Before You Do That Amazing Biotech Deal, Read This Story –

Originally published in the August 2002 issue of VCJ

Biotechnology startups have always required a greater incubation period. But 10 years after seeding Metabolex Inc., we discovered just how long that can take.

Metabolex, based in Hayward, Calif., is developing drugs to treat Type II diabetes. Charter Ventures seeded it in 1991. We alone backed the first two venture rounds, willingly taking the economic and science risk from the start meaning that we would help build the company like any other startup, while funding the creation of entirely new scientific research. It was just the beginning.

After five rounds, Bay City Capital, a San Francisco-based life sciences venture capital firm, joined Metabolex’s sixth round. The company’s seventh round was a largely strategic corporate round with some of our big pharmaceutical partners. The eighth round closed last December and included all previous corporate and venture capital investors. The total amount raised: $80 million. Metabolex is working on closing a 9th, and hopefully last round of about $20 million, which it hopes to close this summer.

No Waiting Room

Would we do it again? Probably not. It’s not that Metabolex isn’t a great company, or the diabetes market isn’t fertile ground for a home run opportunity. Rather, 10 years is three years too long for a venture investment to bear fruit. Or as one of my partners, Barr Dolan, says: “We’re a very patient firm, but 10 years and waiting is very, very patient.”

Biotech investing is far different than good old-fashioned technology investing. You can’t rush the science. You can’t simply ship product to market after declaring it finished. Food and Drug Administration (FDA) trials can take years. And what works in rats often doesn’t work in humans.

You need to understand this, as well as the changing economic nuances of the pharmaceutical industry, if you’re going to venture into early stage biotech deals. Sometimes they’re worth it and reap Genentech-sized returns. Other times the early stage risks are best left to those with deeper pockets and/or more domain expertise. Metabolex has offered clear lessons in all of this and more.

The Big Hit

Building a venture-backed company should take five to seven years. If you spend any more time on a deal, your internal rate of return (IRR) takes a hit. And limited partners don’t have that kind of patience. Yet, if you’re nave enough, or perhaps ambitious and optimistic enough, there are times when companies, markets and even diseases present such compelling opportunities you can’t turn them down. For Charter, diabetes was one of these special situations; regardless of whether we knew going in that it was to be at least a 10-year runway to success.

Type II diabetes, in particular, needs a drug that reduces blood glucose levels and lipids, has no negative side effects and doesn’t induce weight gain. We knew the market opportunity for such a drug would be huge. But we also knew, perhaps in an idealistic sense, that finding some kind of cure was fundamentally important. In other words, someone had to do it.

Diabetes is a market that’s literally dying for a cure. About 16 million Americans suffer from diabetes, with 800,000 new cases reported each year, according to the Centers for Disease Control (CDC). A disease that affects that many people is classified as an epidemic by the CDC.

More than $5 billion was spent on oral diabetes drugs worldwide in 2000, and over $12.5 billion will be spent in 2006, according to Lehman Bros.

Drugs On Trial

Metabolex, which was seed-funded on little more than an idea and a challenge, represented a startup engaged in discovering new compounds within the spectrum of this major disease. The larger and more expensive time-consuming commitment, however, was that Metabolex planned to develop its own drugs and finance them through the clinical trials process.

Early stage VCs should know going in if this is the type of commitment they’re truly willing to undertake. If the process of drug discovery in the past was traditionally the sole domain of big pharmaceutical companies, now the economics have changed and drug companies would rather operate as sales, marketing and distribution machines. That leaves the R&D pipeline increasingly to biotech startups.

That’s great news for venture firms willing to take science risk at an early stage and stick with their investments for years. But it’s more difficult for those VCs unwilling to commit to multiple rounds of funding, and multiple years of board meetings.

In a sense, 10 years has worked to the advantage of Metabolex. Several of the large pharmaceutical companies face fairly dry pipelines for new blockbuster drugs. With the big boys searching for the next Viagra to boost their stock prices, startups with drugs in clinical trials are well positioned either as acquisition targets or as beneficiaries of huge royalty contracts.

Phase II: $1B

Because it has its own potential blockbuster diabetes drug (called MBX-102) Metabolex stands to reap enormous royalties from a large pharmaceutical partner. If MBX-102 gets FDA approval it will enter Phase II trials in the fall it could generate more than $1 billion in revenue for within its first two years. Gross profit margins could reach 90 percent or more. Such are the potential rewards of biotech investing.

Numbers like these sound too good to be true, but they are entirely possible when you consider the recent performance of two other diabetes drugs (Actos, marketed by Lilly and Takeda, and Avandia, marketed by GlaxoSmithKline and Bristol-Myers Squibb) each sold in excess of $1 billion last year. Both have been on the market for about three years. We think the same thing can happen for Metabolex. And because its product development pipeline includes drugs aimed at increasing insulin sensitivity, enhancing insulin secretion and controlling glucose output, the company has the potential to produce several successions of significant revenue generating products.

Tom Glaze, CEO of Metabolex, describes the risk/reward scenario this way: “Because you can have a proprietary position with good margins, a patent position which is defensible and a competitive position against few specifically similar drugs, a product with therapeutic value makes it relatively easy to forecast a profitable revenue model.”

However, Metabolex still needs access to more capital to continue its growth. Like most drug discovery companies, even after 10 years, it hasn’t generated a single penny of revenue. And the IPO market isn’t giving biotechs without sales much of a break. Aderis Pharmaceuticals Inc., for example, recently failed to price its IPO. And drug stocks across the board have slumped along with the rest of the tech sector.

All of this has made us rethink an optimum biotech investment strategy. Clearly, Metabolex is not the first company to take 10 years or longer to hit its stride. But there are plenty of examples of companies in our portfolio that were successful in far less time, like Intermune. We funded the biotech company from inception, and it went public in 2000 after 18 months.

It’s a balancing act. VCs need to have unwavering optimism and possess amazing realism at the same time. And surely one of the only ways to make money in this business is to build companies and generate ideas in places where other people aren’t.

True Believer

You must be a contrarian. You must be a believer. But you also must be a realist. For us that means deciding whether we have a true competitive advantage in betting on the science early on or choosing to take less risk and invest in a company at a later stage. We’re now erring toward the latter.

As a rule, biotech companies take longer to build. The milestones are further away, as are step ups in valuation. There’s often no price blip until after Phase I trials are complete, and it is at that point where we now see the best opportunities to invest.

Not that we would take back our Metabolex investment. We believe in it fully. But as one of the most experienced biotech VCs in the business, Neil Ryan, founder and managing partner of Oxford Biosciences, says: “If every company you fund takes 10 years or more, you’ll never raise another fund again. The pension fund and endowment limited partners are pretty dispassionate. They’re not there to save the world, they’re there to show an ROI.”

At Charter, we’re out to do both.

Ravi Chiruvolu is a general partner of Charter Ventures, a venture firm based in Palo Alto, Calif. He specializes in enterprise software, software infrastructure, e-business and wireless. He sits on the boards of Ellie Mae, ManageStar, Talaris, Verano Winery Exchange andXavient Technologies.