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Today’s biopharma venture capital challenge: Risk-sharing models versus risk avoidance
June 2008
by Donald J. Elmer  |  Email the author
SHARING OPTIONS:

Safety, simplicity and liquidity are the watchwords driving biopharma product development decisions in today's unsettled capital markets. Falling by the wayside are long-term investments for novel product candidates based on new drug mechanisms and early-stage technology platforms. Today's capital markets are unwilling to invest in opportunities that are not clearly defined and unable to achieve simple and fast returns on their investments.

However, we realize rewards are begotten by accepting risks. In times like these, when the pendulum of fear swings to risk avoidance, biopharma can only develop products that meet both customer needs and Wall Street expectations through innovative, novel product development based on a reconsidered approach to risk management.  

Exodus from biotech investing and shift to "me too" products
Over the past 15 years, large numbers of Wall Street capital market intermediaries (e.g. venture capital firms and investment banks) have lost faith in the promise of biopharma and defected to alternative investment sectors where the prospects are brighter. Wall Street defectors acknowledge the need for future products and believe in today's technologies, but they've lost confidence in biopharma's ability to convert promise into reality and deliver economic rewards to their Main Street customers who supply the capital. Too much political capital has been squandered touting the past promises of biopharma that went undelivered. The debris field from this financial wreckage is clearly visible today by scanning the rosters of private companies orphaned by fractured venture financing syndicates and undercapitalized public companies that languish in microcap purgatory. 

This shift means many fewer pure early-stage start-ups to develop promising, but high-risk science, and a proliferation of late-stage products based on variations on proven drug mechanisms and line extensions using different delivery mechanisms. The effect of the reallocation of risk capital is obvious: fewer novel drug mechanisms in the works and more products are derived from proven existing mechanisms. 

Biopharma's demonstrated inability to create sustainable product pipelines through internal development is the cause for today's excess demand for new product assets to replace aging franchises facing near-term patent expiry. The immediacy of the problem compounds the emphasis on near-term opportunities at the expense of longer-term development of next generation products based on novel mechanisms of action. Responding to the shift in priorities, venture capital firms exacerbate the short-term emphasis through late-stage investment strategies.

The process of realignment: A new model of risk versus reward
To realign this current state of affairs means a change in culture that is cognizant of a more volatile business environment characterized by unpredictable events. In this changed culture, "safety" must expand beyond adverse events in a narrow clinical context to include a broad array of improbable events. For example, how might an unanticipated and unlikely success from an obscure, but novel, drug mechanism cause reconsideration of an established standard of care and market disruption?

Some venture capital firms embrace a new development model that, while acknowledging the biopharma economic realities, believes a better result occurs from a combination of high capital efficiency and intense management applied to a smaller number of single-shot development programs based on novel mechanisms of action. This view is conditioned by a belief that biopharma product values will deflate as current political and regulatory trends unfold. As a consequence, biopharma product development models must factor for long-term real declines in the mean market values for biopharma technology, if the industry is to attract the capital required for new mechanism and products.

Confidence in the ability to achieve high capital efficiency is a prerequisite condition to accept early-stage development risk and the principal factor leading to this is intensive venture management. Intensive management means fund-level general management of a small set of development-stage companies. The individual organizations for the portfolio companies are typically limited to core cadres of experienced scientists and clinical experts. Specific development skills (e.g. regulatory, toxicology and certain clinical trial functions) are obtained on a virtual basis as required. By contracting out a majority of the departmental functions, this model allows development-stage companies to tap into experienced, efficient organizations and vast resources without having to expand the employee base or acquire resources that need to be micromanaged and increase overall capital expenditures.

This business model permits capital-efficient development of early-stage technologies with the potential to become new drug mechanisms directed toward poorly served biopharmaceutical market niches. By their nature, the opportunities selected are unvalidated despite substantial scientific foundations. In a word: they are way too early to provoke serious consideration from biopharma or traditional bioventure investors.

Two companies—Koronis Pharmaceuticals and Illumigen Biosciences—exemplify highly capital efficient development of novel mechanisms. Both mechanisms have the potential to cause reconsideration of the prevailing therapeutic paradigms and give rise to novel antiviral products for poorly served indications. If successful, potentially large rewards justify the inherent development risks associated with new mechanisms.

Founded in 1998 to develop Viral Decay Acceleration, Koronis spent approximately $22 million to reach the initiation of Phase 2a trials in mid-2007. Those trials in treatment-experienced HIV patients are ongoing today.

Illumigen was financed in 2000 to develop tools to identify beneficial genetic mutations. Approximately $14 million was spent to identify a beneficial genetic mutation leading to immune system clearance of the hepatitis C virus, optimizing the associated variant protein and conducting preclinical development leading to an IND filing. Illumigen was acquired by Cubist in December 2007 in a deal valued at $270 million (upfront and milestones).

Realigning conventional wisdom
The long-term interests of Main Street, Wall Street and biopharma will be well served by re-examining some conventional wisdom associated with biopharmaceutical development. For example, consider the following …

Safety in Numbers.
A misuse of portfolio theory often informs a belief that a large development portfolio is less risky than a small one. Many biopharma product development risks (i.e. scientific, technical, and regulatory) are independent events unaffected by the number of chances taken. Unless it is possible to reduce the individual odds of failure in successive efforts, or construct a portfolio that consists of a set of inversely correlated outcomes, nothing is gained by embarking on a multi-program development course. Conventional wisdom admonishing, "kill early and kill inexpensively", offers false comfort unless the odds of success in later outcomes are improved by the presentation of failure in early outcomes. 

Bias in Decision Making. Conventional clinical trial design typically selects very high statistical confidence levels—typically 95 percent—before concluding that a biopharmaceutical product is either safe or effective. At the same time, lower confidence—80 percent—is often demanded when the opposite conclusion pertains: that a program is unsafe or ineffective. The selection of a lower confidence level increases the risk that a safe and effective program is wrongly terminated. Such an error results in a needless write-off along with the possibility of substantial lost opportunity.  This 80 percent hurdle for continued development is one that is pervasive throughout all avenues of biotech development and finance, from investment and clinical evaluation through the Federal Drug Administration.

Betting on Failure.
"We like the program but we need to see more data. We'll happily pay-up when it is proven," is the valedictory conclusion to many business development discussions. Unless the buyer can make the statement with high confidence in an imperfect market without loss of opportunities, this conclusion is also either a wager on the failure of the product or a bet that a subsequent auction-market acquisition will be unnecessary. If proven wrong, the loss of a risk-weighted acquisition for a strategic opportunity may be consequential.

By expanding the definition of "safety" biopharma can revisit long-term product development agenda and challenge the conventional thinking that defines the prevailing culture of risk avoidance. By successfully doing this, the disenfranchisement between Main Street and Wall Street with biopharma will begin to change and enable the realization of the rich potential the industry holds for modern society.

Donald J. Elmer is managing general partner of Pacific Horizon Ventures, a Seattle-based venture capital firm focused on the life science and health care industries.

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