January 1, 2010 (Vol. 30, No. 1)
J. Leslie Glick Ph.D. Independent Corporate Management Advisor
Start-Ups Will Have to Operate with Lower Overhead and Less Capital for the Time Being
To paraphrase Winston Churchill, starting up tomorrow’s biotech firms is a bit of “a riddle wrapped in a mystery inside an enigma.” The riddle is that cutting-edge biotechnology may both increase and decrease risk.
The mystery for biotech start-ups is how to obtain capital when so many investors have been burned before, and may now prefer less impressive but more predictable returns in later-stage investments.
The enigma is how venture capital (VC) firms will raise the funds to invest in biotech or any other technology when so many limited partners, whose portfolios were hit hard by the 2008 financial crisis, have fewer funds to invest in VC firms and, by becoming more risk averse, may prefer to avoid such investments. We’re definitely entering a game-changing era.
First, let’s consider the riddle. Biotech investments have always been high-risk investments due to the high costs of R&D, long lead times for R&D successes to be commercialized, and high R&D failure rates. R&D spending per new biopharmaceutical launched can readily exceed $1 billion. Yet, over the past 30 years, an escalation of discoveries in molecular and cellular biology and a proliferation of concomitant technology platforms have dramatically increased the odds of solving big problems regarding health, agriculture, energy, and the environment.
For example, advances in functional genomics will eventually impact healthcare to an unprecedented extent, not only by helping to enable the widespread practice of personalized medicine, but also by leading the way toward the treatment of learning and memory disorders, the cure of hereditary diseases, and the retardation of aging.
This example of cutting-edge technology will both increase and decrease risk. The increase is obvious. A gigantic opportunity, such as the retardation of aging, will entail many years of research, costly false leads, and huge outlays of capital.
The decrease in risk is due to the coming of age of personalized medicine.
Customized therapeutics are likely to provide greater efficacy with fewer side effects if targeted to population subsets. Clinical trials should require lower enrollments and shorter periods of time to complete and result in reduced failure rates and fewer product recalls following FDA approval. The costs of R&D should drop considerably and lead to high rates of return from such niche market-directed therapeutics.
On to the mystery. A recent PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report (Q1 1995–Q3 2009) has revealed some surprising data in light of the financial crisis that exploded at the beginning of the fourth quarter of 2008. Comparing total U.S. VC investments and number of deals closed in fourth quarter 2008 vs. fourth quarter 2007, first quarter 2009 vs. first quarter 2008, second quarter 2009 vs. second quarter 2008, and third quarter 2009 vs. third quarter 2008, in all cases significant deceases were noted in the quarters occurring one year later than the comparison quarters. For the most recent four quarters, compared to their corresponding prior quarters, the total dollars invested and the number of deals closed averaged 41% and 32% lower, respectively. However, for just biotech investments, the total dollars invested and the number of deals closed averaged only 21% and 22% lower, respectively.
For all U.S. VC investments representing first-sequence investments, i.e., the first investment made in a company from external sources, the total dollars invested, and the number of deals closed averaged 54% and 46% lower, respectively. With respect to first-sequence biotech investments, the total dollars invested and the number of deals closed averaged only 33% and 39% lower, respectively. In other words, the falloff of VC investments from the fourth quarter of 2008 through the third quarter of 2009 was less severe for the biotech industry than for all industries combined, even regarding riskier first-sequence investments.
The relative competitiveness of the biotech sector in securing VC funds during the current economic downturn reflects a similar pattern observed during the prior 13 years, a growth period for both the economy and VC investing. As I reported in the October 15, 2008, issue of GEN, and subsequently documented in the October 2009 issue of the Journal of Commercial Biotechnology, from 1995 through 2007, VC funding of U.S. biotech companies grew at a faster rate percentagewise than total VC funding of U.S. companies (except during the dot-com bubble from 1999 to 2001).
Now for the enigma. Thomson Reuters and the National Venture Capital Association released a report on October 12, 2009, showing extensive declines in the ability of VC firms to raise funds from the fourth quarter of 2008 through the third quarter of 2009. Comparing total capital raised and number of funds closed in fourth quarter 2008 vs. fourth quarter 2007, first quarter 2009 vs. first quarter 2008, second quarter 2009 vs. second quarter 2008, and third quarter 2009 vs. third quarter 2008, in all cases significant deceases were noted in the quarters occurring one year later than the comparison quarters.
For the most recent four quarters, compared to their corresponding prior quarters, the total capital raised and number of funds closed averaged 66% and 54% lower, respectively. Moreover, the declines were most severe in the second and third quarters of 2009, compared to the second and third quarters of 2008, when the total capital raised and number of funds closed averaged 80% and 70% lower, respectively.
Future of Start-Ups
What does this all portend for biotech start-ups? First, start-ups combining first-rate science with experienced entrepreneurs and project managers will have to operate more efficiently with lower overhead and less capital. This may mean forming a virtual company, which, at least for its first couple of products, licenses in technology and outsources further development, manufacturing, and sales.
This also means exploiting other technologies outside of biotech in order to operate most efficiently. For example, according to Malorye Allison in the October 2009 issue of Nature Biotechnology, “One-third of [clinical] trial sites fail to recruit a single patient and fewer than 20% of clinical trials are completed on time, with about half of the delays attributed to patient recruitment.” This has led to the formation of social networking sites by both nonprofits and commercial enterprises. One such enterprise, iGuard, was reported to have recruited over 2,500 patients for more than 60 clinical trials. iGuard claims that its services shorten its clients’ study timelines by 4–6 months.
Second, even though total VC funding has fallen considerably in these difficult times, and biotech companies have also been hard-pressed to secure capital, biotech’s share of VC has increased percentage-wise. This suggests that high-risk investments in biotech are preferentially being made because there is now a critical mass of well-managed development-stage biotech companies exploiting accelerating advances in enabling technologies. For knowledgeable investors the perceived rewards outweigh the perceived risks. As the economy recovers, more risk capital will become available, especially when exit strategies once again include initial public offerings.
Finally, the economic collapse that occurred in late 2008 was not due to a failure in the VC marketplace, but rather a failure in a much larger financial universe involving the massive write-down of poorly understood, high-risk complex investments such as credit default swaps. Fund-raising by VC firms will improve as the economy recovers. Moreover, help is coming from some innovative state programs such as the Ohio Third Frontier, a $1.6 billion commitment that has created and nurtured over 500 companies, with a heavy impact on the biotech sector.
In June 2009, Florida state officials announced the formation of the $250 million Florida Growth Fund, managed by Hamilton Lane, an independent investment-management firm. Hamilton Lane is placing these funds in VC firms as well as directly into companies through investments with other institutional investors. Interestingly, as noted in the October 31, 2009, issue of The Economist, when governments try to directly manage VC funds that they create, they fare somewhat poorly, such as government funds created in Canada, France, Norway, and Malaysia. When they invest directly as limited partners in VC funds, they achieve much better results, such as in Israel and New Zealand.
Perhaps a harbinger of a turnaround regarding VC fundraising in the near future, Ballast Point Venture Partners announced in late October 2009, is the closing of a new fund with commitments of $140 million, exceeding their original target of $125 million. The Florida Growth fund is one of the investors.
J. Leslie Glick, Ph.D. ([email protected]), is an independent corporate management advisor. Phone: (813) 818-9252.