What you need to know before putting money in biotech companies

From time to time, unicorns show up in Harry Potter, the Brothers Grimm and even biotechnology. In the world inhabited by Jerel Davis, a Vancouver-based partner at venture capital firm Versant Ventures, unicorns are his name for biotech companies with billion-dollar potential, low failure rates and high returns. And over the years, he’s found a few startups that are poised to be just as magical to investors’ pockets.

“In life sciences, you can get those 10 or 20 [times the investment] return deals,” says Davis. He adds some biotechnology firms have loss ratios around 25 percent, while “in software, that profile is quite a bit different. The loss ratios tend to be far north of 25 to 30 percent.” That’s in part because the barriers to entry are so low for things like app development. Two guys in a garage really can make a product.

But biotech startups need a lot of seed money. And since they take a while to become profitable, venture capital firms and angel investors often shy away.

“We have to go through a design control process,” says James Fraser, CEO of ChipCare, a University of Toronto spinoff company developing a handheld device that diagnoses HIV. To fund risk identification, mitigation analysis and eventually planning a new product, inventors need a lot of money “before anyone touches your device; before there’s any indication that there’s market demand… You have to invest a lot of money into a biotech company before you’ll get any market validation.”

Davis adds biotech timelines are another strike against the industry for investors. “We don’t like holding periods that are extremely long,” he says, “even if they give good returns, because it doesn’t help anyone get liquidity. On an annual return basis, it’s not as powerful.”

Which is why so many companies have trouble finding funds for product development. “The problem is the upside is potentially huge, but the odds are against you,” says Jeffrey Coull, president and CEO of Encycle Therapeutics. “With a drug, you can put $800 million in and then you may get a bad result, and then you have nothing. So that risk is hard for investors to deal with.”

Toronto-based Encycle Therapeutics is developing a peptide drug called nacellin, which can target conditions like inflammatory bowel disease and fibrosis better than current offerings.

“We like to call this the Goldilockstype of drug,” says Coull. Unlike other classes of drugs, peptides are both small enough to bind with proteins in the human body and large enough to cross membranes and access diseaseaffected cells.

Although nacellin is just right in size to do the job medically, Coull has had a difficult time fundraising during the research process, since all drugs are more likely to fail than succeed. “The problem is, yes, the upside is potentially huge, but the odds are against you.”

Jerel Davis calls this chance of failure technological risk. “It’s whether you can make the product that does what you think, and if you [do], does it actually work.”

Technology risk’s the first of three risks that Joel Liederman analyzes before investing.

“I look at investing as a threelegged milking stool,” says Liederman, vice-president of physical sciences at startup investor and incubator MaRS Innovation. “You want to make sure that you address technology risk, market risk and execution risk. If you’re on a milking stool, milking a cow, and one of the legs of the stool is weak and breaks, you know what you fall into.”

Obey the laws of physics

First up, investors need to consider product feasibility: “You want to make sure the particular invention… doesn’t try to defy the laws of physics.”

Fair enough, but all inventions contain some element of technological risk. “It’s the risk that your product development will fail and you’ll never be able to graduate from an investigational drug to a marketed drug,” says Coull. “That risk is massive.”

To mitigate it, Liederman suggests companies hold off on product development until strong research has pointed to a clear plan. “You use research to solve the problems that come out in development. The second thing you do in the R&D process is you make sure you have a good plan and you don’t wing it. [In the second phase] you want to emphasize the D and not the R.”

Using established technology or picking up where others’ research leaves off is an easy way to cut down on the R.

“Everything [ChipCare is] doing has been done before,” says James Fraser, whose blood diagnostic device aims to determine whether patients, primarily in Africa, respond to HIV medication and if so, whether they’re still contagious. The handheld machine, which costs less than $5,000 to produce, performs the same work as $40,000 flow cytometers used in labs throughout the developed world. “But if you look at the component parts, we’re looking at lasers and optics, which have been done before.”

Similarly, Coull of Encycle Therapeutics turned nacellin’s sights on inflammatory bowel disease because the interaction of molecules had already been studied. “There were already studies about how exactly you would have to design this nacellin in order to effectively modulate that protein,” he says. “We selected that intentionally because it did do that de-risking for us.”

Using established technology also reduces regulatory risk, a top concern for many investors.

“[For] everyone we’ve gone to in terms of investment, that’s a major question they have,” says Fraser. “What is your regulatory plan? Is what you’re telling me going to work, and acceptable to authorities who will give you a license?”

Since ChipCare tests for HIV, a major threat to public health globally, Fraser has it a little easier on the regulatory front.

“There’s been billions of dollars invested, so as a result, they’ve built a regulatory framework to help guide us,” he says. “So when somebody asks me what my regulatory plan is, I can answer with a lot of confidence and with a lot of understanding. If you’re looking at a novel new diagnostic approach, a lot of this doesn’t exist.”

If regulators won’t approve a drug into which lots of time and money has already been sunk, Davis suggests using the medication to target a different disease. “…A number of years ago,” he says, “diabetes [drugs] became very hard to approve because regulators were requiring larger and larger studies for safety.” So the drugs’ developers found other diseases for which the drugs could also provide effective treatment. Doing this let them “avoid this very costly diabetes path.”

Suturing bloody neck wounds

Once a biotech company’s offering has proven to be technologically sound, investors should assess whether the product will sell. “You need to be addressing a very large and growing market need,” says MaRS Innovation’s Liederman. “We like to invest in things that address a bleeding neck wound. A ‘nice to have’ is not so interesting.”

Jerel Davis also assesses sales, competition and an exit strategy (how the startup will eventually sell out) as part of commercial risk, and suggests extensive market research to boost sales. To improve their chances of beating the competition, companies can invest in intellectual property protection.

“We have patented our chemistry,” says Coull about the IBD drug nacellin. “[So while I still] wouldn’t say that we have no worries about [intellectual property] or competitive threats, that’s certainly reduced because we have that protection around the method instead of the molecule itself, so that makes it very difficult for copycats.”

Furthermore, unlike many of its competitors, nacellin will be delivered orally, not intravenously. “And that’s the major value proposition,” says Coull, since patients can “take it like a regular drug, opposed to sitting in a clinic and having it dripped into their veins.”

The edge for Fraser’s ChipCare lies simply in what it does. As a tool for HIV patients in the developing world, it’s got a high feel-good quotient.

“You feel at risk that you’re investing in a startup company, but if it does social good, then for some people they have that in their agenda in giving back; it induces them to accept a little more risk,” says Liederman—MaRS Innovation was one of the early investors in ChipCare.

Liederman adds a product is nothing without the people. “…If the people running the company don’t know to execute—can’t manage the business, can’t get something done, can’t raise the follow-up financing you need— you’re going to fail.”

As an investor in ChipCare, MaRS believed in the technology as well as the market need. “We had some good inventors, but what we needed was some seasoned management,” says Liederman. “That’s why to mitigate that particular risk we went out and hired James Fraser.”

To make sure a team’s performance remains up to snuff, he suggests dividing funding into investment tranches and only releasing each portion after the company meets certain milestones.

“You wouldn’t want to put in $30 million… and then some technical risk pops up three weeks later that halts the entire project,” says Davis. “So it makes a lot of sense to tranche the investment. You may infuse funding at those milestones… to make sure the company is going according to plan.”

As a ChipCare investor, MaRS “said, in order to trigger the second tranche they needed to bring in solid business management to the company,” says Liederman.

But to get MaRS, Versant Ventures or any other investor interested, a biotech company needs to show “specific results that will convince them that some of the risk has been taken out of the equation,” says Coull. “You need to reach a certain level of technology maturation before you’re really able to pull in those venture dollars.”

Coull notes, “if you’re developing a mobile app, $30,000 can get you to market.” But to bring forward a drug like nacellin, “I need $15 million just to get me started in clinical development.

“But to raise $15 million, you need to spend $5 million. That’s what makes it very difficult; you have to spend all this money and produce all these data before you can attract financing that will get you anywhere in development.”

Davis argues investing in a company’s early stafes may be worth the risk. “Of course, the earlier the stage, the more technical risk there is. Those deals tend to be the ones where there is some risk, but also some really big return potential.”

Copyright 2015 Rogers Publishing Ltd. This article first appeared in the May 2015 edition of Corporate Risk Canada magazine

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