Venturing to the great unknown: venture capitalism in biotech. What are some of the key tools in a venture capitalist’s repertoire?
By Bibhash Mukhopadhyay at Sound Bioventures
Historically, the venture business has been one where good ‘pickers’ have been rewarded disproportionally. ‘Pickers’ are investors who chose to invest in companies early on in their trajectories that eventually turn out to be rocket ships from a valuation and returns perspective.
This paradigm was particularly successful in the technology sector, where knowing secular trends in the marketplace drove investment theses and in turn, selection of companies to invest in within those domains. Storied investment firms like Sequioa, Benchmark and Kleiner Perkins all made their names with investments in iconic companies that rode these secular trends and turned out to be massive winners like Google, Apple, Cisco, Nvidia and Amazon. However, biotech investing is different from tech investing.
Firstly, in biotech, the amount of capital at risk to get to an inflection point is greater by an order of magnitude.
Compare the capital needed to test out half a dozen different ideas in a company developing software apps versus that needed to take a potential new medicine from discovery stage to first-in-human trials, which can cost anywhere
from $5-$50m.
Secondly, the time needed to prove whether there is a ‘real’ business opportunity in a biotech company is also different from any other sector, also by an order of magnitude.
Compare the time needed to prove product market fit for a new piece of software to that of proving that a new molecule can be effective against a disease (anywhere from one to three years), let alone confirming that to the satisfaction of regulators globally in larger scale clinical trials.
Thirdly, biotech is quite rightly one of the most regulated industries on the planet; meaning there is very limited opportunity to go quickly with patient safety and lives at
risk. For example, there are very stringent FDA rules on how ‘clinical benefit’ can be defined and adjudicated in any disease setting.
So, one must start with fairly deep pockets, patience and rigorous knowledge of the rules to become a successful biotech investor.
The convergence of intellectual, human and financial capital
In effect, to be a good ‘picker’ in biotech, one cannot adopt a ‘spray and pray’ approach. Rather, one has to be deliberate in assessing the likelihood of success of a company by
doing fundamental, scientific, first-principles-driven analysis on whether it can develop a drug successfully. Investment outcomes are almost always directly correlated to how well an investor can assess the likelihood of success of any drug development project.
Biotech investment outcomes are typically binary; either the drug under development will work, creating value for its investors, or it will fail – there is nothing in between. Since one cannot change the inherent probability of the drug
development process itself, a biotech venture capitalist (VC) is highly dependent on being a good ‘picker’ based on its fundamental analytical capabilities.
In addition to the capital and time intensiveness, the biotech industry has highly complex operational challenges, where the opportunity cost of failure is very high. For example,
a mistake in a drug production run making a therapeutic antibody for first-in-human trials can cost a company $10m and set it back by 12 months.
Extending this line of logic, a biotech company can be successfully built with the convergence of three things: firstly, intellectual capital, which is the scientific substrate and unique insight behind a new company (eg, new
biology, new pharmacology, new target). Secondly, human capital, which is people with deep and specialised expertise in drug discovery, managing the various processes of drug development and building early-stage companies. And finally, financial capital, since developing new drugs is expensive. If the first two are specialised, one could argue that the financial capital fuelling biotech companies should also be specialised to maximise the chances of success.
What you know matters
So, if these are the elements of success in a biotech company, what should be the constituent elements of a successful biotech VC investor? In short, deep expertise in both the ‘how’ of the drug development process, including its challenges and pitfalls, and the ‘who’ of the ecosystem – can a VC connect the right people with the company to maximise its chances of success? – alongside hands-on experience in investing in biotech companies. These elements are crucial and highly complementary.
The knowledge of the ‘how’ best comes through hands-on industry experience in an operating capacity. This typically means some combination of having done drug development in a biotech company or of having a leadership position
within it. In addition, the VC investor on the board of a company should be able to serve as a sounding board to the management team. The investor should support the company with key decisions from how to best allocate resources, capital and time to specific operational tasks. This experience simply does not come to someone who has only been an investor and has never been in the trenches of an operating business, especially when things go wrong.
Sound investment judgement in a specialised biotech venture investor forms after having invested in multiple companies through various windows in the investor’s trajectory. In addition, one makes an astute investor only if the investor has lived through multiple macroeconomic cycles. This experience only comes after having done investments and failed before. Investment judgement is reflected over time
in an investor’s prior track record. The adage that ‘it takes a
$100m to train a venture capitalist’ is true!
Who you know matters, too
Knowledge of the ‘who’ (the highly important human capital) comes from being a member of the industry ecosystem with an extensive Rolodex of contacts. This is critically important because as a board member, a VC investor can provide access to the right people with domain expertise to solve whatever problem the company is facing or might face in the future.
Your company is stuck in a problem on CMC drug production? You should have someone on speed dial with three decades of experience doing precisely that.
Your company needs to estimate how big a sample size is needed in a complex Bayesian trial design? You should be able to introduce the company to someone who understands clinical statistics in that specific therapeutic area.
Your company needs someone to construct a detailed revenue model from first principles of disease epidemiology? You must know someone in your network who runs a consulting firm that does precisely that.
Access to this type of capability on demand is extremely helpful to management teams and is a key competitive advantage or value add of a successful VC investor.
Additionally, one’s Rolodex typically needs to have people in the industry who make the decisions to acquire biotech
companies (typically biopharma executives, including people in business development functions) or underwrite their public market debuts (investment bankers). Most biotech firms provide liquidity to investors through one of two methods: getting acquired by a larger pharma or biotech or going public through an initial public offering (IPO). A good biotech VC will know the people who can make these things happen, essentially serving as a catalyst for the biotech company contemplating M&A or IPO.
Timing is everything – for both entering and exiting an investment
One small but important wrinkle in the generalised statement – that a high yielding biotech venture investment comes from whether the biotech can successfully develop a drug in the real world. Generally, the value of a biotech is inextricably linked to the question of whether there is a real drug in this company (and associated questions of whether the company can execute on clinical trials to bring the drug to market).
But as with every form of investing, investment return profiles are often more nuanced based on where in the drug development cycle one invests and when one exits, especially since drug development takes a long time.
An extreme example to illustrate the point would be the case of the development trajectory of a drug called teplizumab.
Doug Lowenstein, the public affairs and communications strategist, wrote a very informative piece narrating this story on LinkedIn. It takes place over three decades in the labs
of academic investigators and pharma companies (Johnson & Johnson), companies running clinical trials (Lilly and Macrogenics), finally, taken over the finish line with US Food and drug Administration (FDA) approval for type 1 diabetes (by Provention Bio) and now marketed (by Sanofi, which acquired Provention).
Zooming in on Provention Bio, there were probably three windows of time during the long development period in which investors could have made money, with one common theme among investors being the fundamental belief in the clinical data being generated on teplizumab. However, not all investors made money, because they did not time their entry into and exit from Provention appropriately.
Well known biotech companies that have developed drugs, like Genentech, Genmab, Amgen and Vertex, were all ‘unicorns’ at some point, but if you look at the timelines from company inception to approval of their first drug, more often than not, they took decades.
Venture investors typically cannot stay on board for the multi-decade ride, therefore often have to make their returns in a specific window along a company’s trajectory. A good venture investor knows when to get into a biotech by correctly assessing the chances of success of its drug and then helping to create a situation (mostly by M&A, sometime via IPO) in order to get liquidity from the investment.
Betting on both the horse and the jockey
In summary, venture investing in biotech is unique since investors need to be good pickers, good shepherds and good ‘time-clocked’ exiters. The ‘operator-investor’ phenotype, typically with a technical background and a large list of relevant contacts is the ideal biotech VC.
There is an old adage that however sophisticated a discounted cash flow (DCF) or net present value (NPV) model you build in the context of company valuation for venture investment decision, there is only one thing that is certain about it – it will be wrong! The question is in which direction and by how much. In this regard biotech venture investing is not an armchair analysis sport. Analytical proficiency is necessary but not sufficient on its own to make a good biotech venture investor.
This is where capable and competent management teams come in. A VC must have the ability to discern a good operational plan from a bad one.
A good plan is practical, achievable and capital efficient. Good management teams come up with good plans and wrap a capitalisation plan around it to raise money from VCs. Good VCs bet on not only the likelihood of that operating plan being successful on budget and on time, but also how well the management team can execute on it. Winning the ‘derby’ therefore involves not only betting on the right horse (right science, right plan) but also the right jockey (management team).
One could joke that a successful VC is at best a matchmaker bringing together one person’s money with another person’s ideas. A VC fund gathers money from institutional investors and allocators like pension funds (the limited partners or LPs) and invests it into high-risk high-potential companies.
There has to be something unique that the VC firm offers its LPs with regards to investment strategies and something unique it must offer to investee companies in order for one to part with its money and for the other one to accept it.
Therefore, specialisation through knowledge, experience and Rolodex is the key to being a successful biotech VC.
Bibhash Mukhopadhyay PhD, managing partner at Sound Bioventures, is a venture capital fund manager, investor, company builder and board member with around 15 years’ experience in biotech.
Prior to co-founding Sound Bioventures, he worked as an investor within the biotech practice of a large, diversified venture fund (NEA). He has led multiple investments, been involved in private financings and IPOs and multiple major in-licensing, divestiture and acquisitions and cross-border (Europe/US) deals. He was awarded his PhD in the biology of retinal degeneration from Baylor College of Medicine. He is based in Washington DC, US.
