Magazine Article | April 30, 2012

The Quest To Reinfuse Venture Capital Into Biotech Funding

Source: Life Science Leader

By Sara Gambrill, contributing editor

Longtime biotech industry observer Stelios Papadopoulos, Ph.D., remembers exactly where he was when Genentech had its initial public offering (IPO) in 1980 — defending his Ph.D. thesis in biophysics at New York University (NYU). Struck by the excitement among his fellow scientists about the event, he realized he had found his true calling. “Thirty years ago, scientists didn’t talk about the stock market,” Papadopoulos said. “As I was finishing my Ph.D., I was growing curious and interested in doing something other than conventional research. When Genentech hit its IPO, right then and there I knew this was an exciting opportunity and that I could play the role of go-between, interpreting science for businesspeople and business for scientists.”

He earned his MBA while working on the faculty of the Department of Cell Biology at NYU School of Medicine, then in 1985 joined Donaldson, Lufkin, and Jenrette as one of the biotech industry’s first analysts. Two years later he became an investment banker, first for PaineWebber, then Cowen and Co., from which he retired as vice chairman in 2006. Along the way, he also invested in and cofounded several biotech companies. He is still very active in the industry as an advisor, investor, and member of several boards. With a Wall St. career that spans nearly 30 years, Papadopoulos has just about seen it all when it comes to the world of biotech financing, and he shared many observations with me about the current investment climate, how it compares to that of decades ago, why it has changed, and why Big Pharma needs to take a brand-new approach to investing in early-stage biotech companies for the health of their pipelines, the industry, and, ultimately, patients.

Investment Climate Change For Biotech Puts Damper on Innovation
Privately owned biotechs have always largely depended on venture capital for their survival, so the change in the way VCs invest in them has had a significant effect on the development of innovative technologies and drug therapies. “In the 1980s and 1990s, venture capital was a business that tried to identify exciting science and great people, put them together, help them through funding, and help them grow to develop their own products,” Papadopoulos said. 

But, the investment climate for biotechs has changed dramatically in the past 10 years, in terms of the funds available and what types of companies get those funds. “By any historical comparison, the amount of money available for biotech companies in the past few years is meaningfully larger than the money in the 1980s and 1990s. However, the bulk of this money goes into very large, established companies that have products to sell,” Papadopoulos said. “The huge proportion of stock ownership is concentrated, by virtue of their market capitalization, among the top biotech companies — Amgen, Biogen Idec, etc. But, they were both startups once.”

Interest in newer companies is largely concentrated in the ones that have compounds in later stages of clinical development — Phases 2 or 3 — or are about to launch. “There is a lot less interest today and money flowing to companies that may be doing very exciting science but are still in the preclinical stage.”

Papadopoulos sees this investment climate change — this “bifurcation of funding,” as he puts it — as a fundamental problem for both biotech and pharmaceutical companies because biotechs need VC funds to develop their products, and pharmaceutical companies need products to sell.

Nonprofits, Government Step Into The Void

As the flow of venture capital into early-stage biotechs has ebbed, savvy nonprofit disease foundations, state governments, and the federal government have devised ways to support them.

Nonprofit disease foundation investment in biotechs is often referred to as “venture philanthropy.” The investments are relatively small, but, in addition to money, foundations can offer deep expertise in a particular disease, and some may be able to offer help with patient recruitment, protocol design, and other CRO-like services. Venture philanthropists can get a biotech’s compound over the “Valley of Death” — the preclinical stage of development that venture capitalists tend to avoid now — to the proof-of-concept stage, a point when VCs feel more comfortable investing, especially if companies have already been able to attract knowledgeable, well-respected foundation investors.

In addition, top-ranked states in terms of biotech, such as Massachusetts, California, and North Carolina, have financed initiatives to invest in biotechs in their respective states. And on a federal level, the NIH created a new institute in December 2011 — The National Center for Advancing Translational Sciences (NCATS), which could have a lot to offer biotechs. In fact, Papadopoulos served on the advisory group to the Director of NIH with regard to the formation of NCATS. The central role of NCATS will be to provide integrated, systematic approaches to link basic discovery research with therapeutic development and clinical care. In addition, NIH launched a program in October 2011 to benefit startups. (To read more about this program and about NCATS, see “NIH, Industry, and the Translational Science Revolution” in the December 2011 issue of Life Science Leader.)

Crossing The Divide
Despite the funds available from government and foundations, there are simply fewer financing options available to privately owned early-stage companies — even though they may be doing cutting-edge science. Papadopoulos maintains that there is “no clever solution” to private biotechs’ financing issues. He said, “I think the most important point is to manage to cross the divide from being a privately owned company to being a publicly traded one.”

Going public is not an option for all privately owned biotechs by any means. Papadopoulos cautions that becoming public has a hefty price tag attached. Compliance with Sarbanes-Oxley and other Securities and Exchange Commission-related requirements can cost a company a few million dollars per year. “For a company with about 100 employees that may spend $25 million per year in R&D, there needs to be an outlay of $3 or $4 million on regulatory compliance. That’s a lot of money. On the other hand, in a publicly traded company — even though you may suffer from neglect or be penalized by bad results that make the stock price low — there is a lot more flexibility in how you can raise money. There is a lot of customized financing being done for the smaller companies once they’re public,” Papadopoulos said.

There is not as much creative financing even for publicly traded companies as there once was, however. In the 1990s, Papadopoulos was known for his creativity in the area of financing biotechs. “I started my career in physics, which I believe is the ultimate science in terms of reason, logic, and analysis. I looked at the financial challenges of biotech companies as scientific problems, and I tried to come up with an appropriate solution, then cast it in financial terms and worked from there.” He invented a number of ways to finance them that had never been tried or even thought of previously. “In the early 1990s, as Wall St. leaders and company executives, we created and promoted a variety of ways to raise money for companies that turned out to be quite useful in helping create sustainable enterprises. We’re a lot less creative now. It’s not because we’re lazy or stupid, but it’s because the regulatory environment has made it that much more difficult.”

It is also difficult to be an above-average investor in the stock market. As someone who has viewed the biotech industry from several different vantage points — analyst, investment banker, investor/company cofounder — Papadopoulos knows that success relies on a very simple formula, which, paradoxically, is very difficult to execute. “When it comes to investing in public stocks, you need to have a point of view of the company that is different from the consensus and be convinced you are right and that within 6 to 12 months the consensus will come around to your point of view. You also need to understand why the market is making a mistake. That’s really the whole of investing. It’s that simple — in theory. In fact, it’s very hard. The reason is that, by and large, the market is efficient,” he said. “It takes a lot of experience, and that’s why most fund managers perform about average in the end.”

Big Pharma Needs New Approach To Biotech Investment For Future Survival
In the 1980s and 1990s, venture capitalists typically made their money from selling stock in companies after they went public. In the last few years, they have done some of that, but a very large proportion comes out of direct sales of private companies to pharmaceutical companies. “The venture capital business has redefined itself,” Papadopoulos said. “We have a lot of pharmaceutical companies that have reached a mature growth rate in terms of how much more they can sell every year. There isn’t a single Big Pharma that hasn’t bought a dozen or more biotech companies over the years.”

In fact, according to Biotechnology Industry Organization (BIO), the top 10 Big Pharma in terms of cash position have enough cash to buy more than 90% of all publicly traded, drug-focused R&D biotechs. There are 300 publicly traded U.S. biotechs, and nearly ¾ of them develop drugs.

“Nowadays, venture capitalists will either fund a specific project or two at a biotech with a skeleton crew on a virtual model basis, or they’ll start a company on the assumption that by the time it matures a few years later in terms of its technology, Pharma will want to own such a company. That’s a pretty difficult thing to guess,” Papadopoulos said. However, he has made such guesses and been proven right, so it is not impossible. “You have to have an understanding of how the pharmaceutical industry evolves and what its discovery challenges are. I’ve spent 30 years thinking day in and day out about how one goes about discovering drugs.”

Big Pharma needs to take a different approach to investing in biotech, according to Papadopoulos.  Up until this point, they have created joint ventures and strategic alliances and set up their own captive venture funds, but none of these types of investments gets to the heart of biotechs’ funding problems. Big Pharma’s current investment strategies may work for them in the short run, but Papadopoulos warns that without investment in the IPOs of preclinical-stage companies pursuing novel biological ideas, pipelines will run dry.

Papadopoulos and some of his colleagues have proposed a mechanism by which Big Pharma can invest in biotech in a meaningful way — one that could restore the balance in the funding life cycle. As biotechs’ innovations will comprise a significant percentage of Pharma’s drug therapies in the future, it is in Pharma’s best interest to help achieve this balance.

Papadopoulos and his colleagues envision a commitment of a few hundred million dollars from each pharma company for between five and seven years to fund management companies that would invest only in life sciences companies — either in IPOs or follow-on financings — no later than five years after IPO, excluding companies with valuations of more than $500 million. Papadopoulos believes a commitment by pharma companies of $1 billion per year in the aggregate for five to seven years would meet the financing needs of early-stage biotechs and that Pharma’s commitment would attract co-investment of public funds. 

Papadopoulos and his colleagues have proposed one such family of funds to help achieve these ambitious goals, though it remains to be seen whether this proposal will get any traction in the marketplace. He said, “I’m suggesting a way by which we can reintroduce into the life cycle of biotech funding an interest in investing in preclinical-stage companies with exciting science and take them public. If we do that, we’ll reinfuse innovation and creativity into the space.”