A Beginner’s Guide to Biotech Venture Capital
Biotechnology startup companies are unique from other startup ventures in that they have a high burn rate of capital and a long development process, making them very risky for investors. Novel biotechnology often faces legal and political battles during development (stem cells, mRNA vaccines) heightening the challenges that face burgeoning companies. Despite these risks, Venture Capital (VC) is a very important source of funding for biotechnology startups as it not only acts as a cash line, but also provides critical expertise that allow early-stage biotechnology companies to move through development and regulatory issues. So how does VC discern between good or bad investments? In this perspective, we will explore the characteristics of biotechnology companies that are evaluated by prospective VC partnerships.
The first screen for a biotechnology company is whether it fits within the VC’s investment strategy. An investment strategy can be based on target industries, demographics, development stages, geography, capital requirements, or any other number of factors. These requirements allow VCs to draw down focus significantly on a large pool of proposals. These factors may be based simply upon public opinion rather than larger VC ethos. For example, funding companies that rely on genetic modification of plants is generally not well received by large portions of the general public, despite the merit of the science. Some VCs simply do not have the capital to fund drug development, which can cost upwards of $1 billion USD over the course of decades.
If a company fits a VC’s overall investment strategy, the VC will perform due diligence in order to gauge its fitness and likelihood of success. Due diligence is the process through which VCs evaluate a company’s current state of affairs as well its potential growth — this includes a company’s management, current assets, liabilities, and where it may fit within the market. The weight of each criterion is highly debated, but it is speculated that the technological processes are more important in a company’s earlier stages, while management and sales become more important during later stages (1). Many biotechnology companies will not have revenue let alone profitability, which inhibits many methods of valuation. Due to the multi-year timeline required for a biotech product to progress from early phase discovery into a market-ready product, VCs will look for any indication of a product becoming obsolete or failing before inking a term sheet. For example, while shotgun sequencing techniques allowed for the first sequencing of the human genome around 2001, these techniques were largely replaced with next-generation sequencing techniques like RNA-seq by the early 2010s, meaning companies had to adapt or perish. For VCs, a long development process equates to nebulous exit strategies, adding more uncertainty and risk into an investment decision. So in order to conduct proper due diligence on a biotech company, VCs must progress through a logical flow that accounts for development, regulation, profit potential, and a dynamic market.
Due diligence can be performed by specialists within the VC or outsourced by more generalized VCs to experts, like scientists in a given field, physicians, other VCs, or other founders. Even specialized VCs will look for external validation though, which can be in the form of a strategic partnership with a larger company as it indicates additional faith in the company. During the due diligence process, analysts will examine a variety of characteristics including, finances, the current market, technology, and the managerial team. While there is no formula for how to weight the importance of these company attributes, generally speaking, team and technology matter more for early-stage biotech companies while market and finances matter more for later stage companies.
Finances
This characteristic of a company is the potential upside of a commercial product. The SARS-CoV-2 vaccines had tremendous upside as every human (and likely some primates) on the planet was a potential customer. Indeed, Moderna reported a total revenue of $18.5 bn for 2021, but it would be prudent to remember that when Moderna was receiving VC investments more than a decade ago, they would have been laughed at to suggest such an upside. The ability of a VC to turn a profit and the ability to exit the investment — in other words, liquidate stock options through an acquisition by another company or selling to the public through an initial public offering (IPO) — are repeatedly shown to be the most important metric of due diligence (2). Other considerations regarding a startup’s finances are whether the VC will be required to invest further and how much they may be diluted by further investment rounds as a result of giving away additional equity in exchange for capital.
Market
The market is everything outside of the biotechnology company, such as market size. For example, diseases like cancer have a massive market (calculated as the total number of patients or the total amount spent on treatments), which is good because there is potential for a lot of financial upside, but also means that a company may have a harder time breaking into the space due to competition. Cancer immunotherapies represent a space that has dramatically impacted the overall cancer market, but is still relatively new and thus has a lot of growth potential. For example, Chimeric Antigen Receptor (CAR) cells are immune cells primed to specifically attack cancerous cells and have only recently been introduced as commercial products. Currently there are only three FDA-approved CAR cell therapies and treatment costs the patient upwards of $1 million USD. With 1,200 clinical trials worldwide, this cost is expected to fall, but the overall market is expected to grow as new iterations CAR therapies are developed and brought into the commercial space (3). Technologies like these are attractive to VCs as the market will grow rapidly and eat into large portions of the dated chemotherapy market.
Technology
Since biotechnology can be so complex, VCs must be certain that the technology can be protected (can you patent the human genome?), that it will be accepted by the market, and that there is a functioning prototype. Even if a startup has patented their product, that doesn’t mean it is safe from legal disputes from competitors simply trying to silence other products. A recent example is the legal battle waging over CRISPR technology between Jennifer Doudna, PhD at University of California, Berkeley and Feng Zhang, PhD at Massachusetts Institute of Technology. While Doudna pioneered the conception of CRISPR-Cas9 technology, Zhang first applied the technology in mammalian cells and so a fight rages over this multi-billion-dollar technology.
Management
The entrepreneurial team can be the deciding factor as to whether a VC invests or not. In the first phase of biotech creation, many companies spin out of university research labs. The second phase is when the technology starts to take the form of a product, which needs to be sold. Science and sales are two very different skillsets, so the creators of the product are rarely the salesmen of the later stages of a biotech company. This is important to understand — scientific founders may start as C-suite executive members but rarely remain there as the company grows. While a company is growing, management has to be familiar with the science and understand it intimately so the founders can act as the managing team, but once the technology is developed, management doesn’t need such a deep understanding as much as they need the ability to sign contracts and sell the technology or product. Ultimately, the weighted value of the management team will be specific to the VC and their overall investment strategy.
These factors are the overarching criteria that VCs use when evaluating biotechnology companies. In this piece we did not go into some of the minute details VCs may inspect when deciding to invest (flow of physical lab space, quality of labs and equipment) as those are much more specific to individual VCs. Overall biotech companies are evaluated in a much different manner than other technology companies because of the unique path biotechnology must take for commercial success. Long development processes, high costs of maintaining a lab, and uncertain exit points increase the risk for investors. VCs can serve as an important catalyst in a fledgling biotech company, but the technology, market, and entrepreneurs must be there to assure that the company survives.
References
1. Bank of England. The financing of technology-based small firms. London: The Bank; 1996. 73 p. p.
2. MacMillan IC, Siegel R, Narasimha PS. Criteria used by venture capitalists to evaluate new venture proposals. Journal of Business venturing. 1985;1(1):119–28.
3. Polaris Market Research. CAR-T Cell Therapy Market Share, Size, Trends, Industry Analysis Report. 2022.
