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A Hot Summer in the Valley of Death

What post-pandemic economic conditions mean for seed-stage life science ventures

Pyriscence: From the Latin, To open with fire. A strategy in plants for storing seeds until seedlings are most likely to find an environment supportive of new growth. Pyriscence in many conifers is the process by which seeds germinate only after being nearly destroyed in a forest fire. In Wikipedia, see Serotiny.

During the longest economic expansion in our nation’s history (2009 until early 2022), launching or investing in new life science companies has been a notoriously difficult task.

Historically, the chance of success for any new company would approach better-than-even-odds only very near the commercialization finish line. The epoch has been a decade of creation and creative destruction and rightfully has bragging rights for such miracles as STEALTH neurosurgical navigation, engineered cells that cure certain leukemias, and direct-to-consumer genetic sequencing. As of this writing, the SARS-CoV-2 pandemic seems to have been brought to heel through a chain of discoveries and businesses that by July of 2022 had manufactured and administered more than 12 billion doses of vaccines of striking compositional, logistical, and (who knew?) political complexity.

New drugs and devices often require more than a decade of development from inception until use in patients. Outside of interplanetary travel, these are among the most expensive undertakings supported by the venture capital model. Unlike more familiar start-ups, new drug and device companies have no means of producing revenue until they’ve completely demonstrated safety and efficacy. All-or-nothing-at-all by nature, there is no ‘minimal viable product’ for a new drug or surgical device.

In the Spring of 2022, we find the bioeconomy—surely a crown jewel of the modern world — in a retrenched, almost unrecognizable state. It’s worthwhile to spend a moment taking our bearings but also taking a breath.

Photo by Casey Fyfe on Unsplash

What Hasn’t Changed in 2022

I believe that most of the forces motivating and shaping the creation of new life science companies remain familiar:

  • The vast unmet needs in most aspects of human well-being specifically and the entire biosphere more generally
  • Those founding teams who stand ready to tackle those challenges
  • A requirement for early high-risk investment (and investors) to sponsor new enterprises that require many years to bear fruit
  • The regulatory hurdles (and their accompanying administrative tempo) which must be overcome before going to market (think FDA, CMS, …)
  • The needs of later-stage private investors, acquiring companies, and public markets for access to investment opportunities that arise from early-stage company creation and success.

What Has Changed, in some Cases by a Lot

Many features of the bioeconomy nevertheless have been quantitatively, if not qualitatively, transformed for the worse this year:

  • The cost and speed of doing business
  • Interest rates and the cost of capital
  • The short-term outlook for investments made prior to the economic downturn and the ongoing wave of valuation write-downs
  • The risk appetite of founders, potential first employees, and investors
  • The fragility of early-stage life science, health care, and medical device start-ups.

In Q2 of 2022, all these elements coalesced to produce an abrupt change in the number of investment deals closed by life science companies. As shown in Figure 1 (with data extracted from the Q2 Pitchbook-National Venture Capital Association Venture Monitor), deal activity sharply contracted in the Spring. The worst decline was deal volume in seed rounds, which fell to levels not seen since 2014.

Figure 1. Long-term trends in life science investment activity, 2010-present.

What Would Marcus Aurelius Do?

The philosopher and Roman emperor Marcus Aurelius once again said it best: ‘If thou art pained by any external thing, it is not this thing that disturbs thee, but thy own judgment about it. And it is in thy power to wipe out this judgment now (Meditations, 8.47).

Drew Armstrong and Angelica Peebles sum up the mood at the 2022 BIO Conference in this piece from Bloomberg on June 21st.

The moment calls for some skepticism and stoicism. Skepticism in the numbers and headline stories being reported. The earlier and further ‘upstream’ one looks into start-up finances, the harder it is to be confident about what’s going on. Many deals go underreported or unreported altogether. A case in point — there are many more seed-stage start-ups than late-stage private biotech companies, yet the deal counts in Figure 1 suggest almost parity. This can’t be a full accounting of transactions.

And while the number of deals has diminished significantly, at 100 deals between March 1 and May 31st, the Q2 rate of PitchBook-NVCA recorded deal-closing was one new seed stage deal every 22 hours.

Stories running in the business press typically describe average values of many phenomena as well as extreme high-end outliers. Similarly, tales of massive lay-offs, etc., necessarily address only pretty mature companies; early start-ups don’t have massive anything. When you look through data summarizing deal flow, deal value, and so on, stick to the median numbers whenever you can. The data there are sobering but much less dramatic.

Thus a good bit of Stoicism is also in order. Very few individuals on earth have any power whatsoever to change the trends in the start-up space. The times are what they are; all we have is our reaction to them. I see reasons to be bullish.

Photo by Matt Howard on Unsplash

Seedlings in the Burn

In the canopies of many conifer forests, seeds are held within their cone by a resin that, while practically solid at room temperature, liquifies in the heat generated in a forest fire, allowing seeds to fall to the charred forest floor. In the aftermath of an inferno, these seeds, fertile soil, and plenty of sunlight are the starting point for a renewed forest.

Chances are, we’re not quite done with the fire. But the stage is set for what’s next. The Kauffman Foundation’s 2021 Indicators of Entrepreneurship report shows that the number of Americans starting new businesses (~ 4/1,000) remains very near it’s historic high in 2020. Importantly, 80% of those founders are launching companies because they see an opportunity, rather than out of financial necessity.

When will the forest be ready for new seeds?

Here is a short list of some of the dynamics that need to be sorted before growth takes off again.

Photo by Landon Parenteau on Unsplash

First, when early-stage investors can be confident that the economic correction is nearly complete.

What the new economic ground floor looks like exactly, and how we will know we’re there, isn’t obvious. For individual ‘angel’ type investors, the mindset I’ve seen first-hand this Spring is primarily wait-and-see. In conversations with other experienced Angel investors, a clear theme is emerging: The time for great seed-stage opportunities is near. Just not quite yet.

Second, addressing how early-stage companies will be valued going forward.

There are several ways that an investor can assign value to a start-up for the purposes of purchasing a portion of the company through investment. Because there is so much uncertainty in the trajectory of seed-stage companies, investors often resort to ‘comparables.’ That is, an investor will hold a potentially investible company up to similar companies that have been successful and make an estimate of the new company’s value. This is art, not science, and the method is wholly unattractive now. Historical valuations are now unrealistically high. Furthermore, as the number of new deals has slowed, the availability of contemporary comparable companies is also very constricted. Fortunately, other — but more data-intensive — methods are available and will likely come to the fore. Crack open your textbooks.

Third, how the early-stage risk premium is understood in a period of high inflation and rising interest rates.

Investors put money into high-risk endeavors because the possible rate of return counterbalances the chances that the enterprise fails altogether. The difference between the rate an investor needs to “come off the sidelines” in a risky deal and the rate they would obtain in a lowest-risk alternative (like a US treasury note) is known as the risk premium. As low-risk interest rates rise because of central bank efforts to rein in inflation, it’s intuitive that investors will seek increasingly high-risk premiums from start-ups. I don’t know that this can be sustained. If expectations of returns among early investors rise high enough — and these will be reflected in increasingly investor-friendly deal terms — investors will gobble up the spoils of a company’s success such that there is no way founders (or earlier-stage investors) can generate the kind of rewards needed to keep them engaged. I frankly need to understand this dynamic better. I’ll keep you posted.

And finally, the role of micro-VC funds.

It’s estimated, in 2021, that 400 μVCs — funds with less than $50 million in assets under management were created. The median size of these funds was in practice much smaller — only $10 million. Granted most of these are not life science-focused. But nevertheless, I view the rise of very small funds — with fresh capital in hand and needing to be invested — as a very favorable development in the space. Founders may need to be introduced to many more funds than they were expecting in order to find the right fit and the degree of syndication to fill out a round may be larger. But so be it.

Photo by David von Diemar on Unsplash

The times are uncertain, and events both domestic and far from home continue to loom large in what happens over the next year or two in the early-stage life sciences space in the US. But there’s every reason to be confident that the tide will turn and that great companies in the making are poised to take root.

About the Author

John Younger is the Managing Director at ArgoPond, LLC, a life science advisory and investment company that provides analytics and diligence services to companies and funds engaging the life science space. Prior to founding ArgoPond, John had a 20-year career as a physician-scientist at the University of Michigan and was the co-founder of Akadeum Life Sciences, a venture-backed life science tool company that manufactures materials for advanced cell and analyte separation and purification. John sits on the Board of Directors of New View Surgical, a Boston-based start-up creating new visualization tools for minimally invasive surgery as well as on 3 non-profit boards. He has served for years as a reviewer and strategic advisor to the NIH and has provided congressional testimony on how best to support early-stage biotech companies. That testimony can be seen here. He represents ArgoPond as a member of the Life Science Group of New York Angels.

John’s LinkedIn profile and contact information are here.

Read another one of John’s articles here:

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