New life for biotech

There are a host of UK biotech companies thriving today precisely because they steered clear of the venture model.

by . .

William Bains

William Bains

Two contrasting items landed on my desk in February. The February issue of Real Deals headlined the “Death of biotech” as an investment asset class. European IPOs are dead, VC investment is at a decadal low, and the current crop of companies will need an unachievable €3.5bn more capital to achieve their goals. By contrast, January’s Genetic Engineering News (GEN), a US-published trade magazine, had a review of biotech’s triumphant emergence as a growing, successful, profitable industry ripe for investors. The number of public US companies with less than a year’s cash has halved in the last two years. There were three biotech IPOs in 2009 and ten in the first half of 2010. Total net income of public companies was $3.67bn (€2.65bn). How can two magazines look at the same industry and get such contrasting views?

It is certainly true that there is more money in the US, at all stages. The generosity of the UK capital markets is legendary (literally – anyone who has tried to raise money in the US will know that money flows there as readily as the fountains in Atlantis). But throughout the funding cycle the US does it bigger. The US’s SBIR grant programme provides $2bn annually in grants for new technology development, and one-third of those in biotech were over $1m – the UK equivalent, SBRI, is funded to £20m (€23.1m) spread among dozens of programmes and hundreds of companies. UK R&D tax credits, providing tax relief or cash payback for research, cost the Treasury £700m in 2009, most of which went to large companies. The US’s recent QTDP project provided almost identical types of support, but to the tune of $1bn per annum for biotech SMEs alone, averaging $9m support per company. At all stages of private company development, US VCs invest between two and five times as much per round as EU VCs investing in comparable companies.

But history has taught us that pouring money into a hole labelled biotech is not the path to success. There is another factor, and that is investor expectations, attitudes and business model. In short, GEN is talking about biotech as a business. Real Deals is talking about it as an investment asset. Only in the US are these two perspectives even approximately aligned.

US biotech companies are funded on the assumption that they could grow to successful, global, profitable businesses. In the UK, many VC investors limit bio-start-ups’ growth on an assumption that they are likely to fail, a self-fulfilling prophecy. Their concern is not to create successful businesses. As several articles in Real Deals have commented, VC is driven by a business model that is not well aligned with their LPs. The rational VC, looking at the dismal returns from early stage tech investing (between 0 per cent and a 10 per cent loss, depending on the survey), will look for revenue from management fees, directors fees, consulting and advice services, and recharging of investment costs, and not from carried interest on the funds they manage. The more funds under management, the greater this revenue stream is.

So the rational biotech VC wants to raise as large a fund as quickly as they can after the last fund closing, and hence will look to investee companies to support those fundraising efforts. Exits sell funds, and for an LBO turnaround, profitable exit can be shown to future LPs in 12 to 24 months. For an early-stage investment in biotech, exits are typically seven years after series A investment, if the markets are there and willing. This is no use to the managing partner, who wants to raise a fund two to three years after the last close, so investee companies need to be engineered to look good even though they are not yet good in reality.

This results in a wide range of behaviours that are bad for investee companies as businesses (and as investment propositions), including driving them to unsustainable business models, blocking good business decisions, blocked or unproductive M&A, unnecessarily increased overheads, and appointing salary-driven management in place of the equity-motivated entrepreneurs. The business model of VC-funded drug discovery was recognised as being unworkable in 1985, but “Look at the sales of Lipitor! $13bn per year!” looks great in the prospectus providing “... but we can never get there” does not happen until after the new fund has closed.