The In and the Out Crowds of Biotech Investing

Michael Lytton reviews "what's hot" and "what's cold" in biotech investing. .

Question: What are the hot and cold areas in biotech for venture investing?

Answer: There's an embedded irony to the question: once an investment area becomes hot, it rapidly becomes over-populated: company valuations are pushed up beyond the level from which a VC can generate a reasonable rate of return, given the usual exit statistics. A VC's hottest target areas are thus, in a sense, trade secrets; it is easier to be more specific about what we don't like to invest in.

First, what's hot:

1. Anything which can accelerate the translation of genomic information into a lead compound.Technologies which facilitate the validation of targets, the creation of novel chemistries which bind to these new targets, and the selection of appropriate lead compounds are extremely valuable. In 1988, aggregate R&D spending of $15 billion produced 60 new chemical entities; in 1998, R&D spending of $35 billion produced 30 NCEs. The root of this disappointing comparison is increased pre-clinical failures accompanied by inefficiency in drug discovery. The challenge is to develop new technologies which are not only an improvement over an existing method currently used at a single point in the process, but which also act to increase the efficiency of the discovery continuum.

2. Technologies which permit the industrialization of biology.Advances in genomics present the tantalizing prospect of customized medicine and expanded use of gene-based diagnostics. What stands in the way, of course, is the fact that despite the success of the Human Genome Project, little of the information generated is directly useable for therapeutic purposes on a specific individual. While there has been talk of whole genome scanning and the application of pharmacogenomics on an individual basis, the challenge is to advance these technologies so that they are sensitive enough and commercially applicable. Those companies that are able to transform data into useful information will benefit from an enormous market opportunity and be much courted by VCs.

3. Technologies which demonstrably reduce the clinical trial failure rate in Phases II and III, or which increase the efficiency of drug development.As with drug discovery, significant progress remains to be made in transforming clinical development into an efficient undertaking; the average NDA requires 68 clinical trials. Clinical trials constitute the most expensive part of R&D, and tools which permit better design of trials (i.e., the selection of the right patients) and facilitate increased use of the Internet for patient enrollment and trial management should be productive areas.

4. Technologies developed by or affiliated with someone whose last name is Hood, Lander, Langer, Schimmel, or Zaffaroni.Not to be minimized is the "scientific guru" factor in company formation and financing. Proven scientific or business founders attract capital and high quality management. Although success is never assured, the buzz generated by a startup involving well-known founders is a potent lubricant for business success.

5. A business model not dependent on the timing of financing windows in the public equity markets.After the heady days of 2000 and the subsequent return to earth of public market valuations, it is unclear when the IPO market will return for biotechs, or what the qualifying criteria will be. As a result, a start-up must be able to show how it can be acquired, at a high price and within the VC's five-year time frame, by a large cap biotech or a drug company. The pace of consolidation is increasing among both public and private biotechs, which is probably a good thing given the lack of institutional investor interest in public biotech companies valued at less than $500 million and the decreasing number of investment banks rendering services to biotechs (their own merger frenzy has cut the number of analysts who follow the increased number of public biotechs).

Now, what's cold:

1. A technology that is still only a biological guess.It is scary (and usually inappropriate) to invest in a company whose core technology is still hypothetical and/or for which the actual mechanism of action is not well understood. This is the stuff of university research, not company formation.

2. A technology that faces significant regulatory risk or public scrutiny.Embryonic stem cells, gene therapy, and xenotransplantation are areas which venture capitalists will tend to avoid. It is hard enough to commercialize a new technology without taking on the additional burden of a hostile FDA or public controversy. On the other hand, over-generalization can obscure good investment opportunities; despite the public and political outcry over ESCs, some interesting companies have been recently funded to work with adult stem cells and alternative sources of differentiated, organ-specific cells and tissue.

3. A platform company whose business model will not permit migration from a fee-for-service business model.Despite the many successful platform company IPOs in 2000, a number of these companies are at risk of becoming financial market orphans if they fail to do internal drug discovery and/or lack a platform broad enough to interest pharma companies in entering into significant corporate partnering deals. In this regard, some venture funds are wary of bioinformatics. Too many of the start-ups making the rounds have a single tool that, over time, will either become commoditized or will only be the basis of a fee-for-service business. As for the latter, enterprise-wide selling is a tall order no matter what the product, and a long sales cycle can kill even the most promising service offering.

4. Clinical development projects involving subjective endpoints.No VC wants to fund therapeutic indications for which the sign of clinical success is not clear and universally accepted. While a great many people suffer from psoriasis or chronic pain, relief of these symptoms is subjective and dependent upon an individual's self-assessment, rather than an objective clinical metric—which adds risk to FDA review. It is also tricky to take on conditions for which there is no uniformly accepted diagnosis or dose-response therapeutic link. Despite, for example, the apparently increasing prevalence of attention deficit/hyperactivity disorder, only an intrepid soul would fund a startup with this condition as its target indication.

5. Any project where the liquidity event is dependent on FDA approval or profitability.Venture capital investors in biotech companies are accustomed to taking on significant risk—that a technology fails to work, for example; that it only works on a small group of people; or that it has adverse side effects. However, VCs expect liquidity in less than 5 years and possibly less, depending on the fund's investment orientation. Given the lengthy and uncertain time frame of drug R&D, a venture fund's exit, in most cases, must occur prior to a drug's approval. So a company's business model must incorporate intermediate milestones and points of exit. The risks associated with the timing of ultimate product approval and/or profitability are appropriate for investors in public, not private, equity.

Michael Lytton is a General Partner of Oxford Bioscience Partners. If you have any questions that you'd like addressed in this column, or if you have comments, email directly to [email protected]