Biotechnology's Prospects A Year After The Crash

Right after Black Monday, analysts said venture capital would dry up. This tour-page special report shows the still thriving field finding money in new places but facing increased scrutiny. CAMBRIDGE, MASS.—One year ago this month the stock market suffered its worst decline since 1929. In the wake of Black Monday, pundits prophesied dire consequences—for the economy in general and for corporate and entrepreneurial science and technology in particular. Corporate R&D budgets would be cut back in preparation for a drop in consumer spending and a concomitant drop in corporate profits, one argument went. Another said that high-risk entrepreneurial startups would be unable to find venture capital. Of all the high-risk, high-tech endeavors that had been tantalizing market investors before the crash, none had been flying higher than biotechnology. So biotechnology was ninny an analyst's prime candidate for a catastrophic fall in the days following Black Monday. Some even predicted a virtual stagnation of the fledgling industry. “Everybody was in a state of shock,” recalls Janice LeCocq, a general partner with Montgomery Securities in San Francisco. “Down markets accentuate the fears investors have about the risk in biotech, and the assumption was that it would be very, very tough sledding for the industry all across the board.” But was that assumption correct? Based on a series of interviews with market analysts, investors, and entrepreneurs, The Scientist has learned that, as is so often the case, the pundits’ prophecies proved to be oversimplistic. Indeed, the public market’s appetite for high technology companies has waned—until last August, no biotechnology company had managed to go public since the crash. However, money is continuing to flow freely into biotechnology, albeit in some cases via routes used more sparingly before the crash—R&D partnerships, for example, and foreign venture capital sources. (For more on Japanese and European investment in U.S. firms, see article on page 6.) And, in the wake of the first successful initial public offering of a biotech firm on August 11—a move that garnered a Seattle, Wash., startup, NeoRx, less than it hoped for but $16 million all the same (see article on page 5)— some analysts say that the market may once again be warming up to its former fair-haired child of science. Biotechnology in October 1988 is by no means stagnant—but the rules it plays by have changed in significant respects. Traditionally, these rules call for three basic stages of corporate development. A startup receives its seed-round financing from private venture capitalists. Once up and running, the young company finances growth over the first four to seven years through additional rounds of increasingly larger amounts of private financing— mostly from venture capitalists and investment bankers. Eventually, the company grows to a point where, to finance further development, it offers its stock on the open market in an initial public offering. Another source of capital—both before and after the initial public offering—is the research and development limited partnership, which offers investors product royalties and warrants for future stock purchases in exchange for financial backing of specific projects. In the wake of the market’s cata clysmic tumble, however, the fledgling high-tech sector seemed squeezed from opposing directions, and the analysts’ dire predictions that there would be a dearth of investors—both private and public— were issued. Indeed, in the murky postcrash environment of 1988, the more mature biotechs already listed on the public stock market or on the brink of graduating to the public market have been hit hard by the chilly investor climate. The younger firms, however—those still in various stages of private financing—have found that, though venture capitalists are striking harder deals, enterprises continue to be founded, and financed, at a healthy rate. Thus, while no one doubts that the market pressures of the past year have been rough on biotechnology companies, it is clear that the severity of the strain on any given biotech firm depends to a great extent on the stage of the company’s growth. Because the crash portended a tough public market, analysts predicted that brand new enterprises would be abandoned by venture capitalists, who would need their resources to bolster existing com panies. The reality, however, is that startups have largely avoided this year’s financial roller coaster. The Scientist has been able to confirm that at least four companies were formed in the first half of 1988, and analysts predict that by the end of the year, 1988 startup statistics may surpass those of 1987, in which 13 companies were founded (see graph, page 5). This continued growth of the field results from the fact that venture capitalists usually don’t expect returns on their seeding funds for between seven and 10 years. Thus, they aren’t much concerned with the erratic behavior of a public market. Says Kevin Kinsella, who has invested in biotechs as managing general partner of Avalon Ventures in La Jolla, Calif., “My perception is that there never was a connection between what happened to the stock market and investing in seed-stage deals.” Rex Bright is living proof of Kinsella’s contention. After 20 years with major pharmaceutical firms, Bright picked October 1987 to go entrepreneurial—giving up his post as president of Herbert Laboratories, the dermatological division of SmithKline Beckman Corp., to try his hand in a startup. Bright planned to assume the pres idency of Epoulon, a Woburn, Mass., company that proposed to develop growth factors used in wound healing. In order to be in on the ground floor of the new company, Bright resigned his position with Herbert in early October—before Epoulon had been formally incorporated and in advance of its first round of financing. When the market crashed on Oct. 19 he recalls, “I came back to the room and said, ‘Whoa, wait a minute.’” But later that same day, the main venture capital firm behind the deal called to tell him not to worry—the money would still be coming. It arrived last February— to the tune of $2.5 million. Existing firms still in the very early stages of growth were expected to have less of a problem than startups, because it would be counterproductive for a financier to abandon a venture in which he already had an investment. Indeed, The Scientist found that, though scrutiny from potential investors is tougher than it has been in the past for these companies, the pockets of committed venture capitalists are as deep as they always were. Take ImmuLogic Pharmaceutical Corp. of Cambridge, Mass., which got its seed money ($3.25 million) 16 months before the crash and by Black Monday was humming along. But by June 1988, it was ready for a cash infusion and, sure enough, it found itself the center of attention this summer as a group of venture capitalists clamored to dole out an almost unheard of $12.5 million in its first stage of financing since the seed round. And company president Gustav Christensen, who today oversees 23 scientists, has no complaints about the terms of the deal. “I do believe that the venture capital people are investing as much as they have done before in biotech. We certainly found that if the venture people feel that your company has promise they have all the money you need.” A similar situation befell Athena Neurosciences Inc., a 30-scientist San Carlos, Calif., therapeutics firm that focuses on neurological diseases. Last spring, two-year-old Athena decided to attempt a second round of private financing. “We set out to raise $5 to $7 million—and at one point I had offers of over $11 million on the table,” relates Athena’s president, John Groom. Ultimately, he winnowed the offers down to $9.6 million, in order not to give up too much of the company’s private stock. This is not to say the crunch in the public market hasn’t left sprouting companies completely unscathed. Some venture capitalists are driving harder bargains than before. Says James Sherbiom, a senior vice president with Boston-based Genzyme Corp. and cofounder of the Massachusetts Biotechnology Council, “The economic terms have changed. Venture capitalists want more of the company than they did before the crash.” Tom Morse, managing partner of Philadelphia Ventures Inc., concurs, and notes that the slowing of the public market makes it necessary for venture capitalists to wait longer for deals to mature. “That longer term has to be worth it.” By the same token, notes Avalon’s Kinsella, venture capitalists are more stringent in their selection process—and so home in on top-notch firms. Highly speculative ventures (like gene therapy) that would have been undertaken five years ago on the promise of going public just aren’t happening anymore, says Kinsella. “What’s changed in the climate in biotech is the realization that the public’s appetite for stock of companies which do not yet have revenues may be seriously curtailed,” he notes. “If that is the case, then the only thing that’s going to save you in terms of this investment is the quality of the science and its marketability to a large pharmaceutical company.” This modified outlook on the part of the financiers is linked to the fact that biotech’s bluster has in the past been based almost solely on speculation of products—and profits—to come. But Genentech’s experience with the industry’s first major product, the clot-breaking drug tPA, is changing that. That drug is providing the first solid benchmark against which to measure the expectations of biotech investors, explains Russell Ray, a vice president for Alex. Brown & Sons in Baltimore. Largely because studies showing less expensive, forthcoming drugs may be equally as effective as tPA, initial market expectations have not been met. Coupled with an already shaky public investor climate, says Ray, this chilly market reception has hurt Genentech stock, which, in turn, has brought many other biotech issues down with it. Advanced growth generally means public offerings. And this is one arena where the gloomy expectations have been realized. Besides NeoRx, the only major biotech firm daring to test public, waters in the past year has been Cambridge BioScience Corp., of Worcester, Mass. The seven-year-old, 55-scientist firm—which develops diagnostic and therapeutic tools to fight infectious diseases—was already public, and sought to raise cash through this secondary offering. “We had hoped to get the offering off somewhere in the $12 to $13 range,”says chief financial officer Donald Reed. But when the offering was made this June, the company had to downgrade its expectations to $11 per share. The 2.35 million shares that were sold raised about $25 million for Cambridge BioScience, but the dip in share price cost the firm as much as $4.7 million. Not only has the stock market stalled, but established firms are finding that traditional means of raising private money have withered, as well. Nova Pharmaceutical Corp., a 131-scientist company in Baltimore, Md. (see The Scientist, May 16, page 1) last September began a limited partnership it hoped would bring in $68.5 million to help finance further research. At first things looked good, but by December the money flow had been reduced to a trickle—and the Baltimore firm closed the deal with only $42.2 million raised. “The crash hit us and put us into a stall [while] everyone sorted out what their investment plans were,” says Michael Demchuck, vice president for administration and control. To help weather such rough times, firms of all sizes are seeking to beef up research and development agreements. Nova renewed agreements last December with both Eastman Kodak Co. and Marion Laboratories Inc. that promise to bring it $8 million over the next two years. And on Aug. 1, the company announced a gigantic deal with SmithKline Beckman (see box, page 4). “Given a continuation of the current stock market climate, we will not be the only one entering into these arrangements,” predicts Demchuck. But whether the money comes from established corporations, venture capitalists, limited partnerships, or some other source, experts note that investors have changed the stakes in biotechnology by utilizing more traditional benchmarks than those used in the past to evaluate deals. “It usedto be if you had a couple good scientists and a great idea, they’d buy it” says Montgomery Securities’ Janice LeCocq. “[Now] they want more things in place, more complete management teams, more evidence the product’s going to work—something they can hang their hats on.” In other words, the crash has brought something of the real world into the fantasy land of biotechnology. Robert Buderi is a freelance journalist in Cambridge, Mass.

Biotechnology's Prospects A Year After The Crash

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