Early-Stage Investing Hindered By Market Conditions –

Somebody call a doctor! Early-stage life sciences investing is in the sick ward, and its prognosis is bad.

Biotechnology, drug discovery and development and medical technology deals have all taken a hit in the last 12 months. Investors are digging in, pruning their portfolios, weeding out the losers and investing heavily in internal follow-on rounds. Valuations in the sector, too, have fallen. If an investor can get into a later-stage company at an early-stage price, then he’s less likely to take on the risk of a development-stage company. That helps to explain why early-stage investing has fallen out of favor.

In 2002, venture capitalists poured $1.2 billion into 192 seed and early-stage companies in the health care and life sciences sector, according to the PWC/Thomson VE/NVCA Money Tree Survey. Those include deals for biotechnology companies, medical diagnostics, therapeutics, products and services, as well as pharmaceutical startups. When considering that $5 billion went to life sciences, the early-stage portion represents a little more than one-fifth of all investments in the sector, and preliminary results for Q1 show that trend continuing.

But it’s not surprising, nor is its fate unlike that of other sectors right now. VCs say the drop in early-stage deals has nothing to do with a lack of innovation or a slowdown in research. Rather, it’s a question of economics. “Right now we’re in survival mode: pruning the portfolio aggressively, looking to fund companies to specific milestones and to hold burn rates down,” says Stan Fleming, a managing member with Forward Ventures in San Diego.

It’s The Economics, Stupid

With drug discovery companies, for example, Series A rounds are used to fund basic research that might not pan out, so they’re high-risk propositions. Conversely, a second or third round, when some of risk of drug discovery already has been eliminated, is a lot less risky. Since valuations in the life sciences sector have dropped so low, investors can get into later rounds at the same price they paid to get into earlier rounds just two years ago.

“Investors are getting into Series B and Series C rounds because the pricing is so attractive and the opportunity is so compelling,” Fleming says. “No one is willing to put in the blood, sweat and tears it takes to start a new company that’s not likely to get a step-up from it’s A round.”

Consider Forward’s investment in Worcester, Mass.-based Hypnion, a company developing drugs to treat sleep disorders. In March the company closed a $47.5 million Series B round of financing co-led by Forward and MPM Capital. Eighteen months passed between Forward’s initial meeting with the company and the firm’s decision to invest. Back in September 2001, when Hypnion’s management team first met with Forward Ventures, the company was still focused on drug discovery, a business proposition that Fleming calls “un-fundable.”

“In biopharmaceuticals, the market’s attention span is getting shorter as cash reserves get smaller and smaller,” he says. No investment can guarantee a return, he says, but an investor can factor risk out of the equation once a drug discovery company finds its targets and evolves into a product development [company]. Two years of research followed the company’s September 2000 $10 million Series A round of funding. Not only did the company identify a handful of compounds to treat sleep disorders in that time, but its valuation dropped at the same time, like many drug discovery companies. The company was forced into a down round and its second round investors got a later-stage company at a price they would have paid for a higher-risk company at the discovery phase. Hypnion is expected to begin the first phase of clinical trials by June.

One Bright Spot

The good news is, there’s still enough convergence of information technology and life sciences to drive some early-stage investment. To Jim Blair, a general partner with Domain Associates in Princeton, N.J., merging the two fields is the only way to make sense of things like the Human Genome Project.

“Genomics science requires the ability to rapidly access things,” he says. “A researcher might needs to attain genomics samples through screens to check for specific polymorphisms. Getting those samples out to people to do those screens has always been difficult.”

Blair is an investor in GenVault, a Carlsbad, Calif. company that has built a system to store, retrieve and ship DNA samples in a paper-based support structure at room temperature. It’s designed to reduce costs and streamline DNA storage for the agricultural, forensics and pharmaceutical researchers who sometimes require millions of samples to compete their work. “Storing and retrieving DNA is a crude process that can be easily automated,” he says. GenVault closed a $10 million A round led by Domain Associates in March.

Investors, however, haven’t kept the IT hidden behind the Bunsen burner. Health care services, especially, are benefiting from the convergence of electronics and life sciences.

One Santa Barbara-based company, InTouch Health, is using robots to interact with patients living with Alzheimer’s disease in care facilities. The Companion, as the robot is called, sits on a triangular base. There’s a 15-inch LCD screen atop a slender body that projects the face of a health care provider, moves up and down and rotates to communicate with the patient. Equipped with a video camera and full audio capabilities, the caregiver can talk to the patient through the robot, listen to his concerns and respond. It’s controlled remotely and receives direction through a wireless network. In March, Santa Barbara-based Twenty One East Victoria Investments led the company’s $2.4 million Series A round of venture financing.

“There’s not enough skilled human capital to treat all the patients that need care,’ says Robert Skinner, a managing partner at Twenty One East Victoria. ” We need to leverage that skilled base to provide care to an ever increasing needs base. This is a logical play to bridge that dynamic.”

In San Diego, IntelliDot Corp. has created technology to prevent mistakes while distributing medication to patients. The system scans bar codes on patients’ wristbands and on their bottles of medication, prior to administering a dose, to check the accuracy and safety of a dosage.

It’s a four-part system: A handheld device, the size of a pack of gum, reads a small graphic printed on the label of a patient’s medication. The reader verifies the information by relaying it wirelessly to the system’s base stations, communications hubs located throughout the patient care facility. The base stations link up to a server that stores all the patient care information. The system is designed for nurses. At the patient’s bedside, the nurse presses a button and a digital camera inside the device scans the medication’s label. An audio-visual interface immediately lets the nurse know if the medication is correct, or if there’s additional data or documentation needed before administering the dose.

IntelliDot closed a $2.25 million Series A round in March, receiving commitments from American River Ventures and Shoreline Ventures.

Despite those stories of funded, early-stage innovations, new startups still face an uphill battle. In many ways they’re victims of market conditions.

VCs are still nursing the wounds of their troubled portfolios, and they cannot commit capital to new companies until their portfolios are out of the sick ward. With few liquidity options, investors are counting on the fact that they’ll have to carry a company to profitability and must also price that uncertainty into their portfolios. In the first quarter of 2003 only one venture-backed company, a home mortgage lender, priced an initial public offering, while three health care services and three medical device companies were sold during the fourth quarter of 2002, according to NVCA/VE. Until investors have exit options, they are unlikely to saddle themselves with more investments, no matter how attractive the technology.