Preclinical Biotech Structured Deals: Reflections on 2013′s Solid Start

Posted in Exits IPOs M&As, VC-backed Biotech Returns

Several preclinical-stage biotechs have opted for the early Pharma structured buyout as their exit path in recent weeks: Resolve Therapeutics with Takeda, Zacharon with Biomarin, RQx Pharma with Genentech, and Lotus Tissue Repair with Shire.

Here are the quick takes on each:

  • Resolve Therapeutics struck a deal with Takeda (here).  The deal included an $8M upfront payment to fund the company’s work through a Phase 1b lupus study, and a predefined option to acquire in 2 years of ~$60M or so (from what I can guesstimate from the disclosures), and up to $247M if you include the two downstream development milestones.  Resolve raised about $8M from its investors over the past 2-3 years.  The lead program is in preclinical IND-enabling work.
  • Zacharon was bought by BioMarin for its rare orphan genetic disease programs (here).   The company raised about $4M with a post-money of $7.5M, according to VentureSource.  BioMarin paid $10M upfront and a set of undisclosed milestones.  The most advanced programs were in the lead optimization phase of drug discovery.
  • RQx Pharma struck a unique deal with Genentech (here).   On the surface it looks like a normal R&D collaboration, but from what I understand Genentech is funding the R&D from this point forward and so the upfront will be distributed.  The company drew down a little more than half of its $7M Series A round across a number of micro tranches of capital, and when the upfront is distributed it should net about ~1x the invested capital.  The total payments could go up to $111M.  The lead gram-negative bug program was in drug discovery stage. 
  • Lotus Tissue Repair was acquired by Shire (here).  The company was in preclinical development for a very rare orphan disease, dystrophic epidermolysis bullosa.  They had raised about half of the announced $26M Series A, all of which came from Third Rock.  The upfront payment was $49M, or roughly a 3x return, with potentially $275M in milestones.    

These deals have lots of similarities worth highlighting:

  • Innovation.  All were high risk, high science plays.  Two were orphan disease focused, two in areas of larger markets but very high unmet need conditions (lupus, gram negative bugs).  More evidence that innovative approaches are what it takes to get Pharma to the table early.
  • Capability-sharing and risk-sharing deals.   They all chose to bring on a strong partner’s expertise, capabilities, and resources to increase the odds of success in the future, and by doing so offset some downstream risk while deferring the real returns into the future through creative structures.
  • Capital efficient.  These companies only raised between $4M and $12M in equity capital prior to these deals, and none of them should have to raise additional funding going forward as they leverage their partners’ larger balance sheet.
  • Lean, asset-centric plays.  To my knowledge, all of these companies really only had one asset or tightly related set of assets, and the acquirer/partner was clearly interested in that program.  Even were there was a “pipeline” they were tightly focused around the same target or MoA and were more legitimately “backup” compounds than standalone #2 programs.   In addition, I’m pretty sure all of them had very lean teams: all had only single digit numbers of employees, and in the case of Lotus, I think only one.
  • Downstream return potential.  All four appear to have the potential, however small the probability, of achieving outsized 10-20x returns should the deal hit all the downstream milestones.  The “all-in” value of these deals could be between $100-300M inclusive of upfronts and milestones.  Its worth noting these exit valuation ranges aren’t extreme: they are at or above the median for all biotech M&A deals, but not in the top decile of exit values (>$400M).  But because they were so equity capital efficient, the return multiples could easily be in the top 1-5% of all venture deals in the vintage should the milestones deliver.  Even assuming only a third of the milestones are met, which appears to be the recent historic average, then all of these are likely to deliver 3-6x returns, certainly in the top quartile of outcomes in venture.

There are, however, a few key differences worth noting though, and the upfront return is one of them.  Only Lotus really delivered an attractive multiple and particularly IRR off the upfront payment (~3x in 18 months); congrats to the team at Third Rock Ventures who owned 75% of the deal.  RQx Pharma and Zacharon took their money off the table with these deals (~1x upfront) so are protected the downside while looking to their partners’ diligent efforts to drive the real returns.  Resolve is more of an option structure, so while attractive (i.e., no equity dilution, capable and committed partner, control over execution), the shareholders there are unlikely to see a return until Takeda (hopefully) exercises their option to acquire.

These are all interesting deals, and each board made the decision to sell early rather than go longer.  The tradeoff is a tough one.  Several have given up control entirely, others maintain it through the achievement of meaningful milestones.  The important calculus was whether raising more equity and “going it alone” would increase or decrease the odds of getting to that $100M-300M exit range and attractive multiples.  They all clearly came down in the camp of partnering early as the preferred route.

Broader questions are raised by deals like this:

  • Are these types of deals going to replace the typical Series B round?  B-rounds were often what got drug discovery startups into the clinic; to a big extent, these deals were done in lieu of that Series B raise.  Asked another way, will early stage partnering deals fill the perceived gap in early stage funding?
  • If more deals get taken out early in preclinical development, will we have enough substrate as an industry to create the next $500-1B exits, or the next $5B Pharmacyclics?  I don’t think this will be the issue, but its a question often asked.  I think there’s plenty of companies that are still choosing to “go long” into clinical development.  Most of those companies end up regretting it unfortunately.
  • Will the dearth of interesting unpartnered Phase 2-3 programs that exists today begin to shift backward in development as earlier deals are being done?  This issue faces both the capital market buyside and the strategic Pharma buyer eager to find new clinical stage innovation.  I doubt there will be a mad rush to consume all the hot preclinical programs, but even an slight uptick will affect the pool of available clinical stage assets in 2-4 years.
  • Are these types of deals likely to shorten the time to liquidity for drug discovery deals, or once in the arms of a big bureaucracy will the pace of the projects slow and actually extend the timelines?  This is especially important for the IRRs of deals where the upfront doesn’t provide a healthy return on capital.
  • Will these deals deliver big enough $ returns to support some of the large Life Science funds out there?  Returning only $40-80M to a fund is a solid win for a $250M fund, but not much for a $500M fund.  These early deals clearly raise this issue, though owning 75% of them may address it.
  • With more and more of the returns in these early deals embedded in milestones, it poses a bunch of interesting questions.  How should VCs value their milestones with their LP’s?  We currently build discounting models to create a fair market value for them, but there is no standard.  Also, will we finally see the emergence of a market for milestone payments like that which has emerged in the royalty space?  I continue to believe this market liquidity is likely to get created.

Many more questions come to mind, but those are a few.  Interesting deals though, and fully anticipate that we will be seeing more creative early stage partnering going forward.

 

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  • Jens

    Great summary Bruce. One open question that comes to my mind centers around being able to capture future milestone events clear enough in the agreements to trigger payments – as we all know clinical science is rarely black and white. I believe that quite a few option deals are struggling with ambiguities and those are never good when real money is at stake. With the emergence of smart adaptive clinical trial designs the papering of payment triggers becomes a real challenge. It takes world-class alliance management with a keen eye on day-to-day events to keep parties aligned and to maneuver through the real life data.

  • http://www.pharmadirections.com/Team--Richard-Soltero Richard Soltero

    Bruce – great reflections and questions. We can remember the enthusiasm for preclinical research and the funding that went into these biotechs 10 to 12 years ago. By 2003, the funding for anything less than Phase 2 was drying up and by 2005, it mostly Phase 3 companies that were finding funding and exits. Our recollection is that the excitement for preclinical research went bust when the dot com bubble burst and the ability of any company with pre-lead programs was severely curtailed for about another 10 years. It has only been in the last 2 or 3 years that VCs have taken funding of preclinical companies seriously.

    Our premise is that VC funding is subject to same economic laws of supply and demand that affect all other businesses. During the lean pharma years of the past decade, we saw the big pharma partners cherry pick the Phase 3 programs that fit in their sweet spot. As the number of good and available Phase 3 programs decreased, their interest turned to Phase 2 programs until all of these good ones were acquired. All that remained at some point were preclinical and Phase 1 assets.

    In our opinion, preclinical assets are better investment opportunities than Phase 1 clinical assets. Management teams who are able to get their programs into Phase 1 expect a large valuation bump which is inconsistent with the actual value created. You really need to get into Phase 2 to get proof of concept in man. A good alternative for investors is finding really good innovation or innovators at the preclinical stage. These programs are capital efficient and if well chosen, represent a greater potential upside to their investors.

  • Suleman

    Presumably these early stage acquisitions also reflect big pharma’s general shift to acquiring external R&D. They’ve got lots of early stage R&D expertise which might not have enough to do at the moment, and so early stage acquisitions might also be a reflection of available manpower inside big pharma companies.

  • http://www.pharmadirections.com/Team--Richard-Soltero Richard Soltero

    Hi Suleman,

    The acquisition of early stage programs to employ available manpower at big pharma companies may sound like a good idea on the surface, but my experience has shown the opposite. Having been in charge of big R&D groups and also in biotech where we “co-developed” a product with a big R&D group, my takeaway was that giving an entrepreneurial fueled program to a big pharma is a bad idea. Big pharma tend to apply their low risk tolerance and overly ambitious research goals to programs that just need to be expedited to the clinic where the real proof of concept can be determined. Big pharma is prone to letting acquired early stage assets languish in the wake of their own programs – a classic example of “Not Invented Here” in operation.

    I think some of the more progressive big pharma companies have figured out that their bureaucratic research environment is no place to aggressively drive a preclinical asset into clinical trials. They have sold off or drastically reduced their R&D groups to allow these assets to thrive in the biotech arena that best serves their development. Using the old maxim that work expands to fill the available time could come into play if a big pharma is given a preclinical asset to keep them busy. In my opinion acquiring early stage to keep researcher busy doesn’t sound like a good way to use available resources nor to develop preclinical compounds.

  • Murali Apparaju

    Thank you Bruce, excellent insight indeed..

    The news of structured-deals/ buy-outs of ‘tight/ single-EARLY-asset’ biotechs both pleases & scares me… pleases, as I feel this will trigger a healthy change in the way start-ups choose their programs & scary because I (CRO/ CMO) will now start losing clients/ programs much before the conventional PIIA – read-on…..

    While I totally agree with the points raised & the surmises made, I’d like to add a few;

    - This in some fashion is an endorsement of the importance of early venture seeding by the very same stakeholders that typically enable the high value exits for VCs, viz., the mid sized/ big pharma companies.

    - As you say, there seems to be a promise of reward for innovative organizations that know their science – however I’m not sure if there’s any message about preference for a single asset/ tight set of assets, It is rather a niche focus/ platform & this aspect I’d think always mattered to the investors.

    - Do I also see some de-risking in the form of going in for companies who’s lead/ pipeline candidates are inherently safer (recombinant proteins; antimicrobials et al) & hence highly likely to breeze through Phase-I

    - Interestingly, though the indications are rare/ orphan, the therapies themselves seem to be more maintenance than curative & hence more attractive to the investing company

    - This lure of an early alliance/ deal may now encourage the new enterprises to come up with more compelling technologies rather than me-toos… & thus help put drug discovery enterprise model on a correction course

    Now, having seen a lot of my clients getting lapped up by mid/ big pharma & their programs either killed, shelved in favour of the larger companies competing pipeline, I would be a little cynical till I see the next instalment is released/ option executed.

    Finally I would like to ask if there is a message in here for the VCs? – towards an opportunity, a need to structure the initial funding deals differently so that they could still keep an option to enhance their share whenever such early alliances crop-up eliminating avenue of series-B funding?

    Post Thought:

    Quite a coincidence that I was just reading an article in HBR (Mar 2013) titled “How Competition Strengthens Start-ups” by Andrew Burke and Stephanie Hussels of Cranfield University. The authors postulate that exposure to competition in the early stages of a firm’s life increases its long-term survival prospects – competition in this context including competing against a lean-funding scenario & hence learning to stay creative, efficient & productive – Since for all four companies here the early pressure is almost eliminated of by the reasonable/ comfortable funds received (upfront instalment OR buy-out), I was wondering if that makes these companies less long-term in light of the above study.

    Of course I do understand that it’d be foolhardy to apply an academic study arbitrarily to any context, particularly in life sciences, where the author’s themselves have made a provision indirectly through their statement “Of course, early competition has a downside: Some new businesses fail before they have time to build up the immunity we describe” which sure sounds like the business of designing drugs.