By Cindy Dubin
In today’s economy, capital is much more difficult to raise, and the various sources of investment, from private angels to larger VC firms, are understandably much more cautious and conservative about where they place their money. “The economic recession made its impact on life sciences investments, as there have been negative returns on investments for the last 12 years. Venture funds have been pared back, and until there is a change in the economy, the funding will not be there,” says Tracy Lefteroff, global managing partner of the VC practice at PricewaterhouseCoopers (PwC) U.S.
This somewhat bleak picture is drawn out vividly in Dollar Drought, a new MoneyTree report from PwC and the National Venture Capital Association (NVCA), which addresses VC funding in the life sciences sector. The study, based on data from Thomson Reuters, found that the life sciences share of total venture funding fell to 20% during the second quarter of 2012, the lowest level since the third quarter of 2002. Funding for life sciences, which includes pharmaceutical and biotechnology, dropped during the second quarter of 2011 as compared to the same quarter in 2012 (pharmaceutical fell 13% to $89 million in funding and biotech research fell 96% to $3 million).
Early-stage deal volume declined by 16% in the second quarter of 2012 compared to the same quarter last year, and the average deal size shrank to $6.1 million. This drop in early-stage funding could have implications for the life sciences sector well into the future, as there will be less capital available to support start-ups, says Lefteroff. Late-stage funding also declined, dropping 41% year over year to $798 million.
“Overall, the sector has not delivered returns,” says Doug Cole, M.D., general partner, Flagship Ventures, a VC whose portfolio consists primarily of seed and early-stage investments, with some later-stage value investments; healthcare investments; target therapeutics; and medical technologies. “The longer-time horizons, higher regulatory barriers, pressure from payers, and uncertainties around government healthcare policy have all combined to increase the potential capital needs for start-up life sciences companies. At the same time, public markets have become more difficult to access, and the cost of going public and being public has increased. Many funds are focusing primarily on supporting and building companies that are already in their portfolios. In recent years, the apparent success of some social media companies has diverted some venture investors’ attention from life sciences investments, as well.”
Obstacles To Funding
The PwC report states that it will continue to be a challenge for life sciences to raise funds until the regulatory environment becomes transparent for firms trying to move new products into the market. Lefteroff says that the time frame to get through the FDA has significantly lengthened in the last five years. “There really is nothing that a company can do about the regulatory pathway except maybe lobby to streamline the process,” he says.
“The FDA has gotten in the way for sure,” says Adair Newhall, an associate with Doman Associates, a VC firm with an exclusive focus on life sciences. “Companies have to demonstrate quality and efficacy of their data, and many are told to go back and conduct their Phase 3 trials again, which can be too costly. As a VC, we are looking to back companies whose models are not too lengthy and not too costly.”
James Smith, Ph.D., president, NanoSmart Pharmaceuticals, Inc., which is developing next-generation drugs to treat cancer, understands the FDA regulatory approval process all too well. NanoSmart is developing an immunoliposomal drug delivery system capable of targeting a wide variety of solid tumors. By reformulating drugs that are already approved for marketing, Smith believes his company can commercialize these products both rapidly and economically. Due to the lower patient population for rare diseases, the FDA may also allow commercialization of the new drug product following successful Phase 2 clinical studies (typically larger Phase 3 clinical studies are required prior to market approval). In addition, subsequent NDAs (new drug applications) will have a reduced regulatory burden, since much of the analytical and nonclinical safety data for the drug delivery platform will already be available.
“Our regulatory strategy is specifically designed to take advantage of well-established regulatory incentives for commercializing orphan drugs,” Smith adds. The FDA offers several key incentives to companies that endeavor to develop drugs intended to treat rare diseases (these drugs are termed “orphan drugs”). These incentives include tax credits to help offset the cost of development, FDA fee waivers, an Orphan Drug Grant program to support clinical studies, and seven years of market exclusivity.
NanoSmart’s proprietary platform technology utilizes a unique antibody that is capable of targeting a variety of tumor types. When attached to a liposome or other nanoparticle, it can improve accumulation of the drug product at the site of a wide variety of cancer tumors. The antibody is human-derived and targets nuclear material found in areas of necrosis associated with all solid tumors. This allows the antibody to target tumors without having to target disease-specific markers. “Our technology was developed with the intent of mitigating the typical challenges associated with drug development (e.g. our use of a human-derived antibody vs. an animal monoclonal antibody, our selection of already-approved cancer drugs, and the use of well-known excipient materials in our final drug formulations are designed to mitigate regulatory risks and burden),” Smith explains. “We believe investors today will appreciate and support those companies that have the ability and willingness to reduce the risks inherent with any start-up operation.”
Clinical trials for orphan drug products typically require fewer patients and are generally significantly shorter than nonorphan drug products. This translates into more rapid market approval of the orphan drug product. Smith says that by adopting this faster-to-market strategy for NanoSmart’s initial pipeline products, the company ultimately increases the inherent value of its drug delivery platform, substantially reduces the risk of the investment (by demonstrating an ability to commercialize), substantially reduces the overall cost of commercialization (and therefore investment needed, which in turn leads to lower investor dilution), and creates the revenue-generating opportunities from product sales and additional product collaborative opportunities with other products in the pipeline. “All of this should lead to substantial increases in the value of the investment and provide for exit strategies or investment liquidity that is also attractive for today’s investors,” he says.
The recently passed user-fee legislation (i.e. Prescription Drug User Fee Act) contains some incentives for companies to develop breakthrough therapies for infectious and rare diseases. These include extended market exclusivity for qualified infectious disease products and expedited FDA review for therapies that address unmet medical needs to treat rare and life-threatening diseases and conditions. Such incentives could pique the interest of investors in companies developing these products, as they might have a shorter path to market, says Lefteroff.
Mergers and acquisitions also affected VC funding. Life sciences companies closed 15 venture-backed M&A deals during the first quarter of 2012; 7 of them had an aggregate value of $1.7 billion. “The pace of venture-backed exits we saw for life sciences companies during 2011 should encourage investors going forward,” says Lefteroff. If M&A activity picks up during the second half of this year, investors could see a clearer path to returns, which could potentially attract more money to be invested in the sector, states the report.
“M&A is often the outcome of choice for venture-backed companies,” says Cole. “We view this as a great opportunity for win-win scenarios. Larger companies can get access to start-ups’ creativity and novel assets, and the start-ups and their investors can realize attractive returns. A healthy M&A market is critical to all the stakeholders and the health of the industry.”
The new Jobs Act might spur more confidential IPO filings, creating the opportunity for more exits, states the PwC report. The act makes it easier for start-ups with less than $1 billion in annual revenue to go public by relaxing Sarbanes-Oxley requirements for five years.
How To Fundraise
The concentration of VC dollars in the hands of fewer firms will dictate the flow of investment, which translates into less capital available for life sciences, according to NVCA President Mark Heesen. But, the VC pros do offer some insight into how to raise some funds.
“Discipline is critical in any investment environment, but especially now,” says Cole. “We look for investments that combine indisputably leading people, ideas with real potential for disruptive impact on significant markets, strong scientific validation, tractable development paths, clear regulatory expectations, and receptivity among researchers and companies. This convergence only happens occasionally.”
Assembling the best team possible is also an essential prerequisite for success. “Additionally, have a clear value proposition, and be able to articulate it incisively,” continues Cole. “It is necessary to adapt quickly to changing circumstances and new data. Capital efficiency is essential to building value that also has the potential to provide meaningful returns to investors.”
Like many innovator companies, NanoSmart Pharmaceuticals started with an innovative idea and a compelling story that it believed would be viable and important to the industry. Its key drug delivery platform technology patent was issued in 2009 internationally and in 2010 in the U.S., providing the room to innovate with secure IP and a good demonstration of its ability to execute on established goals. Since last January, NanoSmart has raised approximately $1.5 million in private investment.
“We have focused our approach to fundraising around the idea of selling progress, not promises,” says Smith. “Anyone can share a vision of how great things would be if they just had enough of someone else’s money. We felt that, by demonstrating that NanoSmart is a place where efficient progress is continually made on an aggressive development strategy, investors would view us as an investment opportunity where the risks have been mitigated.”
In that respect, NanoSmart developed a rapid and economical plan for development of its lead pipeline products and established a solid management team with expertise and track records in drug development, product commercialization, regulatory strategy, and business development. “We believe that building and maintaining investor confidence is critical to ensure continued funding. In that respect, NanoSmart operates as transparently as practical and openly communicates with its investors to ensure that they can see our successes as well as how we deal with the inevitable challenges that all development-stage companies face. If measures of success include current investors investing more and friends-telling-friends about a good opportunity, then we feel that our approach to fundraising is working very well.”
The Silver Lining
“Although conditions certainly ebb and flow over time, it is likely that the paradigm in which start-up life sciences companies raised a few tens of millions of dollars, established a platform with one or two early stage programs and a corporate deal, and then went public is unlikely to reemerge. We expect funding will continue to be difficult,” says Cole.
That being said, there is a silver lining. Advances in biology, ongoing unmet needs, development of new markets abroad, and increasingly well-educated consumers all create opportunities. The market will continue to recognize and pay for real value. “That is where venture investment should focus,” adds Cole.