Culprits of Biotech’s Malaise: Let’s Also Look in the Mirror

Posted October 12th, 2011 in Capital efficiency, Exits IPOs M&As, Pharma industry

Malaise and despair seem to have taken over the biotech venture and startup community of late. “Venture’s stress” is the cover story of BioCentury.  Biotech VCs are so distraught they are taking the case to Washington DC to lament the fate of our industry.  Venture funds focused on life sciences have struggled to raise money, and several diversified funds with healthcare have cut their allocations.  Prospect  Ventures decided not to move ahead with its recent fund because they didn’t have enough capital to deploy against their strategy.  The head of the NVCA, Mark Hessen, recently said that venture capital won’t return until the IPO market opens up again.  Times certainly seem tough for venture capital and for the biotechs we fund.

What’s are the root causes of this malaise?   Global economic crises? The FDA raising the bar?  Pharma squeezing our biotechs with back-ended biobuck deals?  All the “low hanging fruit” of the target universe picked?

I’m sure all those have some truth to them, and have mentioned some of them before (e.g., FDA’s view on obesity).  But in the spirit of putting all the issues on the table, I think we also did this to ourselves.

For a few decades now the biotech sector has over-promised and under-delivered, and its now coming back to bite us. Sure, biotechs have discovered some amazing drugs like Epogen, Enbrel, Herceptin, Rituxan, and Erbitux, to name just a few. But these are the rare few.  Most of our sector never delivers drugs like those.  But we have endlessly promised that we will, raised endless monies to support the effort, and allowed structural inefficiencies to persist.

In 2000, the Human Genome Project was supposed to “to lead to a new era of molecular medicine, an era that will bring new ways to prevent,diagnose, treat and cure disease”.  It certainly helped, but if this is the “new era” it doesn’t feel so good.  And the bubble wonders of Millenium, Human Genome Sciences, and many others all made huge, bold predictions about R&D productivity and the future of medicine that never materialized. More recently, RNAi was supposed to enable a drug against every gene.  Red wine’s resveratrol was to be the elixir for lots of diseases.  But its not just over-promising in the  2000s.  In the 1990s, high throughput screening enabled by combinatorial chemistry was supposed to provide the chemical diversity to enable a massive boost in drugability, but probably did the opposite.  Earlier still, drugs like IL2 were hailed by Time magazine as a cancer cure in 1988, and antibodies were pitched as the “magic bullets” to lots of diseases in 1980s.  Yet today, even Avastin, one of the most widely heralded mAbs of our time, isn’t very effective at all without toxic chemotherapy in combination.  Don’t get me wrong – the genome, RNAi, antibodies, etc.. – all are great advancements and are keys to the success of our sector, but we certainly missed the mark on the timelines for their impact.

Through our cycles of over-promising and under-delivering, biotech has relentlessly milked the private and public capital markets.  As Gary Pisano has noted previously, outside of a few huge winners, our sector has probably burnt more capital than its created over the past 30+ years.  The sad fact is that most public biotech companies dilute their existing shareholders into oblivion over time.  The list of supposedly successful companies that got sold or currently trade below their paid in equity capital is staggering.  “Successful” biotechs like Isis and Amylin have seen their stocks fall -25% and -51% over the two decades  since their IPOs.  The majority of the IPOs of the past decade are below their offering prices and have been for some time.  We’ve now got a large group of public equity investors who ask why should they buy into an IPO when they know they’re going to be diluted in 18 months at the next financing.

And we wonder why we’re in a somber state of despair about biotech?   The #1 issue doesn’t seem to me to be the FDA’s high hurdle or Pharma’s bad behavior.  It’s us, broadly speaking: it’s all of us that participate in the private and public capital market for biotech: venture investors, management teams, public investors, and importantly Boards.

  • Venture investors: VCs are the brunt of a lot of jokes because the truth hurts: pushing for quick flips, lack of patient capital, over-hyping a story, etc…  This is no way to build a sustainable asset class.  Further, we have simultaneously under-funded many areas and over-funded others.  Many firms have fled early stage and do only clinical or commercial stage deals, largely around reformulated spec pharma assets or Pharma’s discarded compounds. The need to put large fund sizes to work drives many into high capital intensity deals and over-capitalize others.  Returns typically fall off quickly with increasing amounts of capital.  In general there are lots of lemmings in the business chasing the same ideas; fortunately for us, early stage is rather sparsely populated so we have to find our own cliffs to jump off.
  • Management teams: while many have been great stewards of their shareholders capital, a whole lot more have not. Dilution is the bane of existing biotech shareholders, and many management teams (especially in the public markets) seem to forget this by serially trading down their existing investors in favor of new ones until they make it to market, get sold, or die a whimpering death.  An earlier sale of a business may be smarter for existing shareholders than being washed out to nothing, but most management teams don’t like or execute that choice.  Worse yet, most of the time management teams get reloaded with new options to keep them ‘incentivized’ with upside rewards to watch out for their current shareholders.  This is great if the team is truly aligned around dilution, but sadly this doesn’t often happen, as Peter Kolchinsky of RA Capital has noted.
  • Public equity investors: Rightfully burnt by many of the public offerings in the past, many public investors shy away from allocating capital to IPOs or require ‘derisked’ late stage assets.  Its no secret that the vast majority of the IPOs in 2010-2011 were in companies that in-licensed their lead programs or reformulated known actives.  I can’t think of one who’s lead program came out of its discovery organization [Correction: IRWD’s linaclotide was discovered by their team].  This lack of demand for real innovation has skewed the type of startups VCs build and it shows in the ecosystem.  Until public equity investors take a long-term view and help build the next Vertex, Gilead, Cephalon of the world we won’t be able to grow the next crop of mid-sized players.  Sadly this is unlikely in a world where most public investors are traders rather than investors. Since most public investors are just traders, they by nature have abdicated their role in company shaping via shareholder activism.  I know many ‘activists’ get accused of being predatory, and many probably are, but having active, vocal, and well-informed shareholders pushing for better capital allocation from management teams and Boards is a good thing in my view.
  • Boards: Many private company boards are full of VCs and lots of folks complain this is a bad thing.  I certainly have experienced the big venture board problems (i.e., whip-sawing between fear and greed in particular), and this is an issue. But at least these boards have a real interest in protecting the current owners of the company.  Most boards of public biotech companies don’t represent the interests of current shareholders.  And though they are ‘independent’ they are often afraid to rock the boat, ask tough questions, challenge management teams on capital allocation and serial rounds of dilution.  The failure of the public biotech universe to succeed – which is a big part of the capital market challenge today – is in many ways a failure of the public biotech board to manage shareholder value.  This failure in governance has had profound impact on our ecosystem.

Now that I’ve vented about some of the stakeholders in our ailing capital market, let me reinforce a few themes for how to move forward that involve thinking differently about biotech venture creation and company building, and the nature of equity capital. To that end, at the risk of repeating prior blog posts:

  1. We need to change the way we think about building companies.  As I’ve written before, “Go big, go bust” isn’t a viable strategy: raising $100M+ in equity capital and praying for a viable IPO or Pharma takeout is as bad as playing the lottery.  We need to do more than lip service to capital efficiency.  We can and should be building companies that raise far less in equity capital and leverage it through partnerships, non-dilutive funding sources, etc…  This is where the great returns will come from – like Plexxikon and Amira earlier this year, which collectively raised ~$90M in equity and could create upwards of $1.4B in value.  Both were 10x deals because they were “lean on their use of equity” platforms.
  2. We should get back to the basics of backing real innovation.  Its hard to get excited about reformulated, retrofitted compounds of yesteryear.  But funding breakthrough medicine is rewarding – both because its great for patients and shareholders. Just ask Vertex’ HCV patients, or Acetelion’s, or Alexion’s.  Now all of those companies were built in a ‘looser’ financing environment, but its still viable to discover great drug candidates on venture capital today.  And great companies are all about great medicines.  Our startups should start with that in mind.
  3. We have to embrace the depth and breadth of the virtualization toolbox which enables not only fully virtual enterprises (high quality outsourced labs, lean teams), but also adds superb operating leverage to bigger platform companies.  And real innovation can happen – and does happen – in virtual R&D companies.  Its a huge part of the model going forward.
  4. We need new asset-centric liquidity theses that go beyond company–centric IPOs and traditional M&As.  These alternatives include things like LLC-holding company structures and defined liquidity path partnerships.  As these generate returns, they will not only be appreciated by our LP’s, but they will also help create the competitive tension for assets from buysiders and later stage investors that will improve returns to early stage investing.
  5. Boards need to be more involved in governance, especially in small cap biotech companies.  This isn’t about Boards trying to micromanage teams, but about the discipline of capital allocation and strategy in a realistic way that maximizes value for current shareholders.  I hope more activist investors enter the small cap biotech world.
  6. Lastly, we need closer, better, and more transparent relationships with Pharma.  At the end of the day, we’re partners in this ecosystem and we need to drop the zero-sum game mindsets.  Win-win solutions where rewards are appropriately allocated for risk-taking and risk-sharing.

I certainly agree that the FDA needs to improve, Pharma could be more productive in its biotech relationships, IPO windows could be wider, etc…  So we should work on all those, and I don’t mean to belittle those challenges.  But I think we as a sector – investors, management teams, and boards – also need to look in the mirror and recognize we’re looking at a real part of the problem.


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