Financial Growing Pains of a Biotech

Illustrations by Tomasz Walenta

A biotech consultant had reviewed a young biotech's development plan and presented the company with several recommendations. It was clear to this consultant that the company was moving prematurely into a human proof-of-concept study and needed more data to define the appropriate dose. Several weeks later, she was astonished to hear from the company's chief medical officer that while he had personally agreed with her, the company had decided to proceed directly to the next stage of development without further testing, because even at the "wrong" dose it would be able to raise the money needed to stay afloat. It was with sadness, but no great surprise, that she read a year later that the trial had failed. The company was said to be "evaluating its strategic options." Welcome to the reality of financially driven drug development!

Biotechnology companies differ from other high-tech ventures in two ways. First, biotech products are highly regulated. The necessary demonstration of safety and efficacy is a long, risky, and capital-intensive process that drives a nearly insatiable demand for financing. Second, whereas most business models are focused on developing and then commercially marketing a product, biotechnology companies today are generally in the business of developing the value of their intellectual property (IP) and then monetizing that IP through licensure or sale to larger companies. These factors mold the financial life cycle of a biotech company from birth to success.

In the biotech boom of the late 1990s and into this decade, biotech companies matured relatively rapidly from conception to a point where their founders and investors could realize an attractive return on their efforts and capital. During this era, the initial public offering (IPO) was a readily accessible vehicle for early-stage biotech investors to achieve a substantial return on their investment, and public and private investors came to biotech companies in droves.

Today, the appetite of public equity investors for early-stage biotech companies has declined significantly, reducing the ability of earlier-stage investors to generate fast returns. In the '90s, a biotech could successfully raise public equity capital at various stages of its development, but today public equity investors are generally attracted only to late-stage companies with clinically advanced drug candidates, often with legacy pharmaceutical partners standing behind them as additional validation. The market downturn of the late 2007 and early 2008 has further exacerbated these conditions: To date, only one biotech company has completed an IPO on a US exchange during 2008, and that transaction was completed at only about one-third of the original targeted valuation.

Despite these current challenges, biotechnology can be an extremely lucrative business. Legacy pharmaceutical companies have been hit by a productivity drought in drug discovery; the Food and Drug Administration (FDA) approved only 17 new chemical entities in 2007. This is good news for small biotech companies that have attractive drugs in development, as legacy pharmaceutical companies are being forced to pay ever increasing prices for such compounds. The net effect of these trends is that legacy pharmaceutical companies are increasingly outsourcing the functions of drug discovery and early-stage development to biotech companies, and thus have become the de facto buyer of biotech's "product."

In general, a drug candidate increases significantly in value as it advances through the successive stages of development. These value inflections constitute the essence of how biotech companies make money. Based on the analyses of Recombinant Capital², legacy pharmaceutical companies typically pay biotech licensors a midpoint value of ~$220 million for Phase III drugs, compared with only ~$65 million for drugs in Phase I clinical trials. While these headline figures, often referred to as biodollars, illustrate the increased value of later-stage deals, they include cash payments actually received by the biotech company as well as payments that might one day be received if specific criteria (which we call milestones) are met.

Closer examination of the terms of licensing deals reveals an even bigger disparity in the actual cash payments. For example, while a biotech company might receive $5-10 million in up-front cash in a Phase I deal, the remainder of the ~$65 million is made up of highly uncertain success-based payments that may never materialize. By contrast, the typical Phase III deal includes $40-100 million in cash, $150 million in concrete milestones, and attractive royalties on product sales (see figure).

We will follow the financial life cycle of a biotech company from birth to success (which can mean very different things to different companies) and discuss the pitfalls along this path. While in the real world new companies are formed around drug candidates at all stages of development, we have focused on the life cycle of a company founded to develop drugs at the earliest stages, which will provide a clear picture of how the drug development and financial life cycles overlay one another.

The conception of a biotech company happens when an entrepreneurial scientist in academia or industry recognizes that a scientific discovery might have therapeutic implications and decides to try to create a company around that idea. To have any chance of success, the underlying idea must be protectable by a patent or series of patents; this intellectual property is the fundamental asset of any biotech enterprise.

The initial funding or "seed capital" of such an emergent company is typically put together from a number of sources, including government and economic development grants, universities, the inventor, family, friends, and wealthy individuals ("angel investors") who are interested in providing startup capital to catalyze the formation of new enterprises (see figure). Such funding is relatively modest, and rarely exceeds $1-5 million. At this seed stage, the founders, often the scientific innovators and their coinvestors, own 100% of the fledgling company.

The limited funding from seed investors is typically sufficient to fund only basic science studies that contribute to the credibility of the biological story. For example, limited in vitro or in vivo studies in animals can be conducted. These should strengthen the scientific hypothesis underlying the rationale for further development of the compounds, thus reinforcing the basis for proceeding with further development and convincing investors to contribute additional funding.

To progress beyond the seed stage, the emerging biotech enterprise will need to develop and begin to implement a credible business plan, including the recruitment of a management team with industry experience and a successful track record.

As the scientific rationale for advancing a drug towards human clinical trials grows, so too does the amount of capital required to support development. To be able to test a compound in humans in the United States an IND application must be filed with the FDA. The filing of an IND requires completion of a number of in vitro and in vivo preclinical tests (IND-enabling work), which must satisfy fairly strict and expensive regulatory requirements. This requires significant amounts of capital, typically around $5-10 million for a single drug.

The initial investors have a choice at this point. If they want to maintain their ownership share of the company, they will need to increase their investment by putting more of their own money into the company. However, the scale of capital required for IND-enabling studies often exceeds the appetite or resources of angel investors, and requires new sources of financing.

Most frequently, it is venture capital that fills this void. Venture capital firms typically manage pools of money contributed from university endowments, pension funds, insurance companies, and other big institutions, which they invest in early-stage companies to foster their growth. While venture capital firms vary significantly in their investment approach and focus, they do share some characteristics. Like virtually all investors in biotech, they have a defined time horizon; typically venture capitalists seek to invest in the growth of a biotech company over three to seven years, at which point they will seek to realize their return.

The concept of investment horizon has important implications for the types of companies that can readily access venture capital. In general, only those companies that can realistically be advanced through monetizable value-inflection points within a given investor's target timeline will be attractive investment candidates. Once onboard, a stable base of high-quality venture investors can play a significant role in driving a company's success, aiding in the recruitment and retention of skilled managers and myriad other steps that can put a company in a position of strength. However, there are costs that come with this kind of capital. Venture investors typically seek both a dilutive equity stake in the company and significant control over its operations and strategic direction, most often through control of a company's board of directors.

The ownership shares given to new venture capital investors in exchange for their capital will come from shares previously owned by the founders, who will now own a smaller proportion of the company. In other words, the founders' shares become diluted. This dilution would seem to short shrift wthe founders. For example, a founder owning 33% of the company at the conception stage could see her stake reduced to just 13% after a venture contribution of $15 million. The effects of dilution worsen from here; over the course of multiple rounds of new capital leading to an IPO, the founders' stake would fall further to just 2% ownership of the company (see figure).

As more capital is added, however, the value of the company increases. The founder's initial 33% stake in the company originally might have been worth $1 million, but after the infusion of capital, the diluted 13% stake is now worth $3 million. To combat these dilution effects and maintain founders' and key management's ownership stakes at meaningful levels, venture and other investors typically put equity compensation plans in place that grant additional equity ownership to incentivize continued active involvement of key individuals.

The value of the company can be calculated by measuring the new funds contributed, and then dividing by the fraction of the company that the new investors received in return for their capital. For example, if the new investors contribute $25 million and receive 25% of the shares of the company in return, the company would be valued at $25 million / 0.25 = $100 million. Throughout the biotech financing life cycle, investors make money only if the value inflections generated by their capital exceed the amount they have contributed.

As its compounds advance towards clinical trials in humans, an emerging biotech company can become a viable candidate for licensure or buyout transactions with larger companies. However, prematurely entering into either a sale of the company or a licensure of its assets can result in the company receiving significantly less for its assets than could have been realized later and is often a suboptimal outcome.

Receiving FDA permission (IND) to begin clinical studies in patients or normal volunteers is a transformative step for a small biotech company. The value of the compound is increased, thus driving up the value of the company. Conversely, the company's need for capital increases enormously because of the cost of performing human studies. This means that once again the biotech will need to raise money; considering the amounts required, it will need to look to groups prepared to invest substantially larger amounts than the typical early-stage investor.

A range of other investors may become interested in providing capital to companies with promising compounds in early- to midstage clinical trials. These include so-called crossover funds that seek to invest in both growing private and more mature public companies. Additionally, legacy pharmaceutical companies, many of which have investment arms tasked with identifying exciting new technologies, frequently invest alongside earlier-stage venture capital funds, as well as later-stage crossover funds. These new rounds of capital to support more advanced (and larger) clinical development are often referred to as "Series D" and "Series E" rounds and so-called mezzanine capital, and generally come from investors with shorter investment time horizons (most often ranging from one or two years down to just a few months). The growth capital that later-stage venture and crossover investors provide is typically applied towards the generation of compelling clinical data to support the therapeutic value of a company's drugs.

Clinical proof of concept is one of the most significant value-inflection points in the cycle of a drug's development and, together with external factors such as market conditions or data from competing drug candidates, it can be a major determinant of the value that founders and investors can realize. Proof of concept can mean different things for different drugs, depending on the indication being pursued. For example, drugs under development as potential therapies for hepatitis C or for other viral diseases such as HIV can often generate meaningful proof-of-concept data very early in development, where, for example reduction in viral load in just a few patients demonstrates that the drug has antiviral effects. Such studies can often be completed with as little $10-20 million per drug.

By contrast, drugs under development for the treatment of patients with depression, a notoriously difficult indication, might not generate strong proof-of-concept data until large Phase II trials have been completed. A single randomized, double-blind Phase II study of this type can often cost in excess of $25 million, and in many cases multiple such studies will be required to provide adequate efficacy and safety data to justify moving the drug forward. These differing burdens of proof will require the investment of different amounts of money to reach a proof of concept. Therefore, investors may view the risk as too high relative to the capital required.

Innovative forms of financing biotech drug development that rely to a lesser extent on the issuance of dilutive equity can play an important role in enabling companies to pursue a rational, robust path to proof of concept. For example, our firm, Symphony Capital, employs a collaborative development financing model that provides both capital and significant development expertise, which can enable early-stage biotech companies to retain control of their assets for longer and hence realize a greater return on their capital by partnering their assets at a later stage. Other innovative forms of financing include: monetization of royalty streams; financing from contract research organizations that can offer added development expertise in addition to in-kind investment; and committed equity-financing lines, which enable biotech companies to issue equity at their own chosen times.

As an emerging biotech company and its drug candidates mature, its founders and the early- and growth-stage investors need to identify how to monetize their efforts and investments; in other words, how will they exit the investment? Some investors may be focused on the long term, content to remain committed to the growth of a company over a period of many years to decades, but they are rare; most investors want to generate a return on their investment within a shorter time frame. In general this exit opportunity comes in the form either of selling existing stock to new investors or of selling the entire company to a larger acquirer in a merger or acquisition (M&A) transaction.

Although each constituency in a biotech company's investor base - from the very earliest seed-stage investors through mezzanine and crossover investors - has contributed capital at different stages in its life cycle, it is typically only at maturity that any of them have the opportunity to realize a return on their investment. In general, because the biotech business model is rooted in monetizing intellectual property, a biotech company is mature when it has advanced this IP through multiple value-inflection points and to a stage where investors can realize a gain on the capital they have invested. Actually realizing this gain hinges on the appetite of prospective public equity investors and/or legacy pharmaceutical acquirers for a biotech company's drug candidates.

M&A exits, through the sale of emerging biotech companies to legacy pharmaceutical companies, have recently provided early-stage biotech investors a means of realizing a return that is somewhat more attractive than faltering IPO markets. This trend has been driven by the urgent need of legacy pharmaceutical companies for promising new drugs to fill the gaps in their pipelines. However, the values that those larger companies are paying for promising young biotech companies still do not approach the returns investors realized during prior booms when IPO exits were common.

Deciding when and under what circumstances to exit is no simple matter, and is among the most important decisions that biotech entrepreneurs and their investors must make. Ironically, many of the steps a biotech company can take to position itself best for a successful IPO can undermine or limit its ability to avail itself of an M&A exit. For example, whereas one or more product licensing deals with legacy pharmaceutical companies can provide important validation to attract potential IPO investors, striking such deals frequently limits the number of potential legacy pharmaceutical acquirers, because they face the prospect of sharing valuable commercial rights with their rivals (see sidebar). In the current environment, it has become common for maturing companies to pursue a dual-track approach - an IPO and potential M&A transactions in parallel - in seeking an exit in order to identify and pursue the most lucrative exit opportunity.

Viewing the biotech business model in the context of the financing life cycle that sustains it has important implications for therapeutic innovation in general. The pharmaceutical industry has had to turn increasingly to smaller biotech companies to fill the void left by its waning internal R&D productivity and by the effects of generic competition on its revenue stream. The result is a virtual outsourcing of legacy pharmaceutical companies' discovery and early-stage development operations; it is interesting that this has occurred without any reduction in legacy pharma's own internal research costs. This trend has created extraordinary opportunities for biotech companies over the past decade and, to a significant extent, biotech has proved capable of delivering valuable therapeutic advances: Of the 17 new chemical entities that the FDA approved last year, eight were in-licensed or acquired from biotech companies by legacy pharmaceutical companies during the development stage.

Drug development is a complex, time-intensive, and costly process, whether it is done by a legacy pharmaceutical goliath or by a biotech startup. As biotech becomes the dominant source of new drugs, the industry needs to be financed in a sustainable, rational, and dependable manner that ensures continued future therapeutic innovation.

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Sam Hall is an Associate and Alastair Wood is Managing Director at Symphony Capital New York, NY.

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