive and long. Such drugs and medical devices must generally go through at least three phases of clinical studies before they can go to market. Phase I trials test such a drug or medical device for the first time on a small group of people (20–80) to evaluate the product’s safety, including identifying side effects, and in the case of a drug, to determine safe dosage.
Phase II trials expand the number of participants in the studies (100–300) to attempt to establish whether the drug or medical device is effective and to further evaluate its safety and side effects.
In Phase III trials, which examine long-term efficacy and safety, the drug or medical device is given to large groups of participants (1,000–3,000). Successful drugs and medical devices will generally go to market during or following Phase III trials, although studies will continue in order to obtain additional information, including the product’s risks, benefits, and optimal use (Phase IV trials).
It is common for Phases I through III of the clinical studies for a new drug or medical device to cost in excess of $100 million and take at least six years. Due to the amount of capital required to develop such products, life science start-up companies cannot rely solely on bootstrapping or funding from angel investors and must look to other options, with venture capital funds primary among them.
However, even under the best of circumstances, the path to market of a life science startup’s product may run up against the 10-year lifespan of most venture capital funds. And, it should be noted that neither going to market nor FDA approval guarantees the acquisition or IPO for the company that affords venture capital funds and their limited partners with the liquidity they desire.
As Terry McGuire, cofounder and general partner of Polaris Venture Partners and past chairman of the NVCA, asserted in a recent interview, “The [exit] process has gotten to be so long, and the capital required so deep, that it’s becoming more and more difficult to generate venture-type returns, and therefore, make it worth your while to do it.”
The path to market for certain products may actually become more challenging in the near future. Under the FDA’s 510(k) system, a low risk (Class I) or medium risk (Class II) medical device can be “cleared” for use if it can be established that it is substantially equivalent to a medical device (a “predicate”) that has previously been cleared or approved by the FDA.
510(k) clearance requires fewer if any clinical studies, and is therefore, generally less expensive and faster than the approval process described above. About 90% of medical devices submitted to the FDA are reviewed under the 510(k) system.
However, a series of recent recalls of 510(k)-cleared devices, foremost among them Johnson & Johnson’s decision last year to recall more than 90,000 artificial hips, has led to scrutiny of the 510(k) process. The criticism has led to slower turn-around times on 510(k) clearances and an internal FDA review that may result in an overhaul and slowing down of the process.
Life science startups today face daunting prospects—depleted available capital along with higher costs and a longer path to liquidity. Those that survive, or even thrive, do so by employing a variety of creative strategies for funding.
First and most critically, startups must seek out alternative sources of funding—from angels for early-stage companies to strategic partners, foreign funding sources, venture lenders, and government grants.
Second, startups must strategically consider their commercialization plans—for example, some companies are able to secure foreign regulatory approval sooner and less expensively, and then use profits from foreign sales to drive the U.S. regulatory approval process.
Companies may also set their sights not on an IPO or large dollar acquisition but instead on an early sale, which may mean conducting clinical trials not for the FDA but to establish proof of concept sufficient to entice potential acquirers to fund the U.S. regulatory process themselves (perhaps with an earnout payment to company stockholders).
Finally, startups must take full advantage of all of the upsides of a challenging economy, including cheaper rent and greater availability of talent. Innovation today is essential, not only for research and development, but for all aspects of funding and operating a life science startup.
Peter N. Townshend is a partner with the firm’s emerging companies practice, George Colindres (GColindres@perkinscoie.com) is of counsel with the business practice and emerging companies practice, and Monique Y. Ho is of counsel with the business practice at Perkins Coie.