Big ego VC says Pharma needs more big ego VCs

Read it here:

http://www.xconomy.com/san-diego/2012/09/27/kinsella-redux-charting-a-way-back-for-life-sciences-startups/?single_page=true

I'm not convinced that venture returns are meaningfully impacted by the venture partner involved. In the article above, a big ego VC wistfully urges that his sector return to the glory days. One of his funds from 15+ years ago is offered as evidence that he's brilliant and Big Pharma is stoopid.

Not that Big Pharma is blameless, but there are better explanations for declining returns even as drug discovery has gotten more capital efficient. Here's a few that occurred to me:

1) VC's own movement away from investing in early technologies to later stage deals. VCs basically don't do old-fashioned $500,000 seed stage deals anymore. They're now all about financing companies graduating to Phase II. Gee, Mr. Kinsella, I wonder why there aren't as many early-stage companies.

2) the hangover from VC over investment in the early genomics era. Remember the year 2000 hype behind genomics companies like HGSI, Millennium, and others? Yeah, I can't imagine why Pharma stopped trusting VC.

3) the rotation in investing strategy from FIDDCo (fully integrated drug discovery companies) and platform technologies to target driven companies each based on a small amount of closely-related leads. 

4) a lack of public market liquidity for small cap biotech, partly influenced by structural changes (like increased financial regulation reducing the attractiveness of IPOs), but more driven by increasing VC fund sizes. VCs are paid based on assets under management (size of fund = size of paycheck), and with larger fund, it is less economical to make smaller, earlier investments, which also require longer holding times, so VCs moved their money towards PIPES - investments in already-public companies.

There's four reasons generated in about 10 minutes. I'm sure I could come up with 10 more if I spent another hour on the idea, but I'd hate to accidentally give any credence to VC vanity.

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Venture firms see signs of rebirth in life sciences

Here's some reasons to be hopeful that the early-stage life science sector is on the upswing. (though i am skeptical that the e-health ventures will deliver (in general.) investors are bringing dot-com growth expectations to regulated markets where behavior doesn't change fast. (And i'm speaking of consumer, practitioner, and payor behavior.)

http://www.reuters.com/article/2012/09/24/us-venture-capital-life-sciences-idUSBRE88N0EK20120924

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More damning VC performance data - the model is broken

Two weeks ago I pointed to a study suggesting that there are structural problems with venture capital. A larger, more damning study is now in the news, confirming low industry returns, and diagnosing more problems with VC.  

I highly, highly recommend clicking through to read Felix Salmon's reporting and analysis on the
matter. Money quotes:

"During the twelve-year period from 1997 to 2009, there have been only five vintage years in which median VC funds generated IRRs that returned investor capital, let alone doubled it," and

"the VC industry, as a whole, is being incredibly successful at extracting rents from dumb institutional investors."

In a nutshell, a study by the Kauffmann Foundation concludes that:

-It is debatable whether or not VC is a worthwhile investment. "78% of the funds that Kauffman invested in (i.e. those in the study) have failed." Not only does the mean VC fund destroy capital on a risk-adjusted basis, recently these funds have had negative IRRs on a gross basis!

-Quality matters: "If you can’t get into one of the best funds — and everybody knows which funds those are — then there’s really no point investing in venture capital at all."

-LPs really don't hold VCs accountable enough: "once you strip out the top-performing 29 funds, the rest — more than 500 — collectively invested $160 billion, and managed to return $85 billion to investors." Shakeout, anyone?

-incentives are misaligned: VCs are invented to raise more and larger funds, as that's where the compensation is. This also incents goosing early year returns to help with fund-raising, meaning all of that VC chatter about long term investing is bull.

-smaller, more experienced funds are more likely to have outsized positive returns.

It's time to change the life science VC industry approach. Here's a few humble suggestions from my quick reaction to the Salmon article and Kauffman study:


1. Full disclosure. Between intense VC fund secrecy and discretionary allocations of costs and returns among funds, VC investors (LPs) really can't get definitive, transparent performance accounting. It's time for quality VC firms to be proactive in publicly disclosing deal-by-deal and expense by expense fund accounting. The message from LPs needs to be "if you're not transparent, we'll assume you're hiding something."


2. VCs: Climb the risk curve. The data suggests that VC has a problem finding alpha (return). The most immediate way to goose alpha is to take on more risk by investing in earlier stages. In other words, if a VC firm says that they don't invest until B rounds, they ought to stretch into A rounds. (And likely STOP investing in later ('D') rounds. An earlier investment carries a bit more risk, but it is more or less the same type of risk seen in the later stages. (In other words, if the primary risk for an investment is target biology or lead chemistry, it still takes the same understanding/risk tolerance whether investing in round A or C. Only the size of the risk changes.) I think VCs get paid for their ability to manage risks, so if a firm's core competency is vetting lead chemistry, getting in earlier plays to their strengths, and might in fact "train" the firm to better assess and handle those risks.


3. Less therapeutics, more enabling tools and platforms. Investing in therapeutics has a more or less binary outcome - success or failure, with not much in between. One way to minimize the downside for VCs is to invest in operating companies - their ceilings aren't as high as a winning therapeutics investment, but their terminal value is, well, >$0.


4. Create smaller funds, with VC compensation tied even more to performance. Typical compensation for a VC is 2% of the amount invested every year, plus 20% of the downstream gains. If it were up to me, I'd get rid of the 2% annual fee - make the funds invest their own $$$ in annual expenses.


5. More specialized funds. The old investing true-ism is that 80% of investing returns are generated through asset (sector) allocation, not through the selection of individual securities. The suggestion then would be to hyper-specialize. A large fund that invested in "therapeutics" is less likely to deviate from traditional poor returns than a fund specializing in "oncology," though I'd postulate that a fund that hyper-specialized in "kinase inhibition in cancer" would have crushed both, and wasn't that difficult to predict 10 years ago. (Easy for me to say.)


6. Use secondary markets to generate valuations and gain liquidity, lessening short term thinking and attracting Big Pharma investment dollars. New markets like Second Market have made a splash with internet companies for their ability to provide selected liquidity and to unlock equity value for employees. I'd like to see biotech embrace these alternative markets. Earlier pseudo-liquidity would attract more investment capital in general (including from Big Pharma. It would be great to get more of their capital in the game,) provide more transparency, clarify signaling, and likely facilitate consolidation among private companies. There might be some resistance among VCs as alternative markets might disinter mediate them, but they might on net reduce the investing risk for VCs and facilitate earlier liquidity.


7. Begin a 5-year moratorium on pandering to the government to increase funding for young companies and technologies or to reform some regulatory requirement of securities law. If the Kauffman study is representative of the life science industry, then clearly the problem isn't the level of government support, but rather the commercialization efforts that VCs back. VC keeps destroying capital with bad bets, not because there aren't enough ripe, de-risked technologies, or non-equity funds to incubate promising technologies.


8. Fund businesses, not technologies, science projects, or lottery tickets. Sure, the business case for an investment may hinge on Big Pharma buying you out once the leads make it to Phase ___, but if investments aren't businesses first and foremost, you're either ultimately 1) disappointing your Big Pharma customers, and 2) trying to build a skyscraper on a foundation of mud.


Unfortunately, I don't have a lot of confidence in the VC industry adapting. It is way, way more likely that instead of changing the industry's foundation, VC will further squeeze valuations and term sheets for incoming investments in order to try to lift returns.

Structural problems in VC-land

Fascinating blog post and commentary by Noah Smith suggesting that VC returns have lagged the S&P 500 for nearly a decade.

Here's a graphical representation of his point:

Head to Noah's site to get all the details of the study.

(The study seems to be across ALL industries - with biotech/life sciences composing only a fraction of the investing universe for these VCs, but the core lesson probably holds for biotech: VC returns have plummeted.)

The explanation for the plummeting VC returns is an oversupply of risk-capital (and risk-capitalists!), beginning during the dot-com bubble. However, it isn't clear if this is because deal pricing and other investing terms have changed post-bubble, or if the oversupply of capital led to the funding of marginally rewarding portfolio companies, or any of a dozen other explanations. Perhaps it is simply that there had been an artificial constraint on risk capital before the bubble, allowing VCs to earn rich returns by cherry-picking only the best deals.

One commenter at Noah's site provided evidence that VC returns also tend to correlate with the history of the VC team. (In other words, long-term VC groups have done much better than Johnny-come-latelys.)

Whatever the explanations, there are implications for life sciences:

-we're in the midst of a correction in the VC market - many marginal VC players will disappear, and with that, pricing power will begin to return to the survivors.

-if they weren't already, VCs are desperate for returns. Expect them to ALWAYS take the option that cashes them out now at a lower price, than later at a higher price. (If you thought they were short-term thinkers before……..) This is good news for strategic buyers.

-seeing these returns, LPs (those who invest in VC funds) are more likely to "go direct" by investing in PIPES and follow-ons and forego investing with VC funds that 1) don't deliver risk-approproate returns, and 2) charge 2% a year, plus a carry. If this is true, there's more hope for older small cap biotech's, and less hope for early stage companies.

-I'd guess that a side effect will be a decline in risk appetite, which would be a nudge towards tools and tech platform companies, and away from discovery pure-play companies. I'd also guess that target discovery is no longer a viable business - if there's an over supply of VCs, the last thing they'll want to do is add to the oversupply of targets.

-seek quality. All else being equal, the life science VC firm in its' 2nd decade of investing is likely to be a better choice than a firm just beginning in biotech investing.

-as before, there is still a big opportunity for corporate (Big Pharma) VC$.

Hat tip to Tyler Cowen's Marginal Revolution blog for pointing out Noah's post.

"The gravy days are over." (WSJ)

This just in: financing for biotech companies is scarce.

The WSJ article reporting this has in-depth analysis and loads of figures. Depending on your view, any and all of the following are responsible for a general decline in biotech financing:

-big pharma being more selective
-FDA intransigence
-trouble getting liquidity/the difficulty of IPOs. (Due to Sarbox.)
-better options for investors in other industries, especially the internet
-generics and the threat of biosimilars.
-economic difficulties (and US budget pressures) are increasing pressure on basic R&D budgets.

The truth is, with a few very rare exceptions (1999-2000), biotech financing has almost always been scarce, and to think otherwise, or plan otherwise is just plain stupid. There's a high technical barrier to entry for investors, long turnaround times for investments, and enormous technical risk with any drug development effort. Revenue-generating companies - which more investors understand, and therefore have an expanded pool of investment capital for them - take 7-10 years to build in this industry.

This is a sector that SHOULD have a high cost of capital, and probably an undersupply of capital.

But I'd say that this is just about the best time to have a great idea to develop, because:

• pharma's need for new products has never been higher, and the aging US & European populations are increasing demand for pharmaceuticals

• start-up and operating costs have been driven down by outsourcing & virtual operations.

• the abundance of specialized CROs & consultants lets smallish companies rapidly access expertise and capacity.

• with big pharma continually restructuring, there is an abundance of talent and facilities available.

• the current FDA & NIH administrations are trying to streamline the regulatory burden. Also: more regulatory paths are opening. I've heard of plans to gain approval first in China by some companies.

• increasing globalization makes it easier to collaborate. (Design a molecule in the UK, synthesize in the USA, screen in China, on a faster AND more efficient basis than if you had a fully integrated operation at one site.)

• increased genomic understanding and lower sequencing costs are enabling more effective R&D.

• China, China, China: increasing the supply of capital, talent, ideas, and lab assets. And not just in China: I've been told by US & EU academics that it has never been easier to find talented, financially-supported post-docs, from China for their American or EU labs.

• increased IP clarity with the America Invents act, and probably lower patent friction, given developments in gene patenting court cases.

• a growing generation of successful firms and alumni to incubate, mentor, and lead new ideas. (Guys like Patrick Soon Shiong (Abraxis founder, among other ventures) Henri Termeer (ex-Genzyme CEO), and RJ Kirk. (Not that this is exclusively a new development (think Alejandro Zaffaroni), but their numbers are growing. I can't wait to see what emerges from the Genentech alumni in years to come.)

If anything, biotech may suffer from an abundance of good - new drug targets, under-validated lead compounds, and interesting but not bulletproof diagnostic technologies are very easy to find these days. Just walk into any university's tech transfer office - they probably have some promising target IP just waiting for the right investor/believer.

The scarcity of investment capital is probably a good thing, culling the herd such that (on average) only the best ideas go forward.

This is all small consolation to the team at a small company struggling to raise their next round, but it definitely seems that better days are ahead, and it'll be a Molecular Future.

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Will New Business Models Enhance or Endanger Drug Discovery?

A great thought piece by Stewart Lyman at Xconomy, well worth a read. Lyman analyzes the business models that have generated biotech "wins," and concludes that the current vibe is that VCs are oriented towards creating limited, focused companies (tending towards virtual) instead of the ambition a decade or more ago to built fully integrated drug discovery operations.

This reflects the fact that the end consumer (in this case the pharma companies that buy successful or promising therapeutic programs) wants to buy specific assets and nothing else. Lyman doesn't mention it, but this is as much due to the fact that the public markets are closed for any venture with less than half a billion in valuation. 

(This is mostly due to 2 reasons:

-the fact that Sarbanes-Oxley imposes costs on smallish companies that make it impractical for companies of <$500M to be public. In yet another example of regulation trying to close the barn door after the horse has escaped (see also: Dodd-Frank Financial Reform), Sarbanes-Oxley has killed the US IPO market for small to mid-size companies.

-while $100M-$500M in capitalization for a young company may seem large to you and me, it is a tiny number to Wall Street, making analyst coverage unreasonable, and not profitable enough to justify underwriting efforts.

(end rant))

Since VCs can only get liquidity from pharma acquisitions of their investments, companies are not being built to last, but rather built to flip. At the same time, the size of seed VC investments has risen, so biotech  start-ups need to have a quick use of $5-10M in seed capital AND a clear path to liquidity. Gone will be the days where therapeutic assets slowly incubate via SBIR funding (and other non-profit vehicles.)

(Luckily CROs now enable quicker and less expensive R&D. Young biotech companies don't need to build and staff non-core departments in order to progress a lead compound.)

The problem with this model as I see it (and not emphasized in Lyman's article) is that the smallish, asset-lite "disposable" biotech model now in vogue is absolutely terrible for anyone on the day-to-day team at the biotech company. Sign on to one of these "lite" companies and you take a GIGANTIC career risk. 

Scratch that - it's not a risk if something is practically guaranteed - and unless you believe your compounds and company will smoothly grow and progress from discovery to phase III without a hiccup at any stage, you almost certainly will go through restructuring, replacement, or a reduction of one form or another.

To the VC, each $5M biotech investment is a bet with a 1:20 likelihood of payout, but with a 50X payout with a win. The VC wants to take 40 "shots on goal" with their $200M VC portfolio, with the probabilities suggesting 2 "wins" worth a total of $500M.

To the scientific and business staff, though, that means that there's only a 5% chance that their specific efforts will result in a profit. With these odds, a career in academia, at a big pharma, or at a CRO looks a LOT less risky.

So until someone comes up with a business model for VC investment that ISN"T built to flip, start-up biotech's will have a hard time attacking the talent they need to run rings around big pharma. It seems strange to suggest it, but perhaps VC needs to be mindful of the business case for talent, not just for ROI.

Personal note: my opinion is also based on my experience starting a therapeutic discovery start-up.  It was a great experience, but the risk/reward math is just not favorable for biotech employees, and I won't ever work in early stage therapeutics again, if I can help it.

More on Warp Drive Bio

I analyzed the Warp Drive Bio (WDB) launch here (Warp Drive launched with a stunning $125M in financing.)

Even better,  BioIT World has more detail on Warp Drive Bio, including an interview with the CEO.

Interesting to see that the 'put' of WDB to Sanofi is actually formally agreed to - hit certain milestones, and Sanofi has to pay a pre-determined price, so there's more risk on Sanofi's part that I assumed was being carried by the VCs.

Either directly or indirectly, this results in reduced risk for Sanofi, the VCs, and WDB company management - a win all-around - pretty smart. Consider:

-WDB & company management doesn't have as much financing risk as most biotech's - they can concentrate on discovery productivity, instead of chasing next round financing.

-VCs get a liquidity put. There's even less downside, as VC's are providing less than 100% of the start-up capital. (Assuming more than the VC's $75M was required to launch.)

-Sanofi gets exclusive (I assume) access to a novel technology platform, gets R&D expenses off of their income statement, and locks in discovery productivity and the cost of acquiring WDB technology at 2012 prices. As long as SNY's R&D agenda is matched by WDB's, and the value of leads does not go down, this is great.


I think most VCs and company executives would LOVE to do this sort of deal, especially at company founding, but pharma's aversion to risk prohibits most deals of this sort. Big Pharma's usual game plan is to wait to see more data, as they would rather trade potential financial upside for reduced product or program risk. Let's hope that this deal represents Big Pharma's willingness to take a little more risk, especially when a company at start-up has such a great pedigree.


Besides the novel Sanofi partnership, WDB has a very traditional lead discovery value proposition  - their expectation is that their technology platform will generate novel lead compounds quicker/better/or more efficiently.

I'm in no positon to evaluate the technology, but from a business strategy perspective, it is another example of over-valuing lead discovery. (That is, if you believe as I do that preclinical leads are over-valued.)

Consider the typical drug discovery & development timeline, as put forth in Nature:

WDB's value proposition affects only the first two years of the timeline (up to lead selection.) Presumably WDB is more efficient (either in time or cost) during the early stage. Let's say they're 25% more efficient in terms of time, which equates to 6 less months of development over 8 years, assuming that the drugs have the same downstream risks of other R&D programs. (i.e. a WDB-sourced lead is just as likely to succeed in Phase II as any other pharma lead.)

The net effect is WDB's entire discovery advantage is in 1/16th of the total effort required to produce a drug, and does not seem to impact the probability of success. Sure, there's financial value in getting a product to market 6 months earlier, but bringing $250M in revenue forward by six months 7.5 years from now is only worth $31M in present value (25% WACC, 30% OPM).

The same $31M in NPV could be generated just by increasing the probability of a programs success by a small amount. (In other words, quality over quantity.)

For this reason, I'm a fan of investing not in more early leads, but rather any IND leads or technologies, especially if I'm a risk-averse pharma.

Thoughts? Reactions?

Plexxikon: was it worth it?

Congratulations to Plexxikon, acquired today by Daiichi for up to $935M. (And unlike most reported deals, where the eye-popping total value number is based on contingent bio-dollars, the vast amount of the $935M is cash upfront ($805M).)

Plex has been a model of efficiency, raising only $67M in capital over nine years. The result is an outstanding-looking B-Raf inhibitor in P3 trials for melanoma. The potential for this product is in the realm of Onyx's Nexavar and provides an interesting valuation comparable.

ONXX's market valuation is $2.2B, based on their half-interest in Nexavar (a B-Raf inhibitor), which is on pace to break $1B in revenue in 2011. (Quirk: the bulk of Nexavar's revenues are recorded by Onyx's partner Bayer, but ONXX still booked $324M in gross profit from Nexavar in 2010.)

So, if a half-interest in a billion dollar (and growing) B-Raf inhibitor is worth $2.2B, it would seem that Plex got a decent price for its' late-stage product.

(All of this analysis ignores the valuation of other programs and regular items like cash balances, etc.)

So Plex is promising, management drove a good deal, and Daiichi now has a potential blockbuster. But I have to ask, was it worth it? (Not to pick on Plex, because I ask this question of all drug discovery ventures.)

When you consider the prospects of Plex's lead program and the capital efficiency during the company's lifetime, most every aspiring biotech and every drug discovery VC would today trade places with Plex. But, did Plexxikon create or destroy value?

It's a pretty close call.

Mining press releases for financing info reveals 3 rounds:

A: $8.3M in 2001
B: $27M in 2002
C: $32M (year undisclosed, but for purposes of analysis, assumed to be 2007.)

I plopped those figures - along with the $805M pay-off and a risk-adjusted value for the $130M in contingent payments - into a quick NPV calculation. The result: The $67M in investment probably created about $10M in net value.

(Key assumption: a 40% cost of capital. I know some risk-tolerant investors use 30% for a private drug discovery operation, but I think 40% is much, much more reflective of the inherent risk. Other folks will use 50% as a discount rate.)

The conclusion is so close that I took a look at the breakeven cost of capital: 44%. (Gosh, I love the goalseek function in Excel.)

This analysis is no way intended as criticism of Plexxikon or Daiichi, but rather the wisdom of the biotech model. Plex is in the top 5% of biotechs in terms of outcomes, yet only marginally of net value.

You can't argue with how Plex invested their capital. To generate a blockbuster lead in late stage development for <$233M ($67M in financing plus $170M in partnering revenues) is very, very impressive. I think every Pharma wishes that their R&D was that efficient.

I've already mentioned how I think Plex got a fair price on the sale, so if their net spend was efficient, and they got the best deal they could, the only way to increase the value created would be to do the drug development more quickly.

To me, the only possible way to accomplish this would be to keep the technology (leads/chemistry) in a non-profit (academic) setting as long as possible. In other words, future Plexxikons will be more attractive if the leads can be more greatly incubated in an academic setting.

Unfortunately, today there's no capital available within most universities to accomplish this (nor the expertise or risk-tolerance.) It seems a new model is needed and perhaps new institutions. Francis Collins at the NIH seems to have a good idea in the form of their Translational Medicine Institute, but this alone won't increase the odds of success or the ROI of efforts like Plexxikon's.

The only other levers are for pharma to shoulder more R&D risk (which is the opposite of current trends), or for non-profits (and their grant funding) to shift emphasis from basic research to applied research. I don't know how this is likely to change in the future. Until then, we'll celebrate infrequent victories like Plexxikon.