Gauging the Risks of Financing Convergence Start-Ups

VCs and executives believe that convergence is here to stay. But developing and financing sustainable models for drug-device convergence start-ups requires finding an elusive middle ground that blends the risk profiles of each industry.

by Christopher Morrison

Drug-eluting stents are the Reese's Peanut Butter Cups of the health care world. While it might not have been obvious at first to coat blood-vessel propping bare metal stents with antiproliferative agents, the two disparate technologies together created a formidable product. At $2.4 billion, first year sales of Boston Scientific Corp. 's Taxus stent, which incorporated the in-licensed cancer drug paclitaxel from Angiotech Pharmaceuticals Inc. , by far outpaced maiden numbers for any other drug or device. [See Deal] The market could expand to more than $6 billion this year. But not all disparate flavors when combined ‘taste great together,' and subsequent attempts at so-called drug-device convergence have not come close to approaching the runaway success of drug-eluting stents.

But that hasn't stopped companies from trying various combinations of elements of each discipline. Drug-device convergence products—those that attempt to leverage the intrinsic therapeutic aspects of a drug as well as the mechanical and local aspects of a device—are far from a homogenous bunch. Drug delivery, at one end of the spectrum, is once again gaining in importance, thanks to both a renewed focus on traditional life-cycle management as well as novel and improved technology platforms. More than a few firms are attempting to get into the drug-eluting stent market with improved second-generation therapeutically active devices. New orthobiologics and biomaterials in development could improve surgery outcomes and open up new markets. The advent of cell and nucleic acid therapies may hinge on the development of devices to discreetly and locally deliver them. And traditional drugs previously impossible to administer locally—for example, across the blood-brain barrier—are getting a new lease on life with pumps. (See Exhibit 1.)

A handful of recent biotech-device company deals have highlighted the potential of drug-device convergence as natural extensions of the ever-popular repurposing and drug delivery models espoused by investors aiming to reduce the risks associated with drug discovery. Venture capitalists are eager to get in on the game, but drug and device hybrid business models are few and far between. True convergence start-ups remain thin on the ground, a fact VCs say reflects the additive nature of drug risk and device risk. "True drug-device convergence can be extremely challenging," says Interwest partner Chris Ehrlich. "It's not hard to double your pain instead of doubling your pleasure." To reduce risk, new companies starting up in the convergence space are almost uniformly going to be working to improve medical devices with well known, generic drugs, say VCs.

Some VCs look at convergence businesses solely as a way to boost the amount of medical device opportunities. "We'll only do those ‘convergence' deals that look like medical device deals," says Oxford Bioscience Partners general partner Michael Lytton, "where we can allocate the market adoption risk to the buyer. The multiple may be lower [than a biotech deal], but it's more secure." Oxford recently hired Omar Amirana, MD, a former VP of business development in St. Jude Medical Inc. 's cardiology division to augment its device practice. Whereas OBP IV, its most recently invested fund, was 25% committed to device opportunities, OBP V, which it is currently raising, will aim to invest about a third in devices, including convergence opportunities, according to Lytton.

Thus there's a broad feeling that convergence start-up opportunities will have more in common with device start-ups than biotech start-ups, and those investors that are dipping toes into the convergence waters are doing so slowly and carefully. "You'll eventually see more investing in the convergence space but as venture capitalists we have to be very selective," says Dana Mead, partner in the life sciences practice at Kleiner Perkins Caufield & Byers. "You're going to see a lot of stealth with these companies, and VCs have to make sure they're picking companies where convergence is adding value, and there aren't a lot of companies yet where you can check all those boxes," he adds.

The statistics bear this out. According to statistics provided by Frazier Healthcare Ventures' Trevor Moody at Windhover's Convergence: the Drug/Device Summit conference earlier this year only 3% of $6 billion in private money that flowed into health care last year went toward convergence opportunities (compared with 20% in pure device funding and the rest in biopharma). (See "The New Math of Drug-Device Convergence," IN VIVO, April 2005 (Also see "The New Math of Drug-Device Convergence" - In Vivo, 1 Apr, 2005.).)

Becoming Bilingual

The concept of improving medical device performance by adding pharmaceutical products to address a device's shortcomings is intrinsically logical; likewise the idea of improving drug performance and/or limiting drug side effects by using medical devices as delivery vehicles. The reasons pharmaceutical and medical device companies have not produced a comparably lucrative encore product platforms that capture these benefits are generally chalked up to the differences in the industries themselves.

"From a capital perspective and from a regulatory perspective, drugs are a scary proposition for device companies," sums up George Daniloff, MD, PhD, a device executive most recently at Angiotech after the Canadian firm bought Cohesion Technologies Inc., where he was SVP of R&D, in 2003 for $43 million. [See Deal] "Nobody paid any attention to the device-tissue interface until stents," he says.

Device company R&D teams are staffed by engineers; in pharma its biologists and chemists. The regulatory pathway for devices is much shorter and smoother than that of the pharmaceutical world, say executives, and therefore much less capital intensive. The traditional pharmaceutical in-licensing deal is a foreign concept to device firms. And the commercial side of the businesses—distributing and marketing and selling the products—couldn't be more different. "At the end of the day, we speak pretty different languages," says Lothar Krinke, PhD, senior director of business development at Medtronic Neurological , a division of Medtronic Inc.

Of course there are exceptions—Johnson & Johnson and to some extent Abbott Laboratories Inc. are aiming to leverage their expertise across multiple businesses, say executives. And Angiotech has successfully positioned itself as the first specialty pharmaceutical company dedicated to the drug-device interface, based on the revenue generated from its Taxus royalty. (See "Angiotech: Specialty Pharma in the Device World," IN VIVO, September 2004 (Also see "Angiotech: Specialty Pharma in the Device World " - In Vivo, 1 Sep, 2004.).) Some observers feel it's only a matter of time before the industries build limited skill sets that allow them to bridge the gap.

"Drug-device combinations will become more popular, and the device and pharma companies as we've known them are going to have to evolve and change," says Mead. "It's going to be a question of what can you do on your own, what can you leverage from the outside and integrate, but companies have to learn new skill sets. Analytical chemists will have to work effectively with mechanical engineers," he notes. But if for now it remains notoriously tricky for established pharmaceutical firms to broach the world of medical devices and vice versa, then new models and ideas are needed to best exploit the potential of convergence within a small company start-up environment.

One complicating factor is that for now the expectations of VCs for their biopharma investments are vastly different than those for their device investments. While many health care VCs cover both fields, and while in some cases the exit opportunities for biotechnology firms are coming to resemble those of built-for-M&A medical device outfits, the differences in the capital requirements for the two sectors are vast. (See "Pfizer/Angiosyn: Building Biotechs for Device-style Early M&A," IN VIVO, February 2005 (Also see "Pfizer/Angiosyn: Building Biotechs for Device-style Early M&A" - In Vivo, 1 Feb, 2005.).) For a convergence start-up to make sense, argue some observers, it would have to create a means to combine the potentially greater upside of a biopharma start-up with the lower capital intensity of the device world. Developing a sustainable model for convergence start-ups is about finding an elusive middle ground.

"You need a model where tons of capital aren't required up front," says Frazier Healthcare Ventures' general partner Nathan Every, MD. "There's a lot of opportunity here to help patients and make good returns for investors, but there's a good reason we don't see a lot of pure start-ups," he says.

Risk Times Two

Which is precisely why those investors considering putting money into convergence start-up opportunities foresee these hybrids hewing closer to the device model. "You don't need two Phase IIs, two Phase IIIs, and the premarket approval really isn't that bad," says Interwest's Ehrlich of device opportunities. "You're saving a lot of money, so you don't need to raise $60-120 million privately, and you don't need a public market because you've got cash-rich medical device companies like St. Jude, Boston Scientific, and Medtronic that will buy companies out at an early stage," he adds.

To wit, Ehrlich says that when atrial fibrillation specialist Epicor Medical Inc. was sold to St. Jude in June 2004 for $185 million the firm had only 30-40 patients worth of data. [See Deal] Spinal Dynamics Corp. was sold to Medtronic for $270 million in 2002 with only one or two patients' worth of data. [See Deal] With biotech companies it's harder to count on M&A exits, he says, so investors need a robust public market to make their returns. Biotechs require critical mass—Stephen Evans-Freke, managing general partner at the recently launched private equity firm Celtic Pharma suggests that the size requirements for a biotech to become sustainable on the public markets have boomed. "The real truth of the matter is that you need a billion dollar market cap to be viable in the public markets today," he says. (See "Celtic Pharma Sees a Role for Private Equity in Biotech," this issue (Also see "Celtic Pharma Sees a Role for Private Equity in Biotech" - Scrip, 1 Nov, 2005.).)

VCs simply aren't interested in building these kinds of bulky firms from scratch in the convergence space, even if some of the more intriguing opportunities involve those firms pursuing cell therapies or various nucleic acid technologies like RNAi or gene therapy. "Hopefully even these companies pursuing combination products won't require as much capital as biotechs," says Mead. Frazier's Every suggests that models with lower capital intensity are possible in the absence of new chemical entities. "If you can find a generic drug, or one that's made reasonable clinical progress within a pharmaceutical or a biotech company, then it's reasonable," but the capital requirements won't be as low as those of a device firm. For now, combining devices with NCEs in a start-up environment, he says "is close to a non-starter. It's very difficult to make the numbers work with an unapproved drug or one that hasn't made a lot of progress in toxicology," he says.

The complex intersection of two disparate development risk profiles is muddied further by the uncertain regulatory fate a combination product can face. Executives argue that it's still difficult to envisage capital efficient drug-device convergence from the perspective of drug delivery. "Device function has to come first," says Daniloff, "because if the device is the primary function then you will more likely go through the 510k process or PMA regulatory approval." Risks are compounded by the fact that important decisions for combination products need to be made very early on in the development process; in device development, design can be tweaked along the way—introducing a drug to the process means committing for the long haul.

Cutting down regulatory risk is a concern for VCs putting money to work in the convergence space, if only because the concepts are still new. In 2002 the FDA created the Office of Combination Products, which helps determine the proper jurisdiction for approval of products that are combinations of devices, drugs, and biologics. (Three centers are involved; the Center for Devices and Radiological Health, the Center for Drug Evaluation & Research, and the Center for Biologics Evaluation and Research.) (See "Convergence: What's Next at the Nexus," START-UP, February 2005 (Also see "Convergence: What's Next at the Nexus? " - Scrip, 1 Feb, 2005.).) Investors note that the effort is a work in progress. "The office of combination products at the FDA hasn't worked out all the kinks yet," says one VC exploring convergence opportunities. "The drug division and device division just don't think similarly, and even though they're supposed to act in parallel [when reviewing a combination product] it winds up being sequential, or worse, back and forth." The risk, say executives, is that the process doesn't get any quicker or easier.

Deals Fill the Void

Despite the dearth of VC money flowing into start-ups thus far, combination products march on, largely as a result of dealmaking between biotechnology and larger pharmaceutical and device companies. If combining novel drugs with devices won't work at the start-up level, within established medical device companies where the device side of the equation is already covered, there's more room for maneuver. But it's unlikely that convergence companies will be able to expect the same sort of deal paydays that their purely pharmaceutically focused brethren continue to generate.

Medtronic in February 2005 tapped Alnylam Pharmaceuticals Inc. to create RNA-interference therapies that the device maker could deliver to the CNS via pump and catheter systems to treat neurodegenerative conditions. [See Deal] "We don't stay entirely away from early-stage NCEs but you need to find novel ways to partner for these opportunities," says Krinke. Financing them can be tricky as well for firms unused to pharmaceutical-style deals. While specific terms weren't disclosed it's unlikely that Medtronic is paying significant money up front. The deal included an undisclosed equity stake which may rise to $21 million if the collaboration hits its development milestones and the companies decide to initiate joint product development at a pre-ordained review interval.

Few deals between device companies and biotechs will likely mimic the up-front payment and milestone structure of biotech-pharma deals, as traditionally device firms have tended to offer smaller biotech partners backend-loaded opportunities. Small device companies rarely enter into such arrangements in the first place as, since most are one-product companies, it narrows exit options for investors hoping for M&A. Like Medtronic's Alnylam deal, most such agreements are likely to be based on equity—and thus biotechs can't expect much in terms of the non-dilutive financing they can from purer drug deals.

When a licenser has approached the situation already from the perspective of a convergence-oriented firm however, things have been slightly different. Angiotech has struck a handful of convergence-oriented deals—both alliances and acquisitions—to build significant intellectual property and technology expertise, leveraging its success with Boston Scientific's Taxus. (See Exhibit 2.) As a licensee, Angiotech has been the most generous of any of the convergence-inspired dealmakers. Most recently, in October 2005, Angiotech and the biotech CombinatoRx Inc. inked a collaboration to jointly develop implantable drug-device combination products in vascular, orthopedic and general surgery indications. [See Deal] CombinatoRx's platform identifies synergies between two or more drugs that are already approved and on the market—thus attempting to avoid the risks associated with NCEs while at the same time building IP around its therapies.

CombinatoRx received $42 million on closing--$27 million in up-front payments and $15 million in exchange for an equity stake in the company. The biotech will also receive milestones and royalties based on products Angiotech successfully develops and commercializes. While Angiotech has bought the rights to license projects from CombinatoRx's clinical and preclinical pipeline in certain medical device and local interventional applications, the biotech retains systemic, traditional pharmaceutical rights. The CombinatoRx deal represents the kind of collaboration true convergence start-ups could leverage—a pharmaceutical-device hybrid alliance that blends novelty with the potential to develop an entire pipeline of products to test in vascular and orthopedic settings. On the heels of signing the agreement CombinatoRx refiled its S-1 with the SEC; the firm had failed to go public once on its own, but may succeed with the added weight of corporate validation from Angiotech. At $11 per share, the price paid by Angiotech for its stake in CombinatoRx, the biotech's implied valuation is no slouch in today's stingy markets: $173.1 million.

Cell therapy has also seen a handful of convergence deals, albeit with a greater element of shared risks and rewards. In early November Cytori Therapeutics Inc. and Olympus Corp. became the latest pair to set up a joint venture to create autologous stem cell systems. Cytori, which aims to use adult stem cells derived from adipose tissue to treat a variety of diseases including cardiovascular and gastrointestinal disorders as well as for tissue reconstruction, could earn up to $55 million in research, equity and milestone payments. The firms join Genzyme Corp. and Medtronic's joint venture MG Biotherapeutics Inc. [See Deal], an Osiris Therapeutics Inc. and Boston Scientific joint venture [See Deal], and a handful of other firms racing to harvest and deliver regenerative and stem cell therapies for acute and chronic conditions.

Not all deals have paid off. Perhaps underscoring the difficulties in developing entirely novel convergence products, Bristol-Myers Squibb Co. 's stab at convergence via the blockbuster 2003 deal with Corgentech Inc. for that company's edifoligide E2F Decoy was terminated in March 2005. [See Deal] The product, a novel combination device-oligonucleotide to treat complications related to coronary artery and peripheral arterial bypass surgeries, failed to prevent vein graft failure following CABG surgery in Phase III trials. (See "Corgentech/BMS: Finding Specialty Appeal in a Drug/Device Combo," IN VIVO, November 2003 (Also see "Corgentech/BMS: Finding Specialty Appeal in a Drug/Device Combo" - In Vivo, 1 Nov, 2003.).) BMS's foray into convergence is at odds with a general perception among device executives that pharmaceutical firms will continue to rely on mass-market products. But those drug companies that embrace specialist opportunities—and there are more than a handful doing so—may find convergence within their remit.

More to Come

In perhaps a unique take on the convergence opportunity, Merck & Co. Inc. and the atherectomy device company FoxHollow Technologies Inc. have teamed to identify biomarkers of atherosclerotic disease progression by analyzing the plaque removed using FoxHollow's SilverHawk plaque excision system. [See Deal] (See "FoxHollow/Merck R&D Deal: The Value of Plaque," IN VIVO, October 2005 (Also see "FoxHollow/Merck R&D Deal: The Value of Plaque" - In Vivo, 1 Oct, 2005.).)

If one of the world's largest pharmaceutical firms can find value in the plaque shaved off the inside of clogged arteries, the optimism of convergence proponents is perhaps well founded. Industry executives and venture capitalists maintain significant enthusiasm for drug-device convergence opportunities, particularly as the price of building sustainable biotechnology businesses continues to rise. Companies like CombinatoRx, with a mandate to repurpose existing drugs, or deliver existing drugs in new formulations are already considering device-mediated local delivery systems as an extension of their basic business models. Those firms pursuing cutting edge cell- and oligonucleotide-based strategies like Cytori, Osiris and Alnylam have also turned to device manufacturers to overcome the safety and pharmacology issues associated with systemic delivery of their products. "We believe strongly that therapies need to be delivered locally," says Medtronic's Krinke. "Think of the next generation of protein therapy, or cell therapy or gene therapy. Devices can play a terrific role in delivering agents to the CNS across the blood-brain barrier," he says. "We view the opportunity in terms of catheters, pumps, and drug-eluting devices like stents."

Smarter medical devices through the introduction of greater computing power and IT innovation are also attracting significant attention as physicians and device developers are placing a greater emphasis on patient- and disease-management. Gathering the physiological data in the real time necessary to help improve the treatment of chronic diseases, says Kleiner Perkins' Dana Mead, is of particular interest.

It may be the simplest products that make the biggest impact. Device executives point out that the ultimate customer for many of these products, surgeons, already implant half a million pacemakers and defibrillators every year. As in bare metal stents there are means to incorporate pharmaceuticals to improve the outcomes of these surgeries, through drug-laced biomaterials to thwart the infections that result in expensive and dangerous second surgeries. Companies are springing up to do just that. TyRx Pharma Inc. , a Boston Scientific-backed re-start originally founded to focus on tissue scaffolding, is developing implantable devices that will fit around pacemakers and ICDs, coated with an antibiotic-loaded polymer. (See "TyRx Pharma Inc.," START-UP, September 2005 (Also see "TyRx Pharma Inc. " - Medtech Insight, 1 Sep, 2005.).)

According to Chris Ehrlich, Interwest is nearly ready to lift the hood on its own investment in a new biomaterials firm. Other VCs maintain that it's only a matter of time before they make moves in the space. "In the end, a start-up has to convince investors that going it alone can produce a product that's going to help patients and provide good returns for everybody," says Frazier's Every. "You've got to make the risk and the reward line up." Biomaterials and other technologies are jockeying to become the next drug-eluting stents. Observers feel it's only a matter of time.

What is certain is that alliances between existing firms—most likely dominated by biotech-device company combinations—will help to shape and justify VC investment in the convergence space. Additional hybrid deals like Angiotech/CombinatoRx will validate the idea that a middle path between device and biotech dealmaking won't result in a dead end. This flexibility may allow a similarly middle ground when it comes to starting up and funding convergence companies. Leveraging any sort of partnership to build a pipeline of products already distances these start-ups from today's young device companies.

Ultimately dollars going into drug-device convergence start-ups will be predicated on the success of today's emerging hybrid products. "Convergence makes an awful lot of sense because in the end it does improve efficacy," says Mead. "Everyone is pointed towards it and more funding is going out to support these ideas. It's not a fad."