The key to biotech returns: Innovate with less

Biotech markets, like most others, are in turmoil. There hasn’t been a single biotech IPO this year, and the small cap indices have lost 50% of their value this year. Even the IPOs that did occur during the 2003-2006 “window” have underperformed: The median return for all biotech IPOs from offering until today is negative 62%, according to CapitalIQ. In short, the biotech public equity market is abysmal and has been for some time.

Against that backdrop it’s surprising that biotech venture financing remains relatively robust, with $4.4 billion in financings for the first half of 2008, according to the Moneytree Survey by PricewaterhouseCoopers and the National Venture Capital Association. While that number is lower than the $5 billion invested in biotech deals in the first half of 2007, it is ahead of the $3.8 billion invested in the first half of 2006. Furthermore, a lot of capital has been raised by VC funds in 2008, with nearly $7 billion committed to those meaningful life science allocations.

The robust flow of venture capital into biotech is due to a stellar M&A environment. While its pace may be slowing, M&A remains an attractive source of liquidity for VC-backed firms: More than 25 deals have been done with emerging biotechs in 2008 for an aggregate purchase price of over $6.5 billion, according to CapitalIQ.

In light of the closed IPO window, abundance of private capital and reliance on M&A, what’s the strategy for making good returns in early stage biotech? We certainly emphasize two rather simple drivers of returns in our strategy:

1. Reduce capital intensity. The bane of biotech returns is our burn rate. Exceptional returns appear to have a direct correlation to capital efficiency. An article published in Nature Biotechnology (“When Less is More,” August 2007) examined ~90 exits from 2005-2007. Of the 14 deals returning > 5x, an average of $26 million was raised. The 36 companies returning <2x raised an average of $86 million.

In short, spending more didn’t increase exit values. In the late 1990s, capital intensity really didn’t matter. Companies were valued on their promise and their “Hollywood” founders, and were rewarded with more money to fund the vision. Today’s markets are not equipped to do this, nor have they been for some time.

A recent analysis suggests that 60% of the attractive M&A exits since 2004 were for platforms around either new drug modalities or ‘hot’ biologic targets.

In this environment, startups must leverage their capital efficiency advantages vis-à-vis Big Pharma: Absence of legacy infrastructure and open access to a vendor ecosystem that enables leaner business models amenable to tighter milestone-driven financings. Capital efficiency is essentially about titrating in capital as risk is mitigated and early value inflections are achieved.

2. Increase the “innovation quotient.” The health care system will be increasingly focused on pricing for value, and only innovative breakthroughs will likely be rewarded. Me-too products, repurposed drugs or reformulated agents are unlikely to garner the interest of acquirers. A recent analysis suggests that 60% of the attractive M&A exits since 2004 were for platforms around either new drug modalities or “hot” biologic targets (see StartUp magazine, September 2008).

Enhancing the “innovation quotient” involves a back-to-the-basics approach of starting companies around more compelling (and risky) substrates: new pathways, composition-of-matter generating platforms or unique convergence technologies. Early on these project-like deals should be structured to “prove” the hypotheses with limited capital, and once they are incrementally “de-risked,” they can be built and scaled as appropriate.

Driving returns in biotech is challenging but not impossible: Capital efficient models coupled with true innovations are likely to be hallmarks of outperformance going forward.

Bruce Booth is a Principal at Atlas Venture and invests in early stage biotech companies. He may be reached at bbooth@atlasventure.com.