How Hard Is It To Be A Biotech Venture Capitalist?
8 mins read

How Hard Is It To Be A Biotech Venture Capitalist?

A major step in the development of a biotech startup: an initial public offering takes a biotech … [+] company from the private to the public market, a profound change for management and investors. THE AGE BUSINESS Picture by WAYNE TAYLOR. (Photo by Fairfax Media via Getty Images/Fairfax Media via Getty Images via Getty Images)

Fairfax Media via Getty Images

Very hard. Many people, including most venture capitalists, believe that success in biopharma venture capital—both for individuals and firms—depends on the ability to make successful investments. They are wrong.

Well, not entirely wrong. Good investments are necessary but not sufficient.

There is much more to surviving in the venture world than writing checks. Venture capital involves all the considerable challenges of drug development (returns to drug development have averaged less than 5% for the last 5 years), plus financial risk—the likelihood of getting paid. A venture manager can be a first-rate judge of technology and management teams, but he is not likely to be successful if he doesn’t understand how to manage risk in financial markets.

The Complicated Bio-Venture Landscape

Firms raise money for their funds in the institutional market where the professional money managers of pension funds, insurance companies, family offices, endowments and the like invest their capital. Once a fund is raised, each member of the team invests that money in startup companies formed to acquire technology in the academic research market, which involves negotiating with tech transfer offices at major universities.

A venture manager finances the development of his portfolio companies by attracting investment from other venture firms in private equity markets and, in return, investing in their companies. The VC hopes to partner with or sell his companies to large pharma in the private innovation market. Unfortunately, sales are rare. More often, the venture capitalist sells a portion of his company to investors in the stock market through an initial public offering to raise the money needed to complete development.

If all goes well—it seldom does—the company might get a chance to sell the approved product in the pharmaceutical market. Each market exists to serve a different set of buyers from scientists to financiers. A venture firm and its managers must operate in all of them.

Success in technical development depends on data from clinical trials. Good results can raise the value of the equity (stock) of a small company overnight. To realize that value, managers must translate—monetize—those achievements into the cash CEOs need to run their companies or venture capitalists can return to their investors.

These transactions take place in financial markets that are ruled by interest rates—the price of money. When the Federal Reserve restricts the supply or raises the interest rate, money becomes scarce for most companies and unavailable for small ones. Markets and company values fall.

Venture managers must understand the cycles of financial markets, as well as the complexities of cutting-edge bioscience, the desires of major pharmaceutical customers, the state of medicine and ultimately the needs of patients. To maximize the exit value (selling price), venture capitalists must align those forces.

Hard Lessons In Finance

The penalty for a mistake in any one market can be severe. Take, for example, a venture fund that raised its second $100-million-plus fund in 2003 and was ready to go back to the institutional market for its next fund in mid-2007. Conditions appeared ideal for raising money. The early investments were doing well. Several of the companies the firm had started had completed second rounds with top-tier venture partners at steps-up in valuation. The institutional market was receptive.

The firm could have gone back to the market, but the managers were busy making new investments. The team, experienced entrepreneurs all, were new to the institutional venture market. No hurry: conditions were good…until they weren’t.

Markets collapsed the following year at the start of the Great Recession, and the firm never raised another fund. Between 2007 and 2010, more than half of the early-stage bio-venture firms went out of business; eight of the top ten in the sector disappeared. Some firms had the bad luck to come to the institutional market when there was no money available. A few were fortunate to raise money ahead of the crash and had enough to carry them through the trough. Still others, like the firm in the example, which weren’t paying attention to financial markets, went out of business.

The markets for early-stage biopharmaceuticals—both private and public—are what economists call “inefficient.” They don’t reflect the true value of assets and can’t be counted on to provide money when a company needs to replenish capital reserves, or an investor needs to cash out. Rather than managing to corporate milestones, companies must raise money when it is plentiful and hold on when it is tight.

Biopharmaceuticals’ Unique Challenge

There is another reason for inefficiency, unique to biopharma. No one knows or can know the true value of a small company trying to develop a new drug. As explained in an earlier post, drug development is inherently unpredictable. Without a clear underlying value proposition, small biopharmaceutical companies rise when financial markets are strong and fall when they turn, unlike big pharma, which is considered a hedge against down markets. People get sick, regardless of whether interest rates are up or down.

A company can have a successful trial when money is scarce and not get paid full value. Triangle Pharmaceuticals completed the registration trial for their lead drug, emtricitabine, in 2002 at the depth of the post-Y2K bubble crash. Raising the hundreds of millions to launch the new drug in a down market appeared impossible. The board and management sold the company that year to Gilead for $464 million.

In most cases that sale would have provided a nice return, but this time it was a fraction of the value. Gilead, to their credit, made the drug a cornerstone of their HIV program and earned tens of billions of dollars in the process.

Markets driven by financial rather than technical considerations do not afford small companies the flexibility to deal with unforeseen setbacks. Development can take longer than expected as in the case of Soleno Therapeutics, which was working on a treatment for a devastating childhood disease with no alternative therapies. The company went public in November of 2014 and completed their first registration trial in May of 2020.

Despite generally good results and the remarkable improvement of the patients on drug, the trial failed to meet its primary endpoint when Covid-19 struck. The FDA requested a second trial. Low on cash, the company was forced to raise money at a price of pennies a share. Between the end of September 2021 and March 2022 the value of the stock dropped by 75% and continued lower. The original investors saw millions of dollars of value washed out. The final round investors enjoyed hundreds of millions in profit when the follow-on study demonstrated robust efficacy.

Good Drugs Are Not Enough

AFR Picture by PHIL CARRICK (Photo by Fairfax Media via Getty Images via Getty Images)

Fairfax Media via Getty Images

No one is in the early-stage bio-venture business who does not at heart want to help patients and alleviate suffering. Most see themselves as drug developers, but ultimately a venture capitalist is judged by the returns he provides his investors.

As a result, he must operate in two different—and often opposing—worlds with limited control over outcomes. No matter how hard he works or how skilled he is as a manager, if the data doesn’t pan out or the market is down on the day he must raise money, he loses.

Being a biopharma venture capitalist is, indeed, very hard.