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by Cynthia Robbins-Roth, Ph.D.
Biotech Model Broken
Lower IPO Valuations Quashing Early VC Biotechnology Funding
By Cynthia Robbins-Roth
BioWorld Today Columnist
For the past 20-plus years, I have fought hard against the idea that the biotech model is broken - a concept that rears its ugly head every time the public markets close for a while. But I've finally concluded that it's true; if not dead, the model is hurt real bad.
What changed my mind was realizing that the concept of creating new biotech firms around innovative preclinical research wasn't broken - that's still a real opportunity and the driving need of the entire biopharmaceutical industry - but what is broken is the financing model.
That financing model drives the company structure model. The reality of time frames and capital needs for biopharma product development won't change, but the poor fit between those needs and the needs of the industry's historic benefactor - the venture capital community - has gotten increasingly problematic.
This War of the Worlds was the focus of a recent conversation with Alan Walton, chairman of Oxford Bioscience Corp., which operates a venture partnership managing $850 million and has about 80 companies in its portfolio. Walton, originally an academic researcher, prefaced his 20 years at Oxford Bioscience by founding and running University Genetics in 1981. That company went public in 1983 and showered a 60X return on its original investors.
His firm has been a leader in funding the genomics revolution, and Walton has never shied away from stating his opinions. His most recent foray into writing, How to Make Money Investing in Biotech, is a self-published collection of thoughts on the wonderful world of biotech investing for innocent bystanders (i.e., those restricted to public market investing).
Everyone in and around the biotech sector has noticed the increasing difficulty many public and private firms are having in raising money. Even teams based in the long-established San Francisco scene are finding it tough to raise capital at a valuation that doesn't make them shriek, and some CEOs with industry track records can't raise money at any price.
BioWorld's figures show that many companies have filed for IPOs and never got them done, leaving them to depend on the kindness of existing investors. Those firms that have gone public gained market valuations far below the mystical $500 million mark, leaving them trapped in the dreaded roach motel of small-cap companies, in which many big funds refuse to invest.
A huge chunk of the venture investment in the sector has avoided the classic innovative, early stage research plays and headed instead into specialty pharma companies - typically a small team spun out of an established firm with a couple of in-licensed clinical-stage drug candidates. The demand is bring me clinical candidates! Those firms unlucky enough to have the classic biotech design are finding the venture community uninterested in taking on decade-long time frames and about $50 million price tags for reaching an exit - IPO or acquisition. Walton pointed out that the industry goes through four-year cycles between high times in the public markets for biotech. His cynical, but realistic, explanation of that cycle is that it matches the average lifespan for managers at the big institutional funds.
How long does the average institutional investor chief at a place like Fidelity or Oppenheimer keep their job? Four years! he said. So you're getting in new blood with no history in the sector. They get excited all over again by the promise, and haven't lost money in it before.
Clearly, we are in the wrong part of the four-year cycle. Walton said that today might be the first time historically that individual public investors can buy biotech stocks cheaper than the VCs, because IPO prices are so low.
The amount of money that has gone into these companies is more than their public market capitalization, because there is no real IPO window today, Walton said. Companies are being forced public by their need for capital. He pointed out that the overall Dow and Nasdaq indices are still dropping.
There has never been a biotech IPO market when the Dow is dropping, because people become more conservative and you don't buy biotech when in conservative mode, he said.
After years of the venture firms playing the bad guy, the big institutional players in the sector have realized that they are in the driver's seat, forcing IPOs to become down rounds that raise capital at a lower valuation than the last private round.
While that can be good news for public buyers, it's bad new for private investors. Because prices are so low, there's no big kick-up in valuation at the IPO. Walton said the average amount invested in biotech companies in 1999 was $80 million, with a pre-money price at IPO of $300 million, thus generating a nice return for the venture investors.
Today, Walton said, things are different. The average amount invested pre-IPO is about $150 million, but the pre-money valuation at IPO is only $115 million. The IPOs generated prices only 1X to 2X the average private price. Many venture funds have actually lost money since 1999 - their returns are less than the money ploughed into the portfolio companies. Walton pointed out that several companies in the 2003-2004 IPO market had IPO valuations of less than the capital invested, and that's bad news for start-ups.
The venture community is driven by fads, just like the fashion industry. In 2000, the Human Genome Project and a desire for quicker returns drove investment in platform technology plays.
But now, Walton said, product companies are what sells. The play of the moment is recapitalizing later-stage companies that are running out of money and thus have big drops in valuation [so the venture investor can get a lot of stock for cheap]. Investors also flock to specialty pharma companies, which are essentially another way to kick-start a later-stage company.
As many of company executives will attest, the focus in the venture community and private equity funds is on getting the best price possible, with no thought for the down-steam consequences.
And what are those consequences? Management teams spend far too much time fund raising instead of running companies, which are chronically undercapitalized. The teams find themselves spending a year raising a chunk of cash that they know is not enough to get them to the next fundable benchmark. Meanwhile, in-house operations are less than optimal, and nobody's minding the store full-time.
By driving the price down, the private investors are increasing the probability that the thing they fear will come to pass - the deal will stay underwater, not generating that required return on investment needed to support the fund's overall performance, and thus not contributing toward raising the next fund.
Walton said, It's a shame, but nobody is willing to wait the seven years for the return [from an early stage deal]. But if the only thing that sells is a company model with product candidates in Phase II and III testing, and nobody is supporting early stage companies, at some point you have killed off your novel product stream. It becomes a self-fulfilling prophecy.
He doesn't believe that the focus on specialty pharma models will avoid that fate. Those clinical compounds face the same risk of failure as others - many will fail. But those companies don't have in-house technology to generate new compounds and are dependent on finding them elsewhere. Net effect: They eventually won't be able to help maintain the return on investment of the venture investors.
Everyone agrees that biotech therapeutics generate the best return on investment - if they actually reach the marketplace! The failure rate means that pipelines supported by platform technologies are crucial to providing backup compounds. But the small companies can't raise enough capital to develop multiple compounds simultaneously. Walton said that the new generation of venture capitalists are calculating how long it will take to make a multiple that supports raising their next fund. Bad public markets amplify that effect all the way down the chain, reducing the number of start-ups that get funded, and making even those venture funds that classically support early stage R&D become far more focused on squishing down prices.
The question, then, is how do we overcome this? Tuesday, I'll offer a possible solution.
-- May 2, 2005
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by Cynthia Robbins-Roth, Ph.D.
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