Pushing Forward With Collaborative R&D Models In Biotech: Roche-Spero And Biogen-Ataxion

Posted in Atlas Venture, Biotech investment themes, Business Development, Exits IPOs M&As, New business models, VC-backed Biotech Returns | Leave a comment

With today’s announcement of Roche’s deal with Spero Therapeutics LLC (here), and last month’s news regarding Biogen’s deal with Ataxion (here), we’ve added further momentum to our strategy of working closely with larger BioPharma partners to create innovative “external R&D” models around the development of new medicines.

Structured option-to-buy deals are of course not new to the industry, and I’ve discussed them on this blog before (here in particular); the Ataxion and Spero deals are presumably somewhat similar to deals like Resolve-TakedaSideris-Novartis, or PharmAkea-Celgene, among many others (though I don’t know the specifics of the latter set).  We believe this type of deal will be an important component and contributor to early stage venture capital going forward, and thought it useful to review the background and characteristics of these structured deals.

Both Spero and Ataxion were founded by Atlas in 2013 as part of our seed-led strategy (here), and these new option-based collaborations establish tight working linkages with our new Pharma partners.  In the past few months, both deals met the clear seed-stage “signals” we hoped for around scientific progress, talent aggregation, and now, with these collaborations, market traction, supporting their “graduation” into the broader portfolio and aligned with further the financing and acceleration of these companies.

These two deals represent the continued evolution of our initiatives to partner with larger players in the industry to help them build “prospective pipelines” via external R&D collaborations.  These efforts were formalized in 2010 when we kicked off our Atlas Venture Development Corp initiative (here), which gave rise to both Arteaus Therapeutics with Eli Lilly (here) and Annovation Pharma with Medicine’s Company (here).  Shire’s deal with a Nimbus Discovery’ subsidiary (here) around lysosomal storage disorder program is also similar, and derived from the Shire-Atlas Rare Disease Alliance (here).  All of these deals involve the partner purchasing an option to acquire the company/program upon delivery of key future milestones.

To help illustrate the nature of these deals, and option-to-buy structures more generally, here are seven themes common we’ve seen that serve as a loose framework for future deals for us.  Each of these collaborations:

  • Pursue highly innovative pre-clinical programs within single-asset entities.  Ataxion and Spero, like Arteaus, are each working on a focused therapeutic program, addressing a first-in-class novel mechanism; Annovation is targeting a best-in-class profile.  The nucleating assets when we began Ataxion, Spero, and Annovation were sets of lead series in the midst of drug discovery and optimization campaigns.  Reasonable preclinical confidence in rationale from in vivo animal models was in hand.  Arteaus was a “late stage” deal for us, focused on an IND-ready mAb program out of Lilly against CGRP.  Its worth noting that Spero is an LLC-holding company (described here), so there could be future anti-infective assets in their own sub-entities.
  • Operate as virtual, lean startups with little fixed cost infrastructure.  None of these startups have their own dedicated labs.  Instead, all leverage significant and important academic partners and CRO collaborators, aligned in some cases through equity relationships.  Arteaus had five team members, including part-timers, when it exited last month; Annovation, Ataxion, and Spero all have (or will soon) similar or smaller team footprints.  Their burn rates are almost entirely dedicated to moving the projects forward rather than turning on the lights.
  • Embrace Big Bio/Pharma partners who add real value.  VCs and entrepreneurs like to joke about “value-add” from the former (here).  In this case, we truly believe our partners are bringing more to the table than the financial structuring of the option.  In most cases, they are heavily involved in the projects from an advisory level, and in several instances our partners have brought significant in-kind services to the deal itself (e.g., screening compound files, lead optimization resources, preclinical model expertise, clinical and regulatory guidance).  Finding the right partner for each project is key to its eventual success.
  • Provide an attractive equity capital efficiency.  All of these programs should be able to achieve their critical milestones on significantly less than $20M in equity capital, and in some cases a small fraction of that. Further, material non-dilutive capital infusions from our partners will help to push most of these projects forward with less impact on the ownership structure. This helps Atlas and other founders to maintain meaningful ownership at time of the exercise of the purchase option (and thus projected liquidity), and sets an attractive post-money valuation in the event we “go long” with the story.
  • Preserve the potential for top-decile, non-correlated returns.  As I’ve noted in the past, these deals are structured in a way that provides for cash-on-cash returns commensurate with historic “top-decile” outcomes in venture capital.  The risk-adjusted returns, integrating conservative assumptions of attrition and such, have to be >3x for us to engage in a transaction like this.  They also need to access the “right-sided tail” of the distribution curve through downstream economics (e.g., milestones or royalties).  Importantly, these deals offer significant portfolio diversification with a “non-correlated” element: these deals don’t require active an IPO window or appreciable public market appetite.  That may not be relevant today, but public markets ebb and flow and having some diversification in the portfolio should help to improve returns.
  • Offer an enhanced capital velocity.  The timelines for candidate nomination and development work across these deals, even with expected delays of plans-hitting-reality, should all be in the 2-3 year time frame; this is typically the window for the option.  As holding periods in venture capital are on average in the 6-7 year range (here), this shorter duration to initial liquidity offers compelling “capital velocity” (or the cycling of capital) back to investors and their LP’s.  These shorter times convert the cash-on-cash returns mentioned above into very attractive IRRs.
  • Maintain optionality around an independent “go long” path for the future.  Regardless of our partner’s decision around the option, in each case we would be (or would have been with Arteaus) excited to bring company forward to next value creation point independently.  The stringency of our initial thesis, and of the “go long” thesis in particular, rests on the robustness of the data signal generated from the asset.  If the partner decides against moving forward, there are no encumbrances in these deals that keep us from forging ahead aggressively with future financings.

Those are some of the defining characteristics of these structured deals.  Not all programs or technologies are good fits for this kind of deal; but conversely, many assets don’t warrant building a bigger “company” around them and are perfectly suited to this virtually operated, highly networked, and financially-structured R&D investment.  Figuring out what company construct is required to bring early stage assets to the right value inflection is critically important – we aim to tailor our models to the assets, not the other way around.

Lastly, it’s worth noting that these structures have particular appeal to certain types of entrepreneurs.  First, most the team members in these single-asset deals straddle more than one opportunity – they are able to simultaneously work on several assets at once.  Second, the quicker go/no-go here also allows entrepreneurs to invest their time more efficiently; it’s typically evident in 2-3 years whether the asset has met the trigger for the option.  Since an entrepreneurs’ time is the most valuable resource in biotech, this  “time allocation efficiency” has significant merits.

As we think of building our portfolio of biotech investments at Atlas, deals of this type – structured option-based deals early in the life of a startup – represent roughly a quarter of the capital we’d like to put to work.  When combined with deals of other phenotypes (or other worldviews), such as “novel biology platforms”, “drug discovery engines”, or focused pathway/target biology companies, these deals create a blended portfolio that we believe offers attractive return prospects.   Time will tell.

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Tradeoffs and Timing: IPO vs. M&A Decision Making in Biotech

Posted in Biotech financing, Exits IPOs M&As, VC-backed Biotech Returns | 1 Comment

In light of the continued interest in biotech IPOs by the capital markets, there’s probably not a venture-backed biotech boardroom that hasn’t been discussing the merits of going public. Whether warranted or not, taking a company public via an IPO is tantamount to grabbing the proverbial brass ring, a publicly recognized marker of success.  Unfortunately, it’s not always the right choice for shareholders.

Weighing the opportunity of an IPO versus alternatives isn’t always straightforward. If it’s just about raising another financing, then getting public has some advantages over staying private, especially for management teams looking to lift an onerous liquidation preference off their heads. With valuations that appropriately reward early stage innovators, getting public is often smart relative to raising more “costly” private money.

So, how do we compare an IPO to an M&A alternative?  Parallel tracking an IPO and M&A process is difficult, but when done effectively it can generate real choices for a company.  How should a board weight these alternatives?  There are lots of softer issues around the alternatives related to the team and culture, the long term vision of the company and its aspirations, as well as financial issues around future burn rate, updating internal reporting and accounting capabilities, dealing with the Street, etc..

But from a shareholder perspective, there are at least three important issues to consider:

  • Risk/Return Profiles: Biotech is a risky business; getting paid for taking earlier risks, and sharing downstream upside with a partner via milestones, has to be weighed against “going longer” in the public markets where the upside may exist but so too the downside.
  • Time to liquidity: M&A typically offers realized returns today, whereas IPOs can take years to exit (especially for thinly traded stocks or for insider shareholders).  Future payouts via milestones obviously represent future liquidity points in an M&A deal.
  • Dilution: Taking a company public implies selling a piece of the company to others; typical dilution can be 20-40% for an IPO.  Some pre-2013 IPOs were north of 50%.  Pre-IPO shareholders need to factor this into their return calculus.

The first two are fundamental drivers of how a company’s cost-of-capital can impact expectations and the relative merits of IPO vs M&A.  More risk requires higher returns, and biotech’s risk profile (vs. other equities) therefore implies a higher return expectation – i.e., a higher cost-of-capital.  Furthermore, time costs money; investors only want their cash locked up if they are generating a sufficient return.  The cost of capital represents the required annualized return to make an investment worthwhile.  Most analysts would suggest small cap R&D-stage biotech stocks have a cost of capital of 25-35%, if not higher.

To illustrate how these three issues play into decision-making, I’ve constructed a chart below.  Assume for a moment that there was a theoretical M&A deal on the table with an all-upfront value equal to the “pre-money” valuation of the IPO at the time of offering.  Would it have been smart to take it, or should the company have gone ahead with the offering?  I’ve normalized the chart to 100 as the theoretical M&A value.  The lines and shading represent the “equivalency” of returns from an Internal Rate of Return perspective between an M&A today and the company’s valuation at a future liquidity point.

Expected Return Curves Post-IPO V2

The first impact is dilution at the time of the offering; this model assumes 25% dilution from the issuance of new shares in the IPO.  The slopes over time are the increase in value expected under different cost-of-capital assumptions over time.  For instance, if it takes 2 years to get liquid following an IPO (not an unreasonable expectation actually), and the cost-of-capital is 25%, the minimum required valuation to make the offering a smart decision for pre-IPO shareholders is a doubling of the valuation over that time period, e.g., a $400M IPO needs to be an $800M company within 24 months.

What’s the right expectation for time-to-liquidity?  I don’t have the data on the average, but my guess is that two years is the median.  A quick look at some of the 2010-2012 IPOs and their major holders is instructive.  NEA is still well invested in Tesaro, two years later (here).  Bessemer just exited a majority of its position in Verastem, two years later (here).  And Alta sold in 4Q its Chemocentryx position (here).  Holding periods in the public markets depend on several things: an institutional interest in “going long” (or not), insider knowledge restricting the sale of shares, and daily trading volume.  Again, I’d argue that historically it has taken 2+ years to exit most positions so the middle of this chart is a reasonable expectation.

For a Board and its shareholders, if you are confident (or optimistic) that you’ll be in Zone A when you want to achieve liquidity of your shares, than the IPO is obviously the right choice. If you think there’s a higher likelihood of being in Zone B at that point, below the curves but still above the IPO valuation, its smarter to take the M&A deal now.  This is the critical takeaway of this chart.  Higher future valuations, above the IPO price, could still make an M&A deal today more attractive if they aren’t high enough to compensate for dilution and the cost-of-capital.  It all comes down to whether you have realistic valuation and time-to-liquidity expectations.

The above analysis obviously ignores two things that could change the analysis from the shareholders perspective.  First, most M&A deals today aren’t all upfront, and the milestones can represent big increases in value in the future; this would push the “return equivalent” valuation line upward.  This isn’t illustrated in the chart because it gets too complicated.  Second, most biotech’s issue follow-on primary offerings within the first two years following an IPO; these are dilutive and would further push the “return equivalent” valuation line upward for pre-IPO shareholders.

This also ignores another important factor – liquidation preferences and their impact on management teams.  Its common for biotech deals to issue stock called participating preferred, as I’ve blogged on in the past (here).  In that post, the impact of participation on the value of a management team’s ownership can be dramatic in deals that raise large amounts of equity capital.  So there’s a huge incentive for going public, where the participation feature disappears.  For instance, in a deal that has raised $100M of participating preferred stock, there’s a nearly 2x difference in favor of a $200M IPO for a management team vs a $200M M&A deal (ignoring dilution for a moment, since ownership/options are at least partially reloaded in many cases).  This is material, and obviously impacts enthusiasm for one alternative over the other.  Its important for Boards and management teams to have an open and transparent dialogue about these topics.

This IPO vs M&A analysis may seem totally theoretical, but it has real implications.  Take Forma’s recent decision to do a deal with Celgene vs going IPO; it clearly mapped out a path of little dilution, and significant funding, to achieve its vision and line up a successful exit down the road.  Or Aragon’s decision to sell to J&J a year ago: $650M upfront with $350 in milestones would need to be a $1.5-2.0B biotech today to on a “rate of return equivalent” basis.

For more practical examples, lets take a look at some practical examples from the 2010-2012 IPO classes (where enough time has passed that cost-of-capital impacts are meaningful).  Below is a chart of some case studies. The pre-money valuations were normalized to 100 for each of these stocks, and then the actual IPO dilution was factored in along with a range of “required” returns implied by the cost-of-capital range; these are banded by the ranges on the chart.  Today’s valuation is a diamond.  As you’ll see, a few stocks would have been better off selling instead of going public if, as a mental exercise, they had an M&A alternative at the pre-money offering valuation.  These include the obvious underperformers Merrimack and Chemocentryx (below their IPO valuations), but also Ironwood and Verastem.  The latter two haven’t delivered a cost-of-capital commensurate with biotech following their IPOs.  The future could change for all four of these stocks – if Ironwood’s new drug sales exceed expectations or Verastem’s cancer stem cell drugs show great efficacy, they could achieve valuations that provide compelling returns above their cost-of-capital.  But as of right now, these have not fulfilled that promise.  Aegerion on the other hand has massively outperformed, way above any cost-of-capital expectation.

Post-IPO Performance Relative to M&A

Boards need to understand that institutional investors have other choices.  Although we focus on cash-on-cash multiples in venture, the rate of return is an important comparative metric across asset classes.  And the above analysis shows that, when appropriately framed with realistic assumptions, the expected returns (and therefore cost-of-capital) can have material impacts on choices between an IPO and an M&A alternative.

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