Venture Financing

H E A LT H C A R E
The Funding Landscape for Small Biopharma Ventures, 2010-2015

Trends, strategies and priorities By Gaurav Misra
Gaurav Misra
Gaurav Misra specializes in pharmaceutical licensing, valuations and opportunity assessments as strategy consultant for biopharmaceutical companies. He has participated in and led projects on revenue forecasting, product pricing, sales resource allocation and investment due diligence over an eight year career in the sector. Gaurav has an undergraduate degree in Chemistry and an MBA from the Richard Ivey School of Business, where he specialized in Healthcare & Life Sciences.
Copyright 2010 Business Insights Ltd This Management Report is published by Business Insights Ltd. All rights reserved. Reproduction or redistribution of this Management Report in any form for any purpose is expressly prohibited without the prior consent of Business Insights Ltd. The views expressed in this Management Report are those of the publisher, not of Business Insights. Business Insights Ltd accepts no liability for the accuracy or completeness of the information, advice or comment contained in this Management Report nor for any actions taken in reliance thereon. While information, advice or comment is believed to be correct at the time of publication, no responsibility can be accepted by Business Insights Ltd for its completeness or accuracy.
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Table of Contents
The funding landscape for small biopharma ventures, 2010-2015
Executive Summary
Macroeconomic trends and implications Accelerating biopharma collaboration Valuing investment opportunities in small biopharma Priorities and preferences of private investors Top-line trends in venture financing Investment choices of most active firms in 2009
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10 11 12 13 14 14
Chapter 1
Summary Introduction Recent events
Macroeconomic trends and implications
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18 19 19 20 21 23 25 26 29 30 31 33 34
Supply side factors- higher cost of capital Demand side factors- Decreased earnings potential Provider-level constraints Patient-level implications Short and long term implications Non-dilutive funding in an era of excessive dilution Research grants and government contracts Incentives of non-profit foundations Government incentives and associated initiatives Issues surrounding NDF from non-profit agencies
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Chapter 2
Summary
Accelerating biopharma collaboration
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38 39 43 44 47 49 50 50 51 52 52
Accelerating biopharma collaboration Rapidly evolving deal structures De-risking R&D via options-based investing Due diligence in biopharma alliances Marketing agreement Licensing arrangement/Product acquisition Joint venture Alliance/Corporate partnering Outright acquisition of a company Conclusions
Chapter 3
Summary
Valuing investment opportunities in small biopharma
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54 55 55 56 57 57 58 60 61 62 65
Introduction Valuation methods and usage Discounted cash flow Risk-adjusted net present value Real options Comparables Assessing commercial potential Sales potential Pricing and positioning Cost of commercialization
Chapter 4
Summary Introduction Stages of investment
Priorities and preferences of private investors
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68 69 69 72 72 73 74 74
Investors: definition, overview Distinction between private equity and venture capital funds Angel investors Venture capital funds Mezzanine investors
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Venture investors versus buyout investors Process of getting new investment Term sheets Type of security Board representation Valuation Capital expenditure Single versus multiple investors Investor priorities in the new landscape Market attractiveness and product-market-focus The organization Financials Business plan Assessment of risks Intellectual property protection
75 77 78 79 80 82 83 84 85 86 87 87 88 88 89
Chapter 5
Summary
Top-line trends in venture financing
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92 93 94 94 94 94 95 95 95 96 96 96 96 97 98 99 100 101 103 105
How to use this chapter Definition of key terms Venture financing Seed Start-up Early stage Growth/expansion capital Later stage Mezzanine Bridge loan Private placement Other Countries attracting the most venture financing Recent trends Conclusions Distribution of venture financing rounds by investment stage Recent trends Further analysis of financing rounds by stage Conclusions
Chapter 6
Summary
Investment choices of most active firms in 2009
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108 109 110 110 113 114 115 116 116 117 119 121 125 125 125 127
Most active venture capital investors in 2009 Analysis of investment preferences Therapeutic areas of focus Investment destinations by geography Stage of investments Two types of venture investors Corporate Venture Capital (CVC) funds Emerging role of CVC in Life Sciences Strategic motivations Novartis Venture Fund Novo A/S, Denmark Independent venture capital funds SV Life Sciences Investment focus in 2009 Texas Coalition for Capital
Chapter 7
Index
Appendix
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129 132
Research methodology
List of Figures
Figure 1.1: Figure 1.2: Figure 1.3: Figure 1.4: Figure 2.5: Figure 2.6: Figure 2.7: Figure 2.8: Figure 2.9: Figure 2.10: Figure 2.11: Figure 3.12: Figure 3.13: Figure 3.14: Figure 3.15: Components of government healthcare expenditure in US, 2008 Market share of generic medicines in Europe, 2007 (by volume) IPOs have recently reappeared at a low level Grant-making focus of Bill & Melinda Gates Foundation How biotech entrepreneurs hope to deal with the financial crisis Reliance of big pharma on R&D externalization Trends in biotech-pharma deals by development stage Overview of partnering issues Option agreements by top 20 pharma companies (Phase I) Reliance on the option model varies by company Deal structures and responsibilities Primary valuation methodology by investor type, 2009 Assessing the net earnings potential of a medical intervention Assessing revenue potential Pricing and positioning 22 24 28 32 39 41 42 44 46 47 48 59 60 61 63
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Figure 3.16: Figure 3.17: Figure 4.18: Figure 4.19: Figure 4.20: Figure 4.21: Figure 5.22: Figure 5.23: Figure 5.24: Figure 5.25: Figure 5.26: Figure 5.27: Figure 5.28: Figure 5.29: Figure 5.30: Figure 6.31: Figure 6.32: Figure 6.33: Figure 6.34: Figure 6.35: Figure 6.36: Figure 6.37: Figure 6.38: Figure 6.39: Figure 6.40:
Impact of incoming therapies on payor budgets Development and commercialization costs Company growth stages and funding sources The deal funnel at a typical VC firm Sequence of documents Board size: advantages and limitations Geographic distribution of venture financing rounds Trends in geographic distribution of venture financing rounds US investments by region, 2008-2009 Total number of financing rounds by stage, 2004-2010 Distribution of financing rounds by stage, 2004-2010 Trends in financing rounds by stage, 2004-2019 Early-stage funding by type, 2004-2010 Mid-stage funding by type, 2004-2010 Late-stage funding by type, 2004-2010 Preferences of top 15 venture finance investors, 2009 Preferences of top 15 venture finance investors, 2009 Number of deals by investment stage, 2009 R&D performance scorecard Novartis Venture Fund investments in 2009 Novo A/S ownership structure Novo A/S investments, 2000-2008 Novo A/S investments in 2009 SV Life Sciences investments in 2009 Texas Coalition for Capital investments in 2009
64 65 71 77 78 81 97 98 99 100 101 102 103 104 105 111 113 114 118 120 122 123 124 126 128
List of Tables
Table 1.1: Table 2.2: Table 2.3: Table 3.4: Table 4.5: Table 6.6: Table 6.7: Non-dilutive sources of funding Established and evolving deal structures Incentives in a strategic licensing arrangement Overview of valuation methods Stages of equity investing Most active venture investors in 2009 R&D focus of top 15 venture investors, 2009 30 43 50 56 70 109 110
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Executive Summary
Executive Summary
The higher cost of raising capital has increased the hurdle rates of healthcare investors across the world, fundamentally reducing their capacity to invest in risky drug development assets. In particular- hedge funds, private equity funds and public markets seem wary of the life sciences sector and have been liquidating the positions they had taken in the boom years. Small-mid cap biopharmaceutical companies are struggling to offer the risk profile and cash flows needed by investors in todays recessive economic climate. Growth in healthcare costs in developed countries will continue to outpace GDP growth due to demographic trends and increasingly unhealthy lifestyles. As government funds are locked up in bailing out national banks and averting a recession, an ageing population demands ever increasing healthcare spending. This has fundamentally altered the willingness of society to pay premium prices for drugs that provide marginal improvement over cheaper alternatives. Healthcare payors have become extremely price-sensitive in their quest to manage increasing healthcare needs, and new biomedical therapies cannot expect high levels of market access at premium prices unless they fundamentally improve the standard of care. The largest components of healthcare spending like physician salaries and hospital care are relatively difficult to control and require long-term initiatives. By contrast, prescription drugs are a smaller component of total healthcare expenditure but offer more immediate opportunities for spending cuts. This is primarily because of the large number of expensive drugs facing patent expiry over the next five years.
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Thus not only have investors become more selective about risky biopharma investments, the earnings projections of the assets they have already invested in have had to be scaled back.

An increased focus on collaboration between large and small stakeholders of the biopharma value chain will be among the most important consequence of the financial crisis, particularly between large pharmaceutical companies and smaller biotechnology companies. The risks of drug development can be better mitigated by having smaller, disaggregated units working on exploratory ideas. Big pharmas drive to externalize early stage R&D stems from this realization, and they are best positioned to understand the risks associated with early stage drug discovery. Small biotech companies are struggling to maintain working capital reserves as private equity investments have been scaled back and the IPO is no longer a feasible source of funds. The few remaining investors are offering terms that are very dilutive for the original owners. Such a situation has improved the bargaining of big pharma companies. In the absence of public market participation and with a much reduced private equity investment pool, large drug manufacturers are likely to become the primary source of funding for small-mid cap biopharma via a variety of established arrangements such a licensing/ marketing agreements, co-development, jointventures or M&A. The intricacies and tiered structures of partnerships between these small and large companies have evolved rapidly over the past five years. So has the fluidity with which one type of transaction changes into another via an options-based deal structure.
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Almost every start-up has already conceded some level of ownership to VCs that provided their earliest funding, and hence option alliances that often represent nondilutive financing offer an attractive alternative to traditional equity investments.

This chapter deals with the process of assessing the commercial viability of an R&D asset. The asset in question can be a particular project within a biopharma company, a related portfolio of projects, or the entire company itself. All valuations are based on a set of projections such as revenues, costs, profits and cash flows. Even though valuation techniques differ in the way they evaluate the cost of capital and risk, the concept of free cash flows and earnings potential are applicable across the all methodologies. Choosing a valuation method or discount rate is a hot topic when making financial valuations and has been the subject of much theorizing. Business development and M&A teams in large pharmaceutical companies tend to rely on methods such as DCF and risk-adjusted NPV. Venture capitalists and private equity firms prefer estimating enterprise value by comparing it to what other investors are willing to pay for similar opportunities. Deals based on an options-based valuation structure are better able to offer fairvalue to both parties because financial and strategic commitment can be deferred to the point in time when new information becomes available. The pricing-positioning trade-off has become a critical component of the due diligence involved in assessing the commercial potential of a medical intervention. The impact of a certain pricing-positioning strategy on the budgetary dynamics of healthcare providers is now a key input in forecasting the real-world uptake of the product/ technology asset.
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In the context of this chapter, all firms investing in non-publicly traded equity are classified as private equity investors. These include angel investors, venture capitalists, private equity funds, mezzanine funds, funds-of-funds, and others. Although each operates along different stages of a companys lifecycle, traditional operating niches have been greatly stretched as the -funding model evolves to keep pace with the changing landscape. Private equity firms are willing to consider earlier stage companies and VC firms are willing to lower yield requirements in securing later stage opportunities. Unlike earlier years, the term sheets for biotech funding are no longer investor friendly, and include multiple clauses that limit the risks to the investor. With less venture funding available, small biopharma companies have to sacrifice more to raise funds. To maximize the chances of raising funds, the seller must anticipate the preferred exit strategy of the target investor and build the valuation with this end in mind. Biotechs that require high levels of capital expenditure are out of favor with private equity investors, who prefer to invest in leaner organizations with a greater ability to adapt to changing priorities. Even venture funds are wary of investing in companies that have committed large resources towards fixed assets that may or may not be required as their R&D strategy evolves. There is a limit to the extent of managerial/strategic input that investors can provide, hence communicating a sound business plan goes a long way in reassuring investors of the safety of their capital. The entrepreneur must make it easy for the investor to assess the people behind the business, specifically in terms of their ability to prudently manage an organization with a high burn rate. Since many aspects of the job are intangible, the seller must think of ways to communicate their ability.
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US companies attract the most venture financing, followed by companies in mainstream European countries like the UK, Germany, France, Italy and Spain. The financial crisis has not changed the geographic distribution of venture financing in any discernable manner. The US and Canada will continue to remain the hubs of biopharma innovation in the next five years. Certain states within the US are clearly the hotbeds of private equity investment in the biopharma sector. Among the top 10 regions, the triangle comprising the areas of Boston, New York and New Jersey is clearly the leader, followed by parts of California. In terms of stage of investment, the number of deals involving drugs in Ph II and Ph III trials has increased substantially. Based on the number of venture rounds financed since 2004, late-stage financing rounds constituted 2% of the total between 2004 and 2006. In the following three-year period (2007 to 2009), this number has increased to 14%. Existing investors are reinvesting in assets they have already committed funds to because newer investors are demanding excessively dilutive investment structures that do not favor the existing owners. Private equity investors will prefer to invest in companies with late-stage clinical assets over companies with early stage assets in the next five years.

The MedTRACK Venture Finance database was used to identify the investors that participated in the maximum number of financing rounds in 2009. The investments of these top investors were segmented on the basis of their therapeutic area of focus, industry segment, stage of investment and investment destination.
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Most of the top 15 investors are from the US and hence invest primarily in USbased companies. This reflects their local investment mandates and the greater ease of dealing with companies located close by. European firms invest in a greater range of countries, not only within Europe but in other Asian and North American destinations. Deals in Europe tend to be fewer in number but greater in scope of financing. 9.2% of financing rounds were in companies located in Europe, which commanded a 12.6% share in terms of investment value. Corporate Venture Capital arms of large pharmaceutical companies are becoming increasingly active and visible members of the VC community. Unlike traditional VCs, many CVCs are set up as evergreen funds that aim to combine financial motivations with the overarching strategic motivations of their parent organizations. A large proportion of companies that successfully raised VC funding in 2009 have a focus on biotechnology-based approaches to medicine, oncology therapies and medical devices. Over 50% of total financing by value and over 50% of the rounds of financing fall under these three categories. Nearly a fifth of all money invested was targeted at oncology therapies, but oncologys share in terms of number of deals is comparatively lower (<10%). This highlights the fact that clinical development of oncology products involves large scale and expensive clinical trials.
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CHAPTER 1
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Chapter 1
Summary
The higher cost of raising capital has increased the hurdle rates of healthcare investors across the world, fundamentally reducing their capacity to invest in risky drug development assets. In particular- hedge funds, private equity funds and public markets seem wary of the life sciences sector and have been liquidating the positions they had taken in the boom years. Small-mid cap biopharmaceutical companies are struggling to offer the risk profile and cash flows needed by investors in todays recessive economic climate. Growth in healthcare costs in developed countries will continue to outpace GDP growth due to demographic trends and increasingly unhealthy lifestyles. As government funds are locked up in bailing out national banks and averting a recession, an ageing population demands ever increasing healthcare spending. This has fundamentally altered the willingness of society to pay premium prices for drugs that provide marginal improvement over cheaper alternatives. Healthcare payors have become extremely price-sensitive in their quest to manage increasing healthcare needs, and new biomedical therapies cannot expect high levels of market access at premium prices unless they fundamentally improve the standard of care. The largest components of healthcare spending like physician salaries and hospital care are relatively difficult to control and require long-term initiatives. By contrast, prescription drugs are a smaller component of total healthcare expenditure but offer more immediate opportunities for spending cuts. This is primarily because of the large number of expensive drugs facing patent expiry over the next five years. Thus not only have investors become more selective about risky biopharma investments, the earnings projections of the assets they have already invested in have had to be scaled back.
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Introduction
This chapter recaps the macroeconomic trends shaping the funding environment and discusses their implications over the next five years. Investment decisions are driven by supply-side factors such as the cost and availability of capital, and demand-side factors like economic growth and earnings potential.
The financial crisis has raised the cost of capital for investors and made them more selective about the type of companies they invest in. Simultaneously, growth in healthcare-related expenditures is fast outpacing GDP growth for most developed countries- a trend that is certain to gather momentum in the next decade. These two macroeconomic trends collectively dictate the constraints within which biopharmaceutical companies seek to attract investment over the next five years.
Recent events
Aggressive risk taking by highly leveraged financial institutions led to the financial crisis we have today. Investors came to expect a level of economic growth that was inherently unsustainable. The cost of raising money from public and private markets was artificially held down at unrealistic levels, which ultimately led to the collapse of mortgage backed securities. Until as late as 2008, highly leveraged investors such as hedge funds and investment banks were a key source of capital for the small-mid cap biopharma sector. Their financial positions were severely damaged when the mortgage market collapsed forcing them to stop investing in the biotechnology sector and liquidate their positions. All of a sudden, a sizeable component of the total money going into the small-mid cap biopharma sector was withdrawn, and is unlikely to return in the near future.
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Once the reasons behind the financial crisis unraveled, the creditworthiness of borrowers, the sophistication of investors and the distribution of credit risk were widely questioned. The reaction has lead to a liquidity crisis in which companies across all sectors (not just biopharmaceuticals) have struggled to raise capital at what they consider acceptable rates. But this is not another down cycle of investor sentiment that the industry can wait out. This time around, private equity investors are not just disenchanted with the high risk and long lead times in drug development, they have a fundamentally diminished capacity to invest.
Thus the global financial crisis has fundamentally altered the market landscape for small-mid cap biopharma companies. Market conditions are far from what was considered normal and this is not going to change anytime soon. The very definition of normal will have to evolve and this will be neither quick nor easy.
Supply side factors- higher cost of capital

Most of the money invested in small-mid cap biopharma companies is financed via traditional private equity investors and big biopharmaceutical firms.
The big pharma companies usually provide such investment via licensing arrangements, royalty monetization, joint-ventures or outright M&A. This group is more able to fund such transactions from their internal cash reserves. Although the cost of raising capital has increased for all parties, the larger pharmaceutical companies, with their AAA credit ratings and stable cash flows are among the least affected stakeholders.
By contrast, private equity investors rely on highly leveraged capital raised from institutions like pension funds and insurance companies. Their cost of raising capital has gone up to level at which smaller biopharma companies are no longer able to offer
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a viable investment opportunity. In effect, the performance expectations of private investors have risen sharply in the past three years.
Aside from the higher cost of capital, some well-known historical reasons for the dearth of private equity capital for small-mid biopharma companies include: Long lead times between identification of promising compounds and ultimate regulatory approval/ market launch, which can be as long as 8-10 years. Other industries offer much shorter lead times, even if the eventual cash generation is smaller in its scope. A renewed focus on positive cash-flow generating businesses, therefore a shift away from companies that do not have significant marketed drugs. A decline in the number of therapies approved for broadly defined patient populations by the FDA and other mainstream regulators. This makes potential investors wary of investing in good ideas that may never be approved at a commercially viable level. High levels of project attrition at the research and development stage. Private investors are not as well positioned as mature pharma companies to understand the inherent development risks of immature biotechnology companies. They also have greater freedom to branch out into unrelated industries.
Demand side factors- Decreased earnings potential

The fundamental drivers of growth for biopharmaceutical companies are relatively independent of the wider economy. Epidemiological trends that stem from an ageing population and disease prevalence are not influenced by economic conditions. This implies that the demand for healthcare will continue to grow over time and remain relatively inelastic over time. However, tougher economic conditions directly impact the willingness of society to pay for expensive therapies, and hence influence the
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commercial potential of upcoming biopharmaceutical drugs. It is a question of inelastic demand versus inelastic budgets.
Increased healthcare spending was already a critical area of concern for policymakers and regulators long before the credit crisis. The non-availability of finances has only served to exacerbate budgetary pressures. Figure 1.1: Components of government healthcare expenditure in US, 2008
800 700 600
$ 731
$ 718
US$ billion
500 400 300 200 100 0
10% of total expenditure was on Rx drugs
$ 234 $ 160 $ 138 $ 114 $ 69 $ 66 $ 65 $ 44
Prof essional services
Prescription drugs
Public health activities
Medical products
Administration
Hospital care
Nursing homes
Home care
Source: Centers for Medicare and Medicaid Services, Natl Health Statistics
Business Insights Ltd
The demand for cuts in healthcare spending will increase as the gap between growth in healthcare spending and GDP widens. The largest components of healthcare spending such as physician salaries and hospital care offer limited scope for spending cuts. This is because they involve public health workers wage expectations in an inflationary macroeconomic environment, which restricts the room to maneuver within overall healthcare budgets. Short-term cuts can only be made in certain areas.
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Research investments
Other investments
In such an environment, the impending patent cliffs in the biopharmaceutical sector have drawn the worlds attention to the cost containment opportunity they present. Although expenditure on prescription drugs only constitutes a relatively small component of overall healthcare costs (Figure 1.1), it is more visible to the public eye. As a direct consequence, biopharmaceutical therapies are always one of the first items under scrutiny when there are discussions on healthcare cost control.
Provider-level constraints In the context of this chapter, providers or payors include all health plans that have the responsibility to provide healthcare services to a population under their purview; and manage the costs in a manner most suitable to their needs. Examples include health plans sponsored by insurance schemes, government sponsored institutions like the NHS, specific schemes within larger government bodies, hospitals, etc.
Healthcare providers control reimbursement policies for biopharmaceutical therapies. As the entities that pay for biopharmaceutical therapies on behalf of patients, their importance as stakeholders in the healthcare value chain has risen tremendously over the past five years. They are also under enormous pressure to lower healthcare delivery costs. The pressure on drug revenues will vary by market, depending on the nature and extent of cost containment measures used by healthcare providers. Regardless of the market, healthcare providers across the world are using similar strategies to lower the costs of healthcare delivery. Some of these are recapped below. Increasing demand for proof of added value. Added value has two components; the clinical unmet need fulfilled by the drug, and the manner in which the drug influences the economics of healthcare provision. If a drug provides a clear medical benefit over incumbent competitors and also lowers the cost of treatment, it will encounter few obstacles in being accepted within the treatment paradigm by healthcare providers. This is perhaps the most important factor in assessing the commercial potential of biopharmaceutical companies. While a superior clinical profile may have been sufficient for a drug to be competitively successful in the past, the economic component has become as important in the
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current/ future context. There will definitely be greater use of recommendations by bodies such as NICE (National Institute of Health and Clinical Excellence) in the UK, and these recommendations will be carefully studied by payors in other countries as well; leading to more restrictive reimbursement policies for new products. Increased generic usage. In many of the key markets for biopharmaceuticals, usage of generic drugs is still low. Figure 1.2 below shows how nearly half the markets in Europe still use less than 20% generics in terms of volume of drugs consumed. Other markets have put in place specific policies to encourage generic usage. To reduce healthcare spending, regulators in these countries are expected to replicate tried and tested means of increasing generic usage, such as prescription guidelines, electronic prescribing systems, drug-substitution at the pharmacist level, and incentives/ disincentives for pharmacists and physicians. Figure 1.2: Market share of generic medicines in Europe, 2007 (by volume)
80%
60%
40%
20%
0% Spain Germany Netherlands Denmark Belgium Austria France Portugal Sweden Italy UK
Source: EGA Market Review, 2007
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Measurable health outcomes and changes in pharmaceutical purchasing. The willingness of governments and purchasers to pay premium prices for new drugs has clearly decreased over the past two years. New, creative deals that are based on specific budgetary and clinical goals will become the norm over the next five years and beyond. Examples include volume based discounts, bulk purchasing, greater demand for rebates in the tendering process and reimbursement based achievement on short-term, measurable health outcomes. Policy changes in the US. Now that the landmark healthcare bill has been signed into a law in the US, there will be wide-ranging implications for biopharmaceutical companies. On the plus side, the new law will eventually extend health insurance cover to about 32 million Americans. This is a direct addition to what was already the worlds largest and most lucrative patient pool for biopharma companies. However, even as demand increases, the ability to fund such medical expenses is severely restricted and this deficit will continue to increase in the coming years. The inherent strategy underlying the law is that savings will eventually cover the deficit, but this is not likely to happen before 2020, or even 2030. In the meantime, it is extremely difficult to forecast the consequences on the earnings power of new biopharma therapies seeking to launch in the US market. In spite of the uncertainty, it is obvious that cost-containment policies will take centre-stage. As an example, the removal of the Medicare non-negotiation clause in Medicare Part D could decrease revenues of biopharmaceutical drugs by between $10bn and $30bn annually.
Patient-level implications The impact of the recession is also felt at the patient level. Even though most healthcare costs are covered by government schemes such as the NHS in six of the seven major markets, consumer spending is a key component of biopharmaceutical earnings projections. This is especially for the case for the more discretionary elements of pharmaceutical/ healthcare spending, such as cosmetic-related therapies and surgery.
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Aside from the major markets and other developed countries, emerging markets have started to become a key component of biopharma revenue projections. The government plays a relatively smaller role in healthcare provision in such markets and 60-70% of the value of drug spending comes from out-of-pocket expenses. Historically, only people in the highest income brackets (rich and the super-rich) contributed anything substantial to the earnings of branded drugs in these markets. This was widely expected to change as the mass-affluent segments of these societies became increasingly willing to pay premium prices. Such predictions were built into the revenue projections of analysts. Inflationary pressures and decreased spending power will alter these projections, leading to a decrease in revenue potential.
Short and long term implications

The impact of the financial crisis has been asymmetrical across the spectrum of biopharmaceutical companies. While the cost-of-capital has gone up for everyone, the reliance on external capital varies tremendously between small, mid-sized and large companies.
Large, mature big pharma companies are relatively underleveraged. It is estimated that that the average net debt as a percentage of capital employed for the top 20 pharmaceutical companies is as low as 6%i. This figure can be contrasted with 95% for a typical financial institution. The need of the hour is to effectively utilize the asymmetric access to capital by stakeholders in the biopharma spectrum, and focus on relatively unorthodox/ less used means to secure funding. The recent wave of mergers and acquisitions among big pharma companies is evidence of the opportunities they possess in these times of contrasting fortunes. The biggest pharmaceutical companies have tremendous cash reserves and starved pipelines. Small biotechnology companies
Boston Consulting Group, 2008
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are starved for cash but have promising pipelines. This asymmetry has been recognized and capitalized upon by both parties even before the credit crunch.
In the long term such strategic partnerships will not only increase in number but evolve into better and more creative collaborations that tackle the specific incentives of the two parties. This highlights the fact that the relationship between biotechnology and pharma companies is co-evolutionary in nature. The very terms- pharmaceutical company and biotechnology company are no longer particularly relevant in todays market environment because a biotechnology-based approach is a critical component of the pharmaceutical industry at multiple dimensions. The real long-term effect of the credit crisis will be to accelerate this mutual evolution.
In the medium-to-long term, the ability of the private equity community to finance risky biopharma ventures will remain diminished due to which a large proportion of small-mid cap biopharma companies will find it harder to raise capital. This situation has already improved the bargaining position of the large, cash rich pharmaceutical companies, which have capitalized on the opportunity in various different ways: Acquiring small R&D-centric biopharma companies to plug gaps in their pipeline portfolios In-licensing compounds/ platforms via deals and alliances Out-licensing non-core R&D assets Leveraging corporate venture funds to scope out early stage/ potential product opportunities
The Initial Public Offering (IPO) route as an exit strategy for investors is currently unrealistic and will continue to remain so in the next five years. Figure 1.3 below illustrates the sharp drop in IPO activity over the past two years. Public offerings will not be the primary exit strategy for life sciences investors, nor will they be a realistic source of funds for entrepreneurs in the foreseeable future. Instead, the most likely exit
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strategy promises to be collaborations/ deals with the big pharmaceutical firms. Such a trend is already apparent in the investment preferences of Venture Capitalists who have been proactively approaching big pharma and big biotech firms to understand the type of assets they might want to buy. Armed with such information, VCs are tailoring their funding and development plans accordingly. Figure 1.3: IPOs have recently reappeared at a low level
35 30 30 Number of IPOs 25 20 15 10 5 0 2007 * Year-to-date Source: MedTRACK Business Insights Ltd 2008 2009 2010* 2 3 1
In the short-term, small-cap biopharma companies will continue to find it difficult to raise funds. Industry analysts have already advised investors to stay away from biotech companies in urgent need of capital. Companies that wish to avoid a big-pharma alliance or those that are yet to reach the crucial milestone when their value is best perceived will have to find a way to keep working capital coming in. There appear to be three types of alternative: The first includes expensive short-term financing approaches such as venture debt, bank loans and some form of royalty monetization. Although costly, an increase in such alliances is already apparent and will remain so in the next 12-24 months.
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The second includes the relatively (if not entirely) non-dilutive sources of funding such as research grants via foundations and government bodies, partnerships with academia or mergers with similar biopharma companies. Within these two categories, a wide variety of creative strategies are being adopted and the next 1224 months will reveal which of these are the most successful. Even in the short term, the necessity of experimentation is clearly perceived from the bench to boardroom by entrepreneurs and investors alike. The third category constitutes sale to traditional private investors (specifically those not affiliated to the big pharmaceutical companies). Biotech companies having to raise capital via such private channels in the next 12 months will either be forced do so at the expense of shareholder value, or will not be able to raise capital at all. Other biotech companies, with limited financial resources, will need to conserve cash by closing/delaying a large part of their pipeline. A large number of biotech companies are already adopting such strategies and others will follow suit in the months to come.
Non-dilutive funding in an era of excessive dilution

A biotech company has to pass several fund raising rounds before it can launch a drug and generate revenues. In each successive round, the equity interests of pre-deal shareholders are progressively diluted. In the post credit-crisis era, such dilution has reached enormous proportions with new investors being more cautious and attributing a lower value to the asset than existing shareholders and entrepreneurs. Consequently, existing investors have to give up more of their ownership to raise the same amount of funds and feel that the new investors have excessively diluted their positions.
To reach their optimal value inflection point, start-up biotechs have to make many risk diversifying moves such as raising enterprise costs or delaying advancement of a program. Such moves can increase the overall enterprise value and reduce the short-
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term price of the companys shares. This may create tension with the companys existing VCs, who do not like to see shares devalued.
Thus R&D-based biopharma ventures seek to blend traditional VC funding with nondilutive financingmoney from third parties that can be obtained without giving up stock. Many such non-dilutive sources are discussed in the following chapter on collaboration between small and large biopharma companies. This section focuses on government assistance and grants from disease-area foundations. Table 1.1: Non-dilutive sources of funding
Investment vehicle Debt Venture debt Convertible debt Royalty monetization Licensing Dilution No No No No No Tax No No No Yes Yes Transaction Costs High Hidden fees High Low Low Capital costs Low Medium Medium Medium Varies
Source: authors analysis, secondary sources
Research grants and government contracts The government and society as a whole is acutely aware of the looming healthcare crisis we see today. At a broad level governments are keen to encourage skills and infrastructure development in the life sciences sector- to cater to their internal healthcare needs and also to develop an internationally competitive industry. Biopharma ventures with research mandates that connect with the social incentives of governments and non-profit foundations may be able to raise funds (directly or indirectly) by tapping into the research grants and government contracts.
A research grant is a sum of money used to fund a specific project or purpose. The foundation funds work that meets specific grant-making priorities and supports the foundations guiding principles. Most such grants come from non-profit organizations committed towards a specific disease area or healthcare initiative. They may be the
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philanthropic efforts of wealthy individuals or corporations, government initiatives or a combination of the two.
Incentives of non-profit foundations Disease area foundations have the goal of finding therapies that solve the problems of the patients they support. As such, they are judged on the basis of the unmet needs they are able to serve within a healthcare niche.
Their emphasis varies by therapy area but always focuses on either break-though, novel approaches to treatment or on the unmet needs not served by the large biopharmaceutical manufacturers. Although each disease area is likely to have its representative foundations, the funds available to such foundations vary enormously. For example, the American Heart Association (AHA) represents patients suffering from cardiovascular ailments in the US, which is among the most-high-profile therapeutic areas. Hence the scale of their funding activities will be proportionately higher than that of foundations representing an orphan or ultra-orphan disease.
Other foundations have funding initiatives that marry a medical and social motive. For example, TDR (supported by UNICEF, UNDP, WHO and World Bank) funds specific projects in diseases of poverty, which cover infectious diseases and the culture and environment that contribute to these problems. Its grants are designed to find innovative ways to develop new drugs, barriers to the insects and worms that carry the parasites, diagnostics and other tools against infectious diseases in developing countries.
The Bill and Melinda Gates foundation is another important foundation that funds research in various disease areas including: Diarrhea and Enteric Diseases HIV/AIDS
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Malaria Maternal, Newborn, & Child Health Neglected Diseases Nutrition Pneumonia & Flu Polio Tuberculosis Vaccine-Preventable Diseases
Its grant making focus is outlined in the figure below. Figure 1.4: Grant-making focus of Bill & Melinda Gates Foundation
The foundation begins by asking:
What affects the most people?
They look for projects that:

Produce measurable results
What has been neglected?
Use preventive approaches
Where can we make the greatest change?
Promise significant and long-lasting change
How can we harness innovative solutions and technologies? How can we work in partnership with experts, governments, and businesses?
Leverage support from other sources
Accelerate work the foundation already supports
Source: Bill & Melinda Gates Foundation
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Government incentives and associated initiatives Government also supports early-stage research for areas with significant unmet need, threats related to bioterrorism, epidemics, etc. They do this via many initiatives. Most countries also have various initiatives to fund research in the life sciences sector, many of which have gained impetus in the past year as the full extent of private equity withdrawal from the life sciences sector has become apparent. Anxious investors in the private and public markets have shifted money to low-risk investments, and high-risk biopharmaceutical companies, especially those engaged in early-stage development have been left scrambling for cash.
As part of health-care law signed by the US senate is the Therapeutic Discovery Project Program- a provision to aid small companies doing R&D in biotechnology. It involves a tax credit worth up to $5 million per company and totaling $1 billion overall. The program is largely a grants program disguised as a tax credit which covers up to half of the R&D expense for qualifying projects and is targeted at vulnerable young businesses with fewer than 250 employees. Such nascent companies do not earn a profit in their early years and owe no taxes, so the program allows those firms to convert the credits into grants.
In France, the national Grand Emprunt (Big Loan) was launched in 2010. It is a US$73.7 billion economic stimulus package to fund French industry and infrastructure, with at least US$7.9 billion flowing into the life sciences, biotech, clean-tech and academic research. It is the biggest government-driven plan to benefit the biotech sector in the country. Earlier in 2009 the Kurma Biofund was launched as a joint partnership between the public financing body Caisse des Depots et Consignations (CDC) Enterprises and venture capital group Natexis Private Equity, Paris. It is open to newly-created biotech companies spinning off European academic centers. That the national CDC deposit fund is part of these financial investment instruments demonstrates the French governments resolve to push biotech onto its agenda.
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Issues surrounding NDF from non-profit agencies Best thing about grants and government contracts is the money raised is non-dilutive, it does not require the company to issue more stock. Such support also externally validates the unmet need of the clinical goals and also validates the rigor of the scientific approach and caliber of individuals responsible for the program. Start-ups can also apply for several grants in each cycle.
Time and availability: However the process of applying for and receiving funding takes a lot of time. Preparation of an application may take months, as does the selection of winning applications by the foundation or charity. Once accepted, the negotiations on the statement of work and funding amounts can also take many months. While such help is invaluable to early-stage R&D, there are many takers and not enough grants. So even after months have gone into the preparation of an application, there is no guarantee that the effort will yield results.
Support infrastructure: If successful, a good deal of support infrastructure is needed to manage the administrative needs of auditing and communication with the granting agency. Issues typically audited include time-based activity reporting, equal opportunity employment reporting, IP reporting and submission of periodical technical reports.
Loss of focus: The mandate a start-up has to adhere to on winning a grant must tally closely with other commercial projects so that focus is not diluted and resources spread too thin. Once a grant has been awarded, it is not easy to abandon the program and reorient the clinical strategy. Hence a long term view needs to be maintained.
Expensive to apply: Preparation of proposals for grant applications is time consuming and expensive; often taking up senior management time. It requires detailed budgets, specific work plans, quotes from sub-contractors, and provision of abundant data in a non-confidential setting.
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Conflict of interest: There may be conflicts of interest between the mandate of the non-profit granting agency and those of VCs/ for-profit investors who have a stake in the company. The entrepreneur needs to assess the hooks in agreements like diligence requirements, ownership of the assets in developing countries and approvals over potential acquisition candidates. Clauses related to IP also need to be checked carefully. In cases where the grant was made by a government agency, they will usually want to retain a license for any eventual IP in their area of interest, leaving the developer free to pursue other commercial applications for the IP. In other cases, there is greater need to study the implications of the granting agencys preferences related to eventual commercialization.
Lack of commercial expertise: Unlike VC funding, non-dilutive financing via grants and contracts does not bring in business expertise and networks that a traditional forprofit investor can bring. However, the non-dilutive nature often compensates for this, and the extra credibility gained makes VCs more receptive about investing in unrelated for-profit programs that the company may pursue.
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CHAPTER 2
37
Chapter 2
Summary
An increased focus on collaboration between large and small stakeholders of the biopharma value chain, particularly large pharma companies and smaller biotech companies will be among the most important consequence of the financial crisis, The risks of drug development can be better mitigated by having smaller, disaggregated units working on exploratory ideas. Big pharmas drive to externalize early stage R&D stems from this realization, and they are best positioned to understand the risks associated with early stage drug discovery. Small biotech companies are struggling to maintain working capital reserves as private equity investments have been scaled back and the IPO is no longer a feasible source of funds. The few remaining investors are offering terms that are very dilutive for the original owners. Such a situation has improved the bargaining of big pharma companies. In the absence of public market participation and with a much reduced private equity investment pool, large drug manufacturers are likely to become the primary source of funding for small-mid cap biopharma via a variety of established arrangements such a licensing/ marketing agreements, codevelopment, joint-ventures or M&A. The tiered structures of partnerships between these small and large companies have evolved rapidly over the past five years. So has the fluidity with which one type of transaction changes into another via an options-based deal structure. Almost every start-up has conceded some level of ownership to VCs that provided their earliest funding, and option alliances that often represent nondilutive financing offer an attractive alternative to traditional equity investments. To best communicate their value propositions, entrepreneurs need to familiarize themselves with the due diligence process followed by the licensing, business development and M&A teams at big pharma corporations.
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For the biopharma industry as a whole, the most important consequence of the financial crisis will be to accelerate the cooperation between large and small stakeholders along the industrys value chain. This means an effort to find creative deal structures that align the incentives of small and large biopharma companies, CROs and academic institutions. From a big pharma perspective, impending patent cliffs over the next five years have forced them to initiate or import innovation of all types. Thus drug discovery externalization was already an established area of focus for large pharma companies even before the financial crisis. This process has been accelerated by their superior bargaining position in the current funding environment. Figure 2.5: How biotech entrepreneurs hope to deal with the financial crisis
Will try to be acquired Take over undervalued companies Will inlicense earlier Will in-license more Will out-license earlier Will out-license more 0 5 10 15 20 25
Number of respondents
Source: Avance (Corp Finance in Life Sciences) survey, 2008
Figure 2.5 above shows the result of a survey conducted by Avance, a Switzerland based life sciences consultancy. It illustrates that managers at smaller biopharma companies hope to gain funding by focusing on out-licensing as a means of revenue
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generation, and also intend to out-license at an earlier stage of drug development. The traditional sweet-spot for licensing and partnering deals was generally the proof-ofconcept stage (typically on completion of Phase II trials). Restrictive venture capital and IPO activity has forced small biopharma companies to partner earlier. Creative deal making that seeks to limit cash outlays and motivate small company partners is gaining popularity as entrepreneurs and large corporations find new ways of working together. In the absence of public market participation and with a much reduced private equity investment pool, such alliances are becoming the most significant source of biotech funding.
The large pharmaceutical and biotechnology companies import R&D assets from smaller, more focused companies in various ways. The entrepreneur has a choice of arrangements, changing as the R&D lifecycle advances, via which to collaborate with a large pharmaceutical company. Corporate Venture Capital funds (discussed further in Chapter 6) are generally employed to scout for early stage product opportunities that are beyond the parent companys core focus areas. Product licensing, co-development agreements, marketing agreements, etc are employed to plug specific gaps in product portfolios. Joint-ventures and acquisitions can bring in new capabilities/ technologies quickly. Although these transactions can still be grouped together, their intricacies and tiered structures have evolved rapidly. So has the fluidity with which one type of transaction changes into another via an options-based deal structure.
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Figure 2.6 illustrates that most of the early stage assets are owned by smaller, R&D driven organizations. As the R&D process advances, big pharmaceutical companies own a higher share of the pipeline. This is because big pharma companies selectively import R&D assets at the early stages and complete the work in-house to exploit economies of scale. It is also possible that more than one preclinical asset is aggregated together to form a late-stage asset, a process that entails the in-licensing or acquisition of an externally owned asset by a big pharma player. An example of such a situation is one in which a diagnostic platform is developed in conjunction with the drug to develop a composite product. Figure 2.6: Reliance of big pharma on R&D externalization
100 90 5000 4500
Proportion of assets (bar, %)
70 60 50 40 30 20 10 0
Pre-clinical Other Other Phase I Phase II Phase III
3500 3000 2500 2000 1500 1000 500 0
Top 20 companies Top 20 companies
Active preclinical and clinical assets owned by or under exclusive license to large pharmaceutical companies. The line charts represent the number of assets at each stage and the stacked bar charts represent the proportion of assets within top-20 pharmaceutical companies Source: Pharmaprojects, Nature Reviews, Drug Discovery, March 2010 Business Insights Ltd
The process of asset acquisition by big pharma has accelerated rapidly since 1995, especially so in the early stage of development (Pre-clinical and Phase I). Figure 2.7
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Number of assets (line)
80
4000
shows the increase in early-stage deal activity between biotechnology and pharmaceutical companies. The number of Phase II and Phase III deals have also increased, but not at the same pace. Thus the major drug makers are cutting back on their internal discovery and early stage clinical programs. This drive to externalize early stage development has come from the realization that the risks can be better managed by having smaller, disaggregated teams working on exploratory ideas. Figure 2.7: Trends in biotech-pharma deals by development stage
140 120
Number of deals
100 80 60 40 20 0
1995-1999
Pre-clinical
2000-2004
Phase I Phase II
2004-2009
Phase III
Number of deals reported between biotechnology and top-20pharmaceutical companies classified by development stage Source: Pharmaprojects, Nature Reviews, Drug Discovery, March 2010 Business Insights Ltd
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Rapidly evolving deal structures

Pharmaceutical companies, in their quest to shorten the developmental pipeline and increase profitability have long been participating in many types of collaborative agreements with small drug discovery firms. Table 2.2 lists out some of these deal structures. Table 2.2: Established and evolving deal structures
R&D stage Feasibility studies Sponsored research Technology access Collaborative R&D Licensing rights Product licensing agreements Simple license Option-to-license Option-to-purchase Co-development Co-marketing Product swaps Product sale & purchase Single products Portfolios Alternate agreements structures Combined deals Equity investments Royalty monetization
Source: PharmaVentures
Business Insights
The analytical processes followed by business development managers and investors in assessing many types of investment opportunities in small biopharma companies are very similar. This is regardless of the type of deal being assessed, which can encompass buying a product, in-licensing a product, acquiring or licensing technology rights, acquiring a division within a company, or even acquiring a whole company. The legal/financial analysis is inherently very similar in all these levels, and this whole analytic process is an integral part of the due diligence.
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Figure 2.8: Overview of partnering issues
ISSUE
SUB-ISSUE
How do licensors balance the near-term need for capital with
opportunity for increased valuation if programs are partnered at later stages of development?
Partnering now vs. partnering later
this program in spite of partnering now? What is the cost of capital in todays equity/debt markets?
Partnership vs. fund raising

What is the long-term cost of partnering-away a potential revenue
stream?
Are there sufficient data to build a reasonable risk/reward valuation

model?
What are the chances of getting this product approved?
Product considerations
What pricing flexibility will this product have? How can potential reimbursement issues be factored into the valuation
model?
Does this product fill a gap in the pipeline? Can existing development and commercialization infrastructure be
Corporate considerations (Licensee)
leveraged to support the product, or will new resources (manufacturing, sales, etc.) need to be funded?
Whats the opportunity cost to putting money in this partnership

compared with other potential product opportunities?
Source: authors research & analysis
De-risking R&D via options-based investing Big pharma companies use the real-options based investment approach to explore the drug discovery and development landscape externally. The goal is to identify companies with innovative platform technologies/ therapies and good management teams that might push out three or four programs into the clinic over a 3-6 year period. The big pharmaceutical companies purchase an option-to-invest in a promising company/ R&D asset, usually as an upfront down payment. Such an option gives the investor the right, but not the obligation, to continue investing in the asset if predetermined clinical milestones are achieved. The only commitment is to pay for the goals. The down payment on the option is used by the developer to fund certain specified clinical projects. If clinical proof of concept is established, typically at the end of Phase II studies, the bigger partner can choose to exercise its option to take a
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product forward by itself.
Such an approach distributes and shares the risk associated with drug development. The big pharma partner does not directly provide research funding but rather buys options which can be exercised at pre-determined prices at the predetermined stages of development, once new information regarding the success of the initiative emerges. Options also give pharma companies a form of non-debt leverage due to the fact that upfront payments for option agreements are typically lower than taking an outright full license or ownership of an R&D asset.
From the perspective of a small biopharma company, options can be seen as a way to keep a stream of revenue flowing into the company. The model enables them to unlock the real value of their target discovery platform in many more diseases than they would be able to do otherwise. Almost every start-up has already conceded some level of ownership to VCs that provided their earliest funding, and hence the start-ups cannot help but favorably consider option alliances, the up-front payments of which typically represent non-dilutive financing.
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Figure 2.9 shows how the use of such options-based alliances has increased over the past five years in pre-clinical and Phase I stages. Not only have the number of such deals gone up, so has the amount of money invested via options-based approaches. Figure 2.9: Option agreements by top 20 pharma companies (Phase I)
20 40
Number of deals
10
20
10
2004
2005
2006
2007
2008
Number of deals
2009
Average upfront payment
Source: PharmaVentures, PharmaDeals
The use of options-based investing varies from company to company. Some companies use specialist business units, for example GSKs Centers for Excellence in Drug Discovery (CEDD). One of the CEDD units, the Centre of Excellence for External Drug Discovery does not discover and develop drugs internally for GSK like its sister CEDDs but rather explores the drug discovery and development landscape externally to find innovative companies and then form option alliances with them. Other companies also employ similar strategies to a greater or lesser extent. However, it is certain that the use of options-based investment approaches will increase across the board in years to come.
Figure 2.10 below represents the number of deals and money invested using this approach across some of the top biopharma companies.
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US$ million
15
30
Figure 2.10: Reliance on the option model varies by company

15.0 $3000
Number of deals
11.3
2250
7.5
$1500
3.8
$750
Number of deals
Sum of deal values
Source: PharmaVentures, PharmaDeals
Due diligence in biopharma alliances

Determining the most suitable type of deal for the partnering opportunity is among the first steps in the due diligence process. There is a tendency for deals to start in one category and migrate naturally towards another, as further investigation reveals opportunities and problems that were not originally contemplated. Due diligence starts at the pre-deal stage and is conducted from outside the precincts of the target company. The assessments are based on publicly available information to answer fundamental questions regarding the product opportunity before any more resources are expended in a more detailed investigation. For example, perhaps the product/ company in question should not be considered for licensing/ acquisition because its target market is too small, or it cannot successfully compete with incumbent therapeutic options in terms of added value, or because payors are unlikely to offer reimbursement, etc. Thus the predeal due diligence forms the foundation for post-deal due diligence and is critical for a successful transaction.
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US$ million
Once the basic deal terms have been agreed upon, there is a formal process of information exchange that takes place between the buyer and the seller. Such information frequently throws up new questions and negotiating points that were not raised in the preliminary deal analysis and are the subject of post-deal due diligence. All parties involved must keep an open mind and continuously ask questions to test the merits of the contemplated transaction. Figure 2.11: Deal structures and responsibilities
Simplest Most complex
Type of deal
MARKETING ARRANGEMENT OR LICENSING DEAL
CORPORATE PARTNERING OR JOINT-VENTURE
OUTRIGHT ACQUISITION OF A DIVISION OF PART OF A COMPANY
Responsibility
Licensing department of pharma company
Licensing Department or Business Development Unit
Business Development Unit or M&A group
Marketing agreements require the least intensive due diligence effort because the products characteristics are well laid out in terms of its therapeutic profile, label and indications. Licensing agreements are more complicated, especially those conducted prior to Phase III trials, because vital parameters of the products profile need to be anticipated and this involves more probability-based calculations. A joint venture or a corporate alliance/partnering deal is even more complex because joint-ventures involve issues of control whereas corporate partnering frequently has an equity investment element.
This section reviews the rationale for each deal type and allows readers to establish the type of deal that best fits their needs.
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Marketing agreement A marketing agreement confers no technology access to the licensor and usually involves a launched or soon-to-be launched product. It allows great flexibility for both parties and its risks and its rewards to both sides are relatively limited. Therefore, the due diligence requirement is comparatively less demanding. A marketing agreement can be expanded to cover a family of products or a therapeutic field to make use of the commercialization capabilities of the licensor and utilize economies of scale. It can be replicated easily in different countries or regions. For the drug developer it can involve a stream of product-sale revenues or else just the receipt of royalties, paid on a per unit basis or on sales values.
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Licensing arrangement/Product acquisition A licensing agreement or product acquisition typically starts at an earlier stage of the product lifecycle when compared to a marketing agreement, although this is not always the case. It involves a greater level of commitment and confers technology rights to the licensor for a defined period of time in defined geographies. An outright acquisition is more like a full-payout for all commercialization rights. Since pharmaceutical products have a bell-curve shaped sales pattern over a 10-20 year period after which generic incursion reduces the commercial opportunity. These types of transactions are typically handled by a pharma companys licensing department. Table 2.3: Incentives in a strategic licensing arrangement
Licensee Access to new product candidates. Replenished pipeline in the target market /indication. Leap-frog into new therapeutic class or indication without building additional research infrastructure. Diversify development risk across multiple programs. Licensor Access to additional R&D and commercialization resources. A partner with commercialization expertise. Upfront and near-term funding can help build a pipeline and advance development of proprietary programs. Royalties / co-promotion opportunities provide long-term returns. Validation of technology or approach.
Source: authors analysis Business Insights Ltd
Joint venture A joint venture or JV is a way for companies to partner together without having to merge with each other, It involves the creation of a new and free-standing enterprise and is generally taxed as a partnership. The logic for a JV is to provide two companies that have complementary assets with a chance to pool resources and achieve benefits of scale and scope. In a big pharma-biotech context, such benefits can include: Access to new markets via sales or distribution networks
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Sharing of risks and costs of drug development Access to greater resources, including specialized staff, technology and finance
The main problems with a JV are related to control and consolidation, especially in terms of accounting and management rights. Despite these human and accounting problems, a surprising number of JVs exist and some have worked satisfactorily over long periods of time.
Alliance/Corporate partnering This format is basically a means whereby a cash rich big pharmaceutical company (with full manufacturing and sales capabilities) extends its operating, financial and product development assistance to a smaller, underfunded but highly creative company. The smaller company usually does not have the necessary business skills, financial muscle, operational capacity or geographic market presence to fully commercialize its product or technology. For the larger partner, a corporate partnering arrangement achieves a stream of net incremental revenues from eventual product sales, after paying costs such as clinical development expenses, R&D funding, milestones for technical/clinical/regulatory achievements, and royalties. Such details vary depending on the deals particulars.
The first point of investigation for the big pharmaceutical company is to assess whether or not it would be better off acquiring the smaller company outright. If the economies of scale and scope are promising, an outright acquisition may make more sense. However a corporate partnering arrangement gives a more flexibility to adapt, and an acquisition still remains an option that can be pursued later. Often such alliances build in the possibility of an acquisition by including some sort of right of first refusal provision. Corporate partnering deals often include an equity component wherein the larger partner purchases equity in the smaller partner with the hope of capital appreciation of its investment. Therefore the due diligence requirements may be similar to those for M&A transactions.
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Outright acquisition of a company Mergers and Acquisitions require the heaviest and best orchestrated due diligence effort and involve advisory services from investment banks and strategy consultancies. The size of the team involved in such a transaction is larger and includes teams of corporate managers, accountants, lawyers, industry experts, intellectual property experts, etc. Such transactions are usually handled by the M&A department of the big pharma partner.
Conclusions
To best communicate their value propositions, entrepreneurs need to familiarize themselves with the due diligence process followed by the licensing, business development and M&A teams at big pharma corporations. Once entrepreneurs have identified the type of deal that best suits them, they need to develop arguments that convince the bigger of the same.
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CHAPTER 3
Valuing investment opportunities in small biopharma companies
53
Chapter 3
Summary
This chapter deals with the process of assessing the commercial viability of an R&D asset. The asset in question can be a particular project within a biopharma company, a related portfolio of projects, or the entire company itself. All valuations are based on a set of projections such as revenues, costs, profits and cash flows. Even though valuation techniques differ in the way they evaluate the cost of capital and risk, the concept of free cash flows and earnings potential are applicable across the all methodologies. Choosing a valuation method or discount rate is a hot topic when making financial valuations and has been the subject of much theorizing. Business development and M&A teams in large pharmaceutical companies tend to rely on methods such as DCF and risk-adjusted NPV. Venture capitalists and private equity firms prefer estimating enterprise value by comparing it to what other investors are willing to pay for similar opportunities. Deals based on an options-based valuation structure are better able to offer fairvalue to both parties because financial and strategic commitment can be deferred to the point in time when new information becomes available. The pricing-positioning trade-off has become a critical component of the due diligence involved in assessing the commercial potential of a medical intervention. The impact of a certain pricing-positioning strategy on the budgetary dynamics of healthcare providers is now a key input in forecasting the real-world uptake of the product/ technology asset.
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Introduction
This chapter deals with the process of assessing the commercial viability of an R&D asset. The asset in question can be a particular project within a biopharma company, a related portfolio of projects, or the entire company itself. The first part of this chapter discusses the valuation methods typically used by investors, entrepreneurs and advisors. The second part discusses the fundamentals of assessing the commercial potential of an R&D asset.
Even though valuation techniques differ in the way they evaluate the cost of capital and risk, the concept of free cash flows and earnings potential is applicable across the nearly all methodologies; regardless of whether the asset in question is a biologic drug, a typical pharmaceutical small molecule, a diagnostic test or medical device.
Valuation methods and usage Different types of investors prefer to use different methodologies. There are many different opinions regarding what is the correct method and discount rate to use. This section discusses the different valuation methods preferred by different types of industry professionals. The purpose is to make the parties aware of each others preferences and thus facilitate communication.
Private equity/ venture capital investors tend to value biopharma assets based on what others are paying for similar transactions. This methodology suits them best because the overall economic climate is currently recessive, and biotechnology assets are not on the radar of non-specialized investment firms. Entrepreneurs who have to communicate the above-average value proposition of their companies have to rely on the more fundamental, future cash flow-based valuation techniques. Thus choosing a valuation method or discount rate is a hot topic when making financial valuations and has been the subject of much theorizing. The methods most known to industry professionals
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include the Discounted Cash Flow (DCF), Risk-adjusted Net Present Value (rNPV), Real Options and Comparables.
Table 3.4 provides an overview of the different viewpoints on and approaches to biotechnology valuation A more detailed description follows. Table 3.4: Overview of valuation methods
Method Discounted Cash Flow (DCF) Description Future free cash flows are totaled. The total is discounted using the WACC* plus a component for risk. Modification of DCF. Cost of capital and probability of success are calculated separately. Includes valuation of management flexibility. Step by step valuation enables managers to wait for information to emerge and uncertainty to decrease. Pragmatic but simplistic approach. Opportunity is compared to what others paid in a similar transaction. Usage Widely accepted across a range of industries.
Risk-adjusted Net Present Value (rNPV) Real options
Clearly accepted as more relevant to the biopharma sector. Widely used. Not widely used, but considered appropriate for the biopharma sector due to its ability to tackle high-level of risk/ uncertainty.
Comparables
Widely used in early stage investments when future cash flows are difficult to predict.
* WACC Weighted Average Cost of Capital

Source: authors analysis Business Insights Ltd
Discounted cash flow This classic valuation method based on free cash flow analysis is widely used across a broad range of industries. DCF is considered a strong tool because it focuses on the cash generation potential of a business. All future cash flows are estimated and discounted to give their present values. The Net Present Value (NPV) of an asset is the sum of all future cash flows, both incoming and outgoing, discounted to the present using an appropriate discount rate. This discount rate has two components- the
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investors cost of capital (i.e. the payments investors have to make to leverage such a transaction) and a component representing the risk of failure of the project. The overall discount rate is therefore higher than just the companys Weighted Average Cost of Capital (WACC).
Only VCs tend to avoid this methodology as they invest in earlier stages of the pipeline and their paths to exit are normally based on sale of the asset to a strategic investor. However, even VCs must use the DCF methodology to assess how much strategic buyers like big pharma corporations will pay for the particular asset in future.
Risk-adjusted net present value The rNPV or Expected Net Present Value (eNPV) method is a modification of the standard DCF calculation. Each future cash flow is first identified, and then the value of each is adjusted based on its probability of occurrence. These adjusted values are discounted back to the present moment using the investors Weighted Average Cost of Capital (WACC). Unlike the DCF method, this discount rate does not include an additional component for risk, since the risk factor has already been considered in assigning the probability of occurrence for each cash flow. Thus the two discount factors the average cost of capital and the success rate of the project are calculated separately. The discount rate used should therefore be equal to the companys WACC.
The rNPV method allows valuation professionals further granularity in incorporating the probability of success of a project. While the DCF method clubs all components of project risk into a single quantifiable discount factor, the rNPV allows to risk to be assigned to each component separately. The rNPV method is now the defacto standard in the valuation of biotechnology companies/assets.
Real options Both the DCF and rNPV methodologies suffer from the disadvantage of not being able to incorporate management flexibility into their valuations. They assume that the strategy deemed appropriate at the present moment (when an investment opportunity is
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being assessed) will remain the most suitable in future. In this sense, they are static valuations of assets that evolve rapidly in earnings potential. Thus it has been argued that the DCF and rNPV valuation methods are not sufficiently robust when valuing high risk projects, such as biopharma drug development.
The Real Options approach addresses these objections by providing management with the ability to actively modify the project after the initial investment decision is taken should the need arise. This flexibility can reduce the risk associated with a project, and hence increase its value. Such a strategy seems appropriate for long-term, multi phase investment decisions - which are the norm with most biotech investments. Although the use of an options-based approach to investment is gaining ground, it is used by only a minority among biotechnology valuation specialists. The bulk of industry professionals still use DCF and rNPV based methodologies, and the need to speak a common language is restricting the usage of real options as a valuation tool. However, it can be said with certainty that use of this approach will continue to gain ground, starting with biotech-pharma alliances and moving into the broader investment community.
Comparables Many investors believe that the best way to value an investment opportunity is to compare it what others are willing to pay for a similar opportunity. This makes sense for valuing well established, publicly traded companies where earnings ratios and cash flows are well defined and easily compared. Such a method is also applicable at the early stages of drug development when future cash flows are difficult to predict. Therefore comparables are widely used by VCs and other private investors to target the early stages of drug development. It is argued that the comparables method best reflects market value and that market value is real value. This is a pragmatic argument. It is common for an asset to be valued via the traditional DCF/ rNPV approaches, and then juxtaposed using the comparables approach to adjudge a fair value.
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Figure 3.12 below compares the usage of financial valuation methods by different stakeholders in the biopharma investment value chain. Figure 3.12: Primary valuation methodology by investor type, 2009
Valuation experts
60% 50% 40% 30% 20% 10%
10% 60% 50% 40% 30% 20%
Biotech/ Pharma professionals
0%
DCF
rNPV
Real-options Comparables
other
0%
DCF
rNPV
other
60% 50% 40% 30% 20% 10% 0%
Venture Capital investors
DCF
rNPV
other
Source: Financial valuation methods for biotechnology, Biostrat, Denmark
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Assessing commercial potential

Biopharmaceutical companies are typically valued on the basis of the cash flows their R&D asset is likely to generate. The whole process is based on a set of projections such as revenues, costs, profits and cash flow. This is a complex exercise that varies enormously, depending on the type of asset and the eventual goal of the investor.
For example, if the investor is a pharmaceutical company that intends to commercialize the product by itself, the entire sequence of due-diligence activities is relevant to the eventual valuation. If the investor is a financial institution (like a private equity firm or venture capitalist) that intends to sell the assets to another strategic investor, only components of the sequence are relevant. Figure 3.13: Assessing the net earnings potential of a medical intervention
Present value of future cash flows
Revenues
Costs
Volume potential
Pricing and market access
R&D, Regulatory, etc
Sales & Marketing
Manufacturing & miscellaneous
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Sales potential The first step in judging sales potential is to estimate the number of patients that are in need of a therapy to address their therapeutic concerns. Data on the epidemiology of a disease, such as incidence, prevalence and demographic trends are available from a variety of sources. Such data is gathered, verified and forecast for each individual market in which the R&D asset is to be commercialized. Treatment algorithms are studied to assess how the physician community typically treats the disease. Therapeutic guidelines issued by representative bodies (for example the American Heart Association in the case of cardiology diseases, or prescribing guidelines for specific health plans) provide the best reference points. On the basis of such information, the number of patients that are eligible for pharmacological therapy is estimated. Figure 3.14: Assessing revenue potential
Disease prevalence, epidemiology, demographics
How many patients suffer from the disease? How many patients are eligible for pharmacological treatment? How is this number likely to change over the product lifecycle?
Patient populations
Treatment algorithms
Volume potential
Competitive landscape
Which therapies are currently employed to serve this patient population? Will market/ scientific developments alter this scenario during the life cycle?
Ability to gain market share
Fulfilment of unmet medical need
Does the drug add value to the evolving treatment landscape? Is the value established via good clinical trial data?
What level of market access can be expected if the price was comparable to main competitors? Ability to commercialize Does the company possess the necessary sales infrastructure to reach physicians in this therapeutic area?
The next step is to assess the competitive strengths of the drug vis--vis other therapies
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that address the same patient populations. It is best to clearly define the unmet needs within the disease spectrum, which the current therapeutic options do not adequately address. Clinical pipelines and scientific literature can reveal other drugs or technologies under development that can potentially alter the spectrum of unmet needs.
Given the target product profile of the R&D asset, discussions with industry experts can elucidate whether or not the asset fulfills these needs, and if so, to what extent. Based on such reactions and other clues from the marketplace, analysts estimate the market share the R&D asset is likely to gain. Based on such information, probability based scenarios can be developed and further investigated. In such a way, the R&D assets ability to penetrate the market is assessed by juxtaposing its profile with those of current/ future competitors.
The final piece is to assess the ability of the investor (or, strategic buyer if the investor intends to further divest the asset) to capitalize on the strengths and weaknesses of the asset, given their internal resources and capabilities. Now that the market potential has been identified, what will it take to successfully commercialize the asset via sales and marketing? The issue of price can be layered on top of this estimate to develop a more representative picture of the incoming cash-flows.
Pricing and positioning So far we have ascertained the number of patients likely to be given the drug if price were not a key consideration in a physician and/or patients choice. However, given the restrictive budgetary environment facing healthcare providers, pricing is a very critical issue. Not only does it directly impact the revenues generated from a given patient population, it determines the number of patients the drug is likely to be indicated for by payors and regulators. This is why drug positioning and pricing are inextricably interlinked. If the proposed price of a drug is too high, payors are likely to restrict its usage to relatively smaller patient populations via prescribing guidelines, step-therapy or outright removal from the formulary. Conversely if the price is considered affordable, payors are more likely to grant access to a wider patient population. Hence,
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pricing-positioning impacts strategic planning, due-diligence and strategic marketing on multiple dimensions. Figure 3.15: Pricing and positioning
Economic value
Which drugs can be considered adequate comparators, based on their therapeutic profile and place in the treatment algorithm? How does the proposed price of the drug compare to its comparators? What level of clinical value does the drug add over its comparators? Are payers likely to pay extra for this level of improvement?
Proof of value
Clinical value
Pricing & positioning

What market share is the drug likely to gain over its comparators? Budget impact From which brands will the incoming drug cannibalize market share?
Ability to pay
Prevailing sentiment
How will the economics of the payers change, if the drug is granted access to the proposed patient population at the proposed price? Is the payer likely to tolerate such changes in expenditure?
The underlying principle in drug pricing is the balance between the incremental economic and medical value added by the drug in comparison to its comparators. For example, if the R&D asset under investigation is likely to be indicated for patients who have not responded adequately to currently established first line therapeutic options, the comparators are likely to be the incumbent second line drugs. By investigating the cost of treatment of established competitors, and assessing the willingness of payors to reimburse those levels of costs, analysts can gauge an approximate price band for the R&D asset in each individual market. Individual markets follow their own systems of pricing, based on health technology assessments, reference pricing, economic evaluations, etc. If the R&D asset clearly adds value over and above the incumbent
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comparators, analysts need to identify the specific ways in which the value is added. For example, a clear improvement in safety and/or efficacy is likely to command a price premium over incumbent therapies, whereas a smaller improvement, such as compliance advantages, may be less likely to warrant the same. Figure 3.16:
STATUS QUO (no coverage)
Impact of incoming therapies on payor budgets

FULL COVERAGE
Overall market forecast
Segmentation by products
Additional market growth due to incoming drug Market forecast by product (under status quo)
Incumbent market shares/ dynamics
Source of business for incoming therapy
Market forecast by product (under full coverage
COST UNDER STATUS QUO
BUDGET IMPACT
COST UNDER FULL COVERAGE
Given a proposed price and specified health outcomes, the next step is to assess the impact on the budget of healthcare providers. Although the specific research can be very complicated, the following general rules apply: If a drug is therapeutically superior to its comparators and is priced at the same level, it is likely to be granted access to a similar/ greater number of patients If the drug is clinically superior to its comparators, and is priced at a premium, the level of access will depend on the magnitude of therapeutic improvement If a drug is therapeutically equivalent to its comparators and is priced at the same level, it is likely to be granted access to the same patient population
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If the drug is not therapeutically superior, and is priced higher, it is not likely to be granted access/ reimbursed.
Cost of commercialization The costs of drug development and commercialization can be grouped into three broad categories, as shown in Figure 3.17. The first components are the costs related to research and development. The critical assessment is the scale and scope of further preclinical research/ clinical development that will be needed to get the R&D asset approved by healthcare regulators. Once this has been established, the various means of achieving these landmarks are assessed. Figure 3.17: Development and commercialization costs
What will be the scale and scope of the clinical trials required to get the drug approved? Can the R&D be conducted in-house, or does the company have partners that can conduct the trials cost-effectively? Will other technology platforms/ intellectual property need to purchased/ licensed in order to fulfil R&D requirements?
R&D
How loyal are physicians to competitor drugs? What size of a sales force will be required to market the drug? What levels of reach/ frequency of sales calls will the team have to implement? Which other activities will have to be conducted to spread the brand message?
Costs
Sales & marketing
Manufacturing
Is the drug a small molecule that can be easily manufactured and stored? If so, can APIs be easily sourced? Is it a biologic that will require special facilities? If so, will other technologies need to be in-licensed/ developed for cost-effective manufacturing?
Biopharma entrepreneurs have traditionally divested their drug assets once Phase II trials have been completed and a proof-of-principle established. But this is not a
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general rule, and investors/ drug developers usually try to attract investment at the most appropriate point of value inflection for that particular therapy/ technology.
Sales and marketing costs are typically dominated by the expenditure on sales personnel in reaching out to the physician universe. Other marketing expenditures such as conferences and information support do not require the same magnitude of financial resources as a well-motivated sales team. If physicians are extremely comfortable with their incumbent therapeutic options, or if the R&D asset belongs to a relatively new and unknown category, the sales team will have to spend time and resources in educating physicians about its relative advantages. This is a costly process.
The final component is manufacturing and cost-of-goods sold. These are fairly straightforward for typical small molecules, but can be murky for new biologics and protein-based therapies.
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CHAPTER 4
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Chapter 4
Summary
In the context of this chapter, all firms investing in non-publicly traded equity are classified as private equity investors. These include angel investors, venture capitalists, private equity funds, mezzanine funds, funds-of-funds, and others. Although each operates along different stages of a companys lifecycle, traditional operating niches have been greatly stretched as the -funding model evolves to keep pace with the changing landscape. Private equity firms are willing to consider earlier stage companies and VC firms are willing to lower yield requirements in securing later stage opportunities. Unlike earlier years, the term sheets for biotech funding are no longer investor friendly, and include multiple clauses that limit the risks to the investor. With less venture funding available, small biotechs have to sacrifice more to raise funds. To maximize the chances of raising funds, the seller must anticipate the preferred exit strategy of the target investor and build the valuation with this end in mind. Biotechs that require high levels of capital expenditure are out of favour with private equity investors, who prefer to invest in leaner organizations with a greater ability to adapt to changing priorities. Even venture funds are wary of investing in companies that have committed large resources towards fixed assets that may or may not be required as their R&D strategy evolves. There is a limit to the extent of managerial/ strategic input that investors can provide, hence communicating a sound business plan goes a long way in reassuring investors of the safety of their capital. The entrepreneur must make it easy for the investor to assess the people behind the business, specifically in terms of their ability to prudently manage an organization with a high burn rate. Since many aspects of the job are intangible, the seller must think of ways to communicate their ability.
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Introduction
In the context of this chapter, all types of firms investing in non-publicly traded equity are classified as private equity investors. Such a definition includes a wide variety of players, from angel investors to venture capitalists to private equity firms. Although each type operates along different stages of a companys lifecycle, traditional operating niches have been greatly stretched as the biotech-funding model has evolved to keep pace with changing landscape.
The primary driver of change is the increased need to collaborate following the collapse of IPOs as an exit strategy. Private investors like VCs and private equity firms do not have the patience and appetite to hold ownership of R&D assets until the commercialization stage or, increasingly, until Phase III clinical development. Their primary exit strategy over the next five years will be to divest the asset to another strategic buyer that operates along later stages of product development- most often a big pharma company. Thus private investors are looking towards expanding beyond their historical operating niches or stage of investment. This chapter describes their historical stance and comments on how it has changed over the past five years.
Stages of investment The first growth stage of the company is when an idea is generated and the intention to pursue it as a commercial business is formalized. This has been labeled the seed stage, wherein the company has just been formed or incorporated and is busy developing its core product or service. The most common priorities for the founders include completion of the prototype and business plan, and simultaneous IP protection. Additional collaborators/partners in academia may be sourced, and facility/funding needs identified.
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Table 4.5: Stages of equity investing

Stage Seed Start-up Early stage Mid-stage Late stage Established Investor type Founders, Angel investors VC, Seed funds, Angel investors VC, Private Equity firms Seed funds VC, Private Equity firms VC, Private Equity, Mezzanine Private Equity, Buyout Activity Proves a concept Product development Continued product development Expansion, early revenues, not yet profitable Expansion, relatively stable revenues, profitable Recapitalization, slower growth in maturing markets
Source: authors analysis
Once this has been accomplished, the company typically enters the early stage of its lifecycle. It has a core management team and a possibly a proven concept/ technology, but no positive cash flow. Additional senior management may be recruited and VC/angel investor relationships developed. A roadmap for pre-clinical research, clinical trials and regulatory approval is laid out, and the workforce is expanded.
Table 4.5 summarizes the stages of equity investing and shows that VCs focus on startup and early stage companies. However, venture investing may, under certain circumstances, also be appropriate for companies further along the development/ commercialization pathway.
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Figure 4.18: Company growth stages and funding sources
INCUBATION PERIOD
COMMERCIALIZATION
MATURITY
EXPANSION
IPO, Acquisition
REVENUE
GROWTH Banks, VC/ Private Equity IDEA START-UP PILOT Founders Angel investors, Seed funds ROLL-OUT Venture Capital/ Private Equity
TIME
After the company has received one or more rounds of financing and is generating revenue (or is in a position to generate revenue in the short to midterm), the senior management focus typically shifts towards expanding the market, product portfolio and workforce. The main concerns at this stage include follow-on funding, development of the pipeline, new market development, and management/workforce expansion. Once these challenges have been overcome and the company is mature and profitable, the management has to plan for further development. Perhaps the company has gone public or has plans to do so. The senior management focus now shifts to other issues such as their next-generation strategy, global market expansion, facilities expansion/relocation and management/workforce expansion.
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Investors: definition, overview

Private equity is capital that is not quoted on a public exchange. It is typically defined as capital invested in private companies by way of equity, usually not secured by assets. The scope of such investing covers diverse stages of investment and a range of industries (typically excluded are real estate, natural resource extraction and retail). Such investors make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity.
Private equity capital comes from many types of investors such as Venture Capital firms, Leveraged Buyout (LBO) firms, Mezzanine funds and Secondaries / Funds of Funds. Most such entities are institutional investors and accredited investors who can commit large sums of money for long periods of time. The companies gaining the investment usually require long holding periods before the investors can exit their investment via a liquidity event such as an IPO or sale to another strategic investor. Such investors target multiple companies, technologies and therapeutic areas, thereby distributing their risk by putting smaller amounts of capital in play among a variety of companies. On the other hand, drug developers typically place a more focused bet on a single technology or therapeutic area. Their avenues for mitigating risk include diversifying their funding sources or broadening their R&D mandates by branching out into related therapeutic areas.
Distinction between private equity and venture capital funds Historically, VC funds have provided high-risk equity capital to start-up and early stage companies whereas private equity funds have provided secondary sources of equity to companies that are more mature in their corporate lifecycle. Again, traditionally speaking, VC firms have higher hurdle rate expectations and can be more mercenary with their valuations. This reflects the historic trend when VC firms invested at more risky stage of the companys development. Their investments are more long-term because the companies they invest in tend to be young and rapidly
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growing businesses that require time to develop into profitable organizations.
Private equity funds tend to invest in more mature companies where there is greater potential to increase company value via restructuring and exploiting economies of scale. This is because the potential for capitalizing on operational efficiencies is greater in more mature companies. There is also an implicit expectation that their investments are relatively more liquid than those of VC funds.
While the above descriptions are technically correct from a historical perspective, the lines between VC and private equity investments have been blurred by increased competition over the last few years. This has forced both VC and private equity firms to expand their respective investment horizons. These days private equity firms are willing to consider earlier stage companies and VC firms are willing to lower yield requirements to be more competitive in securing later stage opportunities.
In the context of the small-mid cap biopharma sector and hence in this report, both private equity firms and venture capital firms have been clubbed into a single category.
Angel investors A pure startup company often obtains its first round of funding via a seed round which typically involves small investment amounts. Such finding is often obtained from an angel investor.
An angel investor is a wealthy individual, acting alone or in a group, that makes small investments of his or her own personal capital in early stage companies. If the seed round is successful, the company will often require several rounds of venture financing before the angel investors are able to exit their investment through an initial public offering (IPO) or, more commonly, a sale to a strategic investor.
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Venture capital funds A venture capital fund invests in early stage companies in need of capital for growth. The companies they invest in usually do not have stable cash inflows and the investment is made on the premise that such inflows will occur in future. VC funds usually structure their investments as preferred stocks, although this is not always the case. They will usually take a minority, non-controlling stake in the company and may often syndicate the risk of the investment among a number of firms.
There are two key criteria that differentiate venture capital from more conventional sources of capital. A VC investment typically: Involves minority equity or quasi-equity participation (owning common shares outright, or having the right to convert other financial instruments into common shares) in a private company; Is expected to be a long-term investment (generally from three to eight years); and requires active involvement by investors in the companies which they finance until they are sufficiently developed for disposition.
It is important to recognize that venture capital represents an active rather than a passive form of financing. All VCs strive to add value, beyond capital, to their investments in an effort to help them grow and to achieve a superior return. Doing this requires active involvement and almost all VCs will, at a minimum, want a seat on the board of directors. It is also important to recognize that although a VC fund invests for the long haul, it does not imply forever. The primary objective of VC investors is to achieve a superior rate of return through the eventual and timely disposition of investments. A good VC will be considering potential exit strategies from the time the investment is first considered.
Mezzanine investors A mezzanine investor provides later stage investment to companies that already have incoming cash flows via sales of a product or service. Such an investment is invariably
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short-term in its focus, with the purpose of helping a company achieve some critical objective such as an initial public offering or achieving a critical clinical milestone. Such transactions are usually financed via purchase of debt-like securities, which have greater seniority than equity in a companys capital structure (typically at the subordinated debt level).
The securities may feature an accumulating or current pay dividend and will often include equity warrants. Due to its lower risk tolerance and investment in less risky securities, the mezzanine investor typically receives a lower return than other private equity investors.
Venture investors versus buyout investors Private equity investors can also be classified as venture investors and buyout investors, depending on their strategic motivation. Venture investing is about understanding the impact of products and technologies on markets while buyout is about control and deal structure. A venture investor is by nature an optimist who looks for ways to exploit a commercial of a business idea, while a buyout investor is concerned about worst-case outcomes and tries to mitigate risks through deal structures. Buyout investors are not especially relevant to the funding landscape of small, emerging biopharma companies, and have been excluded from the following analysis.
The people participating in venture investing can be broadly classified as either business builders and idea investors. The former are typically serial entrepreneurs or industry veterans who have a thorough understanding of the operations of the businesses they invest in. This gives them the ability to provide direct assistance to the management teams of their portfolio companies. In the course of their careers, such individuals develop an extensive network of industry contacts from their previous industry and investing experience. Such contacts are part of the value they bring to the table when investing in a new venture.
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Idea investors exist at the other end of the spectrum. Such individuals seek to identify gaps in an industry or areas of need that have not been fully serviced. They usually understand the commercial dynamics of an opportunity before others, and seek to capitalize on this understanding before the broader investor community is aware of then. They may have less domain expertise than business builders and hence invest across a broader range of companies. Most private equity investors exist somewhere between these two extremes.
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Process of getting new investment

The process of new investment begins with the introduction of an entrepreneur's idea. The introduction might come from other entrepreneurs, industry leaders, service providers, mutual contacts, or through the investors website. The investment opportunity is formally communicated to private equity firms via a concise overview or executive summary of the business plan. If this appeals to the investor, it is followed up with an initial meeting with the entrepreneurs to better evaluate the team and the opportunity. Figure 4.19: The deal funnel at a typical VC firm
Incoming deals and interesting prospects First meetings and basic due diligence Extensive due diligence
The ever contracting funnel. Hundreds of incoming offers and interesting prospects are funnelled down to perhaps 5-10 closed deals.
Term sheet
Closed deals
If, the opportunity remains attractive after this meeting, the investor begin the due diligence exercise. This involves assessing the market opportunity and the managements capabilities. Activities include discussions with physicians/market experts, scientists or technologists, completing detailed market research, and checking management references. Following successful completion of this review, the
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entrepreneurs are usually invited for an in-depth discussion. At this point, the investor might agree to invest immediately, or may decide to follow up with more questions before making a decision, often involving additional members of the team. The onus is always on the investor to complete this process as quickly as possible and to give opinions and feedback to the entrepreneur along the way. If the final go-ahead is given, a relatively standard sequence of paperwork commences. This is described in more detail in Figure 4.20 below. In the following section of this report, various issues mentioned above are discussed in further detail, keeping in mind the current/future investment climate and priorities of both parties (the entrepreneur and investor).
Term sheets Figure 4.20: Sequence of documents

Key financial amounts and other terms Amount of money Financial instruments Valuation
TERM SHEET
SUBSCRIPTION AGREEMENT
Details of the investment round Number/ class of shares Payment terms Milestones
INVESTORS RIGHTS AGREEMENT
Investor protections Consent rights Board representation Non-compete clause
ARTICLES OF ASSOCIATION
Rights attached to various share classes Procedures for issue and transfer of shares Procedures for holding of shareholder/ board meetings
The term sheet is perhaps the most critical element of the investment process once the decision to invest has been made. It outlines the most important details of the transaction like the valuation, type of security (common shares, preferred shares, etc),
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liabilities and other terms. In the late 1990s and early 2000s, such terms sheets tended to be very investor friendly, reflecting the bullish economic climate. Investors were more worried about losing out on a promising investment opportunity than the repercussions of investing in a failed venture.
In the restrictive economic climate we have today, VC funding for risky biopharma assets has decreased substantially, turning it into a buyers market. Todays term sheets are anything but investor friendly, and include multiple clauses and terms that limit the risk of the investor. With less venture funding available, small biopharma companies have to sacrifice more to gain investment. Unless the entrepreneur presents an unusually attractive investment opportunity, it is better not expect much negotiating power at the term sheet stage. Investors tend to include multiple provisions focused on the exit strategy. These may include a liquidation preference, redemption of the securities purchased by the investor and registration rights.
Type of security The type of security/ financial instrument that investors purchase tends to reflect the exit strategy and associated risks that they foresee when making the investment. Since early stage biopharma assets are inherently risky, a great deal of thought if given to such details, which are specified in the term sheet and further elucidated in the investor rights agreement.
For example, if investors are worried that the company will be sold at a discount or dissolved before its value inflection point, they may use a promissory note to try to protect their investment by having a liquidation preference. Such clauses protect the investor by stipulating that that if the company is sold or dissolved, the investors investment or a multiple thereof is paid back in full before any funds are paid to other stockholders. For the entrepreneur, it may even be easier to manage the concerns of different investors via convertible promissory note structure rather than negotiating a series of individual stock purchase agreements.
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All types of stock are not equal. The main types fall into three categories: Common stock (also called ordinary stock) is the normal type of shares that companies issue. Common stockholders are on the bottom of the seniority ladder within the ownership structure. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders have been paid in full. The upside is that common shares usually outperform bonds and preferred shares in the long run. Preferred stock. Preferred stock is the most frequently used investment vehicle for private equity investments. It is created by amending the companys certificate of incorporation to include the type and amount of preferred stock issuable and the rights and privileges of the preferred stockholders. Preferred shares are senior to common shares during the disbursement of dividends (i.e. preferred share holders will receive dividends before common share holders). Similarly, in the event of a sale or liquidation of a company, the preferred share holders are paid before common share holders. The specific terms of the preferred stock are heavily negotiated and detailed in the term sheet. Promissory note. A promissory note is a written promise to repay a loan or debt under specific terms - usually at a stated time, through a specified series of payments, or upon demand. It identifies the parties, the amount of the obligation, and usually includes the terms of repayment and interest rate which will apply. It may also include an "acceleration clause" which will make the entire amount of the note due if a payment is missed. Convertible promissory note deals are common in very early stage investing or in so-called bridge financings (short-term loans made in anticipation of subsequent equity financings).
Board representation Typically, the first board of directors consists of a minimum of three people including the owner/founder or the first president. As the venture grows and becomes more complex, additional board members are brought in. Ideally each brings a special background that adds value to the total board. Given the varied challenges faced by
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early-stage biopharma assets, the overall board should contain individuals skilled in the technical aspects of most such challenges. A pattern of backgrounds needs to be developed to ensure that the board is balanced and valuable. Figure 4.21: Board size: advantages and limitations
Advantages
Sense of ownership and responsibility for the work
Limitations
Small boards
Easier Communication and interaction Board members know each other as individuals, creating unity Better inter-personal relationships, feeling of satisfaction from the work Fewer administrative staff are required
Limited opportunities for diversity and inclusiveness Fewer skills, perspectives are represented Heavy work load Fewer people are available to serve on committees Board has less continuity in times of leadership change
Members may feel less individual responsibility and More opportunities for diversity and inclusiveness less ownership of the work May hinder communication and interactive discussion Cliques or core groups may form, deteriorating board cohesion May not be able to engage all members, which can lead to apathy and loss of interest Meetings are more difficult to schedule; more staff time is needed to coordinate board functions
Large boards
More seats allow for inclusion of legal and financial advisors, community leaders and funding area experts More people are available to serve on committees Fundraising may be easier because there are more people on the board with more connections Helps maintain institutional memory in times of leadership change
Source: Adapted from MaRS DD, Toronto
When boards get too big, members find it easier to miss meetings. They also find it difficult to hold a reasonable discussion wherein everyone interacts. This situation can lead to the formation of subcommittees of the board where certain directors have greater expertise on a certain issue. This is the usual reason for establishing an executive committee that includes a few key board members. It is easier to get this group together more often. Nevertheless, subcommittees have the potential of lessening the effectiveness of the board. So the general rule is to create few subcommittees, but to have them for at least audit and compensation, and to utilize there the independent (i.e., non-management) directors. It would be common and expected that a large investor would be entitled to at least one board seat but uncommon to give the investor
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enough seats to control the board. Investors normally require an agreement with the company and the other stockholders regarding the investors rights as a stockholder. These voting agreements usually contain provisions permitting the investor to designate board members and prohibiting the company from taking certain actions without the investors approval. It is best to heavily negotiate these aspects at the term sheet stage of the transaction as they will restrict the entrepreneurs ability to run the company as they see fit.
The bylaws of the venture should set a maximum number of directors and the board must endeavor to maintain this level. It is necessary to check the appropriate governing legislation or accreditation guidelines to determine any regulations related to board size. It is also better to have an uneven number of board positions to avoid the problems that might arise from a tie vote.
Valuation The valuation of a biopharma asset is based on a thorough due diligence process that involves looking at the company and its prospects, the values for comparable assets, the overall economic climate and cost of capital. Based on such assessments, investors decide on what portion of the companys total equity they will purchase.
The technical aspects of an assets valuation have been dealt with in Chapter 3. This section covers some practical concerns and general comments derived via interviews with venture capitalists and private equity firms.
At its core, a valuation depends on a set of projections and probabilities associated with anticipated revenues, costs, net profits and most importantly, cash flows related to a biomedical asset. The actual valuation is a combination or art and science, which leaves room for considerable disagreement between the negotiating parties. The entrepreneur can mitigate much of this disagreement via good preparation and communication.
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Most importantly for the seller, this involves anticipating the preferred exit strategy of the target investor and building the valuation with this end in mind. For example, if the investor is a venture capitalist who is unlikely to hold the asset until regulatory approval, the pre-deal valuation must resonate with what the VC can realistically get for the asset at a certain point of time in the future. Most VC investors do not retain an asset till operational revenues via market launch start flowing in. Hence in such a scenario, epidemiology-based revenue projections may be secondary to the perceived value as established by comparing the investors proposed exit transaction to similar transactions for assets with the same risk-reward profile.
In the process of negotiations, it is important to differentiate between the pre-money and post-money valuation, both are valuation measures of companies. Pre-money refers to a company's value before it receives outside financing or the latest round of financing, while post-money refers to its value after it gets outside funds or its latest capital injection. Pre-money valuation refers to the value of a company not including external funding or the latest round of funding. Post-money valuation, then, includes outside financing or the latest injection.
Capital expenditure In early 2009, there were dire predictions on the fate of most small biotechnology companies because of their high burn rate and capital expenditure. A barrage of research pointed to the fact that most small biotechnology companies had less than one year of working capital remaining- i.e. unless fresh funding was found, they would not be able to continue operations beyond 6-12 months. In fact, most such biotechnology companies have weathered the storm, but only by careful fiscal management and greatly reduced R&D goals.
If business strategy was pre-determined and hence the R&D mandate kept unchanged, it would be cheaper to invest in fixed assets that are depreciated or amortized over a period of 4-10 years. However, todays existential realities dictate that the business strategy (and hence R&D mandate) must be kept fluid so that the firm can capitalize on
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new opportunities and extricate itself from failed projects. Such changing priorities have made it difficult for entrepreneurs to commit resources towards capital expenditure, and have made VCs wary of investing in companies that have committed resources towards fixed assets that may or may not be required as their R&D strategy evolves.
Technically, Capital expenditures (CapEx) are expenditures that create future benefits. Examples include the development of infrastructure and acquisition of equipment. Such assets are typically fixed and relatively illiquid; much against the prevailing need of the hour. Thus strict control of Capital expenditure has become a major part of the due diligence process of VC investors. Fixed assets are fixed, leaving little room to maneuver and adapt business strategy to an ever-changing external climate.
In the currently recessive investment climate, VCs prefer to invest in companies that minimize CapEx and carry out their activities via operational expenses. Therefore CapEx should be minimized and activities managed through operational expenditures.
Companies requiring high levels of capital expenditure need to raise proportionately higher amounts of financing at each successive round of funding. The amount of funding required is directly proportional to the dilution of ownership existing investors will suffer. Thus investors are acutely sensitive to the capital expenditure requirements of the companies they invest in. Entrepreneurs must make it absolutely clear to potential investors that money will be carefully managed. Keeping a low CapEx to operational expenditure (OpEx) ratio is one way of being capital efficient, especially for small biotechs for which acquisition is typically the ultimate objective.
Single versus multiple investors Even in todays recessive economic climate, a small biopharma company that offers a convincing value proposition will find many interested VCs and other private equity investors. The entrepreneur is left with a choice between sticking with one VC or
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gaining possibly larger funding via a conglomeration of investors. As always, there are upsides and downsides of having a single versus multiple investors.
Having a single investor often simplifies day to day management- making it faster and less tedious. The overall transaction may even be more beneficial to the seller, although this is not necessarily the case. On the downside, the entrepreneur fate is more closely tied to that of the single VC. The industry networks, contacts and strategic expertise that the investor can provide will be more limited in scope (as compared to a group of investors, each with their own expertise and contacts). Moreover, if the single investor declines to participate in the next round of funding, the entrepreneur has to start from scratch once again. Such a possibility is greatly reduced if there are multiple investors in earlier rounds because there is a better chance that at least one investor familiar with the company and its technology will be able to participate in subsequent financings.
With multiple investors, operational aspects of investor relations and communication can be more cumbersome for a thinly staffed biotechnology company, although this advantage is more than compensated by the greater availability of money and expertise.
Investor priorities in the new landscape

During due diligence the investor will examine multiple aspects of the company such as the technical expertise of the founders and key scientific employees, the market conditions and competition, the patent and trademark/branding positions of the company and clearance over any third-party intellectual property (IP) in the space, the R&D pipeline and future patent protection, the status and estimated cost of upcoming clinical trials, the status of US FDA interaction and approval, the in-license and outlicense agreements the company holds, the agreements with employees and consultants such as contract research organizations, and many other issues. Such issues are discussed in further detail in this next section of the report.
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There are certain standard questions that start-up biopharma/ medical device companies must ask themselves before seeking new investment. They all have the common goal of assessing the business opportunity. The fundamental concepts behind these questions been covered in detail in Chapter 3. What follows below is a succinct recap of the key questions.
Market attractiveness and product-market-focus The first area of investigation is the target market and product-market focus. This is discussed in greater detail in Chapter 3. The investor will need clarity on the following issues to be convinced that the commercial focus of the venture is feasible. Whether or not there is a genuine unmet need and the exact manner in which the product addresses the unmet need; Identification of market segments- their size and rate of growth; The companys ability/strategy to establish a defensible market position based on the level of competition; The level of differentiation again the current/ future standard-of-care and the products competitive advantage; Length of the sales cycle; Likelihood of the companys products being reimbursement by healthcare providers at the anticipated price points Likelihood of physician acceptance of the therapy- which depends on the nature of the product- whether it is a fast-follower to existing therapeutic options or a brave new world solution; The explicitness of the R&D plan and whether or not it can be executed; The feasibility and probability of success of the product/technology.
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The organization Since it is eventually the people that make or break a business opportunity, the entrepreneur must honestly address investor concerns related to the people behind the business. Most investors realize that it is important for a company to have a good management team. The problem is that evaluating management is difficult since many aspects of the job are intangible. It is clear that investors cannot always be sure of a company by only poring over financial statements. There is no magic formula for evaluating management, but there are factors to which investors should pay attention. Whether or not the team is passionate about the opportunity; The track record of the CEO and other senior management leaders; Ability of the company to attract new senior management/CEO; Experience of the founders and the respect they command within the industry; Whether or not the team is innovative, experienced, and success-oriented; The overall strengths and weaknesses of the founders; The ability of the team to build a large company, and the teams open-mindedness; The teams knowledge of the market, and whether or not it is in-depth.
Financials As explained in the preceding sections, the more additional capital a company requires, the more the dilution of equity of the original investors. This is ever more important in the investment climate foreseen over the next five years. Before reaching out to the investment community, entrepreneurs must put themselves in the investors position and answer questions that they would have concerns about, given a reversal in roles. Some of these are discussed below. The company's capital needs in the current financing round, and over the life cycle of the company;
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The companys ability to be financed in future; The paths to liquidity and their timing; The valuations for comparable companies; The companys capital structure and ratios; Whether or not the numbers are realistic and achievable.
Business plan Although private investment is not passive by nature, there is a limit to the extent of managerial/ strategic input the investors can provide to a growing biopharma company. It is well known that the best scientists are not always the best businessmen. Therefore, investors need to be reassured that the people they are investing in are capable of making sound business judgments, while continuing to manage daily activities that are essentially scientific in nature. Central to such reassurance is a sound business plan and strategy. It must address issues such as: Whether or not the strategy is well conceived and clearly articulated; The explicitness of the companys mission and roadmap to profitability; The eventual potential for growth of the company, in terms of size and scope; The capital needs to achieve the eventual goal.
Assessment of risks Both investors and entrepreneurs agree that nothing eventually goes as per plan. In the current investment climate, early-stage biopharma investment is a buyers market. Hence, the entrepreneur must be able to address the risks surrounding his or her proposal to the investor, and clearly articulate how they will be addressed. An honest and upfront assessment of risks goes a long way in establishing trust, and communicates the astuteness of the entrepreneur as a businessman.
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What are the major risks? What is the magnitude of the risks? What is the risk/reward ratio? When will each of these risks be resolved?
Intellectual property protection Intellectual property protection is the central theme of biopharma strategy. It is usually the value of the intellectual property assets that the investor finances because the commercialization or divestment of the asset is dependent on the marketing exclusivity the patent protection provides. Therefore, it is necessary to have clean ownership of any intellectual property (IP). In general, an investor needs to make sure that a business owns the IP for its technology idea without any interference or encumbrance from any other party. Such freedom to operate commercially is carefully assessed, often via lawyers familiar with IP Law. At early-stage rounds of financing, legal documents for an investment, contracts for a strategic business partnership, and merger or acquisition agreements contain representations and warranties with respect to IP assets from the new business and often from founding entrepreneurs. Examples of typical representations include the following statements: The new business is the sole owner of the intellectual property; Except as disclosed, the new business is not party to license, lease or other agreement to use the intellectual property; To the best knowledge of the new business, the new business does not interfere with intellectual property rights of a third party; There are no actions, suits or proceedings pending or threatened against the new business claiming that it is infringing any intellectual property rights of others; To the best knowledge of the new business, no person has infringed on the new business intellectual property rights.
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CHAPTER 5
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Chapter 5
Summary
US companies attract the most venture financing, followed by companies in mainstream European countries like the UK, Germany, France, Italy and Spain. The financial crisis has not changed the geographic distribution of venture financing in any discernable manner. The US and Canada will continue to remain the hubs of biopharma innovation in the next five years. Certain states within the US are clearly the hotbeds of private equity investment in the biopharma sector. Among the top 10 regions, the triangle comprising the areas of Boston, New York and New Jersey is clearly the leader, followed by parts of California. In terms of stage of investment, the number of deals involving drugs in Ph II and Ph III trials has increased substantially. Based on the number of venture rounds financed since 2004, late-stage financing rounds constituted 2% of the total between 2004 and 2006. In the following three-year period (2007 to 2009), this number has increased to 14%. Existing investors are reinvesting in assets they have already committed funds to because newer investors are demanding excessively dilutive investment structures that do not favor the existing owners. Private equity investors will prefer to invest in companies with late-stage clinical assets over companies with early stage assets in the next five years.
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How to use this chapter

This chapter analyses 7347 venture financing rounds that have taken place over the past five years (January 2004 to April 2010). The details were taken from the MedTRACK Venture Finance database. MedTRACK is a product of Life Science Analytics, a US-based biomedical data company that provides comprehensive pipeline, financial and venture information.
MedTRACK is the most comprehensive database of private and public biomedical companies. It contains financial, pipeline, competitive product, mechanism-of-action, sales, partnering, and patent information on 19,008 biomedical companies worldwide. The information can be sorted by parameters such as disease, competitive products, or clinical trial stage. Search functions reach into SEC filings, websites, business and product descriptions, journals, meeting abstracts, news, and announcements. MedTRACK makes it easy to find the data you need. Users can drill down on company fundamentals to establish an opinion, find partnering opportunities, or respond with educated agility to market news. The database contains 19,008 companies, 93,681 drugs, 48,493 deals, 12,863 venture transactions, 1,253 drug delivery technologies, 653 indications, 516,545 news pieces, 123,582 management contacts, 57 countries, 636,931 SEC filings and more. The Venture Finance Database, which has been used in this chapter, provides comprehensive coverage of over 11,000 Venture rounds and other details for more than 2,000 biomedical companies covered in MedTRACK. The MedTRACK Venture Finance Database is the industry leader for breadth and depth of Venture Finance coverage.
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Definition of key terms

To effectively utilize the information presented in this chapter, it is necessary to understand the manner in which the database has been structured. The definitions used by MedTRACK may not be the same as those utilized by other companies; however, they are likely to be relatively similar and can clearly be used to uncover insights based on top-line trends in venture financing.
Venture financing The term Venture financing has been used if the company seeking investment is privately held and seeks private financing from a certain number of investors. A VC firm or private equity firm invests in a private companys preferred. Venture subcategory terminology is explained below.
Seed Seed financing or seed money refers to the initial investment in a project or start-up company, for proof-of-concept, market research, or initial product development.
Start-up This refers to money used to start a business or purchase assets. Banks tend to view entrepreneurial ventures cautiously and rarely make loans to newly organized businesses without taking collateral and if the business venture is a corporation, personal guaranties of the starters. If the entrepreneurs obtain VC financing, a bank loan typically serves as a second level of funding; the bank loan becomes a source of working capital loan to finance conversion of inventory or receivables into cash receipts, whereas the VC funding is a source of longer-term equity capital that ultimately becomes the source of profit to the owners if the firm becomes successful.
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Early stage Financing provided by a VC firm to a company after it has received its initial, or seed, financing has been referred to as Early stage financing. At this early stage the company has a product or service that it is in testing or development, but it is not ready to go to market. In some cases, the product may be commercially available in a limited manner but not yet generating revenue. Typically, a company that receives early stage financing has been in business for less than three years.
Growth/expansion capital Growth capital (also "expansion capital" and "growth equity") is a type of private equity investment, most often a minority investment, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a significant acquisition without a change of control of the business. VCs invest in firms that have a high potential for growth but are not ready to do an initial public offering of stock. These investments tend to be both high risk and potentially high return. In the expansion phase of development, production is underway and commercial activity is taking place. Revenue growth is occurring and the enterprise typically is more than three years old. Expansion funding is used to provide needed capital for the production process that can help generate profits.
Later stage Late stage capital (later stage) is business financing provided to established companies. Vital to fund projects or support company growth, the investments made by late stage VC firms involve risks for those firms in order to gain profits. Finding late stage venture investors can be a tricky process as certain criteria must be met for a company to be considered for late stage capital. A detailed business plan is required to convince firms to offer late stage funding for business.
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Mezzanine Mezzanine financing is a form of late-stage venture capital, usually the final round of financing prior to an IPO. Mezzanine financing is utilized by companies expecting to go public usually within 6 to 12 months. They are normally structured to be repaid from proceeds of the IPO, or to establish a floor price for the public offer.
Bridge loan A bridge loan is a short-term loan that is used until a company can arrange a more comprehensive longer-term financing. The need for a bridge loan arises when a company runs out of cash before it can obtain more capital investment through longterm debt or equity.
Private placement Private placement is a term used specifically to denote a private investment in a company that is publicly held. Private equity firms that invest in publicly traded companies sometimes use the acronym PIPEs to describe the activity. Private placements do not have to be registered with organizations such as the SEC because no public offering is involved.
In the US, a private placement is an offering of securities that are not registered with the Securities and Exchange Commission (SEC). Such offerings exploit an exemption offered by the Securities Act of 1933 that comes with several restrictions, including a prohibition against general solicitation. This exemption allows companies to avoid quarterly reporting requirements and many of the legal liabilities associated with the Sarbanes-Oxley Act. The SEC passed Regulation D (Reg D) in 1982 which clarifies how companies can be sure they are exempt from registration under the Securities Act. Regulation D does include a notification requirement in Rule 503.
Other Financing which does fall under the above categories is classified as other.
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Countries attracting the most venture financing

Figure 5.22: Geographic distribution of venture financing rounds
100%
80%
% of financing rounds
60%
40%
20%
0% 2004 2005 2006 2007 2008 2009 2010 1
US/ Canada
3 Other European countries
Mainstream European countries2

4 Other Asian countries
India, China, Brazil, Israel
1 2
Year-to-date, 15-04-2010 Includes: UK, Scotland, Germany, France, Italy, Spain, Sweden, Switzerland, Netherlands
3 Includes: Ireland, Hungary, Iceland, Liechtenstein, Lithuania, Portugal, Slovenia, Greece, Norway, Austria, Belgium, Denmark, Estonia, Finland 4 Includes: Australia, New Zealand, Japan, Hong Kong, Malaysia, Singapore, Korea, Taiwan, Tunisia Business Insights Ltd
Source: MedTRACK Venture Finance database, authors analysis
US-based biopharma companies attract the maximum amount of investment and generate the maximum number of financing rounds. They are followed by European companies in countries like the UK, Germany, France, Italy, Spain, Sweden, Switzerland and the Netherlands. The proportion of investments in North American companies has remained relatively stable. The same goes for investments in mainstream European countries. Figure 5.22 below presents the overall distribution of
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7347 rounds of venture financing by the geographic location of the company that was seeking investment. In 15 of the 7347 rounds, the specific country was either not mentioned or was ambiguous. These have been excluded from the analysis.
It is interesting to note that investments in companies located in India, China and Israel have increased marginally, with Israel gaining the most from this shift.
Recent trends The above data was segregated into two components: investments made in 2004, 2005 and 2006; and investments in 2007, 2008 and 2009. As is apparent from the Figure 5.23 below, the trends, if any, are marginal. Figure 5.23: Trends in geographic distribution of venture financing rounds
2004-06
3% 16% Other European countries2 Other Asian countries3 India, China, Brazil, Israel 3% 3% US/ Canada 5% Mainstream European countries1 15% 1%
2007-09
5%
75%
74%
Includes: UK, Scotland, Germany, France, Italy, Spain, Sweden, Switzerland, Netherlands
2 Includes: Ireland, Hungary, Iceland, Liechtenstein, Lithuania, Portugal, Slovenia, Greece, Norway, Austria, Belgium, Denmark, Estonia, Finland 3 Includes: Australia, New Zealand, Japan, Hong Kong, Malaysia, Singapore, Korea, Taiwan, Tunisia Business Insights Ltd
Within the US, certain regions are clearly the hotbeds of private equity investment in the biopharma sector. Among the top 10 regions, the triangle comprising the areas of Boston, New York and New Jersey is clearly the leader, followed by parts of
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California. Figure 5.24 shows the distribution of investments (by value) across the US and also highlights the drop in 2009 versus 2008. LA/Orange County reported the greatest drop in 2009 investment with a 53% drop followed by Texas with a 50% drop. Taken together, the top three regionsSilicon Valley, New England, and New York Metroaccounted for 59% of VC backed funding and 52% of deals reported in 2009. Figure 5.24: US investments by region, 2008-2009
12,000
Deal value (US$ million)
10,000 8,000 6,000 4,000 2,000 0
Southeast
LA/ Orange County
San Diego
Northwest
DC/Metroplex
Midwest
New England
Silicon Valley
NY Metro
2009
2008
Source: Thomson Reuters, PWC Money Tree, Full-year 2009 US Report
Conclusions It can safely be concluded that the US and Canada will continue to remain the hubs of biopharma innovation in the next five years. The latter half of 2008 and all 12 months in 2009 experienced the financial crisis. However, this has not changed the overall distribution of venture financing in any discernable manner.
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Others
Texas
Distribution of venture financing rounds by investment stage

Figure 5.25 presents the distribution of venture financing rounds by stage type (as defined at the beginning of this chapter). For statistical purposes, financing rounds have been grouped as follows: Early stage: includes rounds labeled Start-up, Series A and Early stage Mid-stage: includes rounds labeled Series B,C, D, E, F and G Late stage: includes rounds labeled growth/expansion capital, Series H to Series Z, and Mezzanine rounds Figure 5.25: Total number of financing rounds by stage, 2004-2010
1400 1200
Number of rounds
1000 800 600 400 200 0 2004 2005 2006 Mid stage 2007 2008 2009 2010*
Early stage
Late stage
Not-specified
* Year to date (April 2010)

Source: MedTRACK Venture Finance database, authors analysis Business Insights Ltd
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A number of financing rounds did not have a clear stage associated with them. This is either because the stage was not disclosed by the investors, or because it was ambiguous. In total, the stage of investment was not specified in 2743 rounds of venture financing between 2004 and April 2010.
The data above is presented in Figure 5.26 below as a percentage instead of absolute numbers. Figure 5.26: Distribution of financing rounds by stage, 2004-2010
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2004 2005 2006 Mid stage 2007 2008 2009 2010*
Early stage
Late stage
Not-specified
* Year to date (April 2010)

Source: MedTRACK Venture Finance database, authors analysis Business Insights Ltd
Recent trends The following points are clear from the data above: The number of investments in which the stage is not specified has decreased substantially. This is due to a combination of factors, such as better reporting from the involved parties (the investor, entrepreneur and business media), and better data-gathering methodologies.
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The number of late-stage deals has increased substantially. As can be gleaned from Figure 5.27 below, late-stage financing rounds constituted 2% of the total between 2004 and 2006. In the following three year period (2007 to 2009), this has increased to 14%. Regardless of possible data gathering errors, this is a remarkable leap in magnitude. It clearly reflects investor preference for companies that offer exit-strategies in the near-term time horizon. The financial crises has decreased the ability of investors to hold-out for long, and those wanting investment exposure to the biopharma sector are clearly focusing on companies with late-stage clinical assets. Closer analysis of financing rounds in Q1 of 2010 reveals that almost all investments were for growth-expansion capital. This is detailed further in the next section of this chapter. This possibly implies that a select group of companies that are nearing their exit-strategy time horizons are being granted additional funding by existing investors. Figure 5.27: Trends in financing rounds by stage, 2004-2019
2004-06
2% 46%
Not- specified Early stage Mid stage Late stage
2007-09
14% 31%
28%
31%
24%
24%
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Further analysis of financing rounds by stage

This section of the report delves deeper into the financing rounds by stage, specifically to shed more light on the composition of Early, Mid and Late stages defined above.
Early Stage, as categorized in the preceding section comprised of investments that were labeled Start-up/Seed, Early Stage and Series A. They can be looked at chronologically, as the initial investment required to get a company off the ground, and the first round of formal venture backing (the Series A component). Figure 5.28: Early-stage funding by type, 2004-2010
350 300
Number of rounds
250 200 150 100 50 0 2004 2005 2006 2007 Series A 2008 2009 Early Stage 2010
Start-up/ Seed
It is apparent from the data above that most early stage rounds comprise Series A funding.
A possible reporting bias that needs to be highlighted here is that most startup/seed/early stage financing rounds are small in magnitude, and are hence not reported
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by the business media with as much diligence. This may account for the greater share of Series A rounds in the analysis above.
Not all companies go through a formal, multi-step sequence of financing rounds. Although two to three clinical milestones are commonly applied, and these may translate into two to three rounds of financing, it is not a hard and fast rule. For this reason, the majority of mid-stage investments comprise of Series B and Series C rounds. Only the larger companies, with much wider clinical scope, reach beyond Series C financing. Figure 5.29: Mid-stage funding by type, 2004-2010
500 400 300 200 100 0 2004 Series B 2005 Series C 2006 Series D 2007 2008 2009 Series F 2010 Series G
Number of rounds
Series E
A closer analysis of late-stage financing rounds reveals that the majority of investments are for growth/expansion capital. This reflects the poor potential of IPOs for biopharma companies in todays climate, where the bulk of public offerings are not fully subscribed to or are heavily discounted. Strong companies with solid future potential but without the ability to go public are attractive candidates for venture financing. It is also important to note that the time-horizon for an exit for the investors funding
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growth/ expansion rounds is shorter than for those funding early stage rounds, although the risk may be higher. This may possibly be the way forward over the next two to three years. Figure 5.30 below details the distribution of late-stage financing rounds. Figure 5.30: Late-stage funding by type, 2004-2010
300
Number of rounds
250 200 150 100 50 0 2004 2005 2006 2007 2008 2009 2010
Growth/ Expansion capital
Other late-stage rounds/ Mezzanine
Conclusions
Private equity investors will prefer to invest in companies with late-stage clinical assets over companies with early stage assets in the next five years. Companies that do attract investments at the early stage will do so at the cost of earlier investors because the transactions are likely to be excessively dilutive to their existing ownership structure. To counter such dilution, companies with early stage assets have two choices. The first is to seek investments from existing investors who already have a stake in the future of the company. The second option is to seek creative risk-sharing investment structures that are conditional upon successful completion of specific clinical milestones. It is important to note that at the present moment, large pharmaceutical companies are better
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positioned to devise such risk-sharing structures. However, the sophistication of VCs and their understanding of the clinical development process is increasing rapidly.
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CHAPTER 6
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Chapter 6
Summary
The MedTRACK Venture Finance database was used to identify the investors that participated in the maximum number of financing rounds in 2009. The investments of these top investors were segmented on the basis of their therapeutic area of focus, industry segment, stage of investment and investment destination. Most of the top 15 investors are from the US and hence invest primarily in USbased companies. This reflects their local investment mandates and the greater ease of dealing with companies located close by. European firms invest in a greater range of countries, not only within Europe but in other Asian and North American destinations. Deals in Europe tend to be fewer in number but greater in scope of financing. 9.2% of financing rounds were in companies located in Europe, which commanded a 12.6% share in terms of investment value. Corporate Venture Capital arms of large pharmaceutical companies are becoming increasingly active and visible members of the VC community. Unlike traditional VCs, many CVCs are set up as evergreen funds that aim to combine financial motivations with the overarching strategic motivations of their parent organizations. A large proportion of companies that successfully raised VC funding in 2009 have a focus on biotechnology-based approaches to medicine, oncology therapies and medical devices. Over 50% of total financing by value and over 50% of the rounds of financing fall under these three categories. Nearly a fifth of all money invested was targeted at oncology therapies, but oncologys share in terms of number of deals is comparatively lower (<10%). This highlights the fact that clinical development of oncology products involves large scale and expensive clinical trials.
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Most active venture capital investors in 2009

The MedTRACK database was used to highlight the firms that participated in the largest number of venture financing rounds in 2009. Please note that the activity is tabulated using number of rounds only. It does not address the size of the investments or their scope. Table 6.6: Most active venture investors in 2009
Firm Novartis Venture Funds Kleiner Perkins Caufield & Byers New Enterprise Associates, Inc. Polaris Venture Partners Versant Venture Management LLC Domain Associates, LLC SV Life Sciences Novo A/S Texas Coalition for Capital (non-profit) InterWest Partners LLC MPM Capital Abingworth Management Limited GrowthWorks Capital, Ltd. J&J Development Corporation Pittsburgh Life Sciences Greenhouse
Source: MedTRACK Venture Finance database
Number of rounds 21 20 20 20 19 17 17 16 16 15 15 14 14 14 14
Country Switzerland USA USA USA USA USA USA Denmark USA USA USA UK Canada USA USA
Type Corporate Independent Independent Independent Independent Independent Independent Corporate Independent Independent Independent Independent Independent Corporate Independent
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It is clear that most of the active investors are from the US. The presence of three corporate funds of large pharmaceutical companies highlights the growing importance of such VCs. Even though the strategic motivation of the firms listed above varies from non-profit firms to purely profit driven investment firms to CVCs that combine financial goals with more strategic ones, they provide an appropriate sample to investigate the investment preferences of the broader community.
Analysis of investment preferences The investments of these 15 firms in 2009 were first analyzed by segmenting them on the basis of their therapeutic area of focus, industry segment, stage of investment and investment destination. Further discussion highlights the specific preferences of each firm, given their strategic motivations. The goal of this analysis is to seek patterns from the data and link it to the general economic climate prevalent in 2009.
Therapeutic areas of focus Table 6.7 lists the number of venture financing rounds by the R&D focus of the company seeking funds. Table 6.7: R&D focus of top 15 venture investors, 2009
Disease Area Autoimmune Diseases Biotechnology Cardiovascular Central Nervous System Disorders Diagnostic Drug Delivery Drug Discovery/ Development Infections Medical Device Metabolic Diseases Oncology Ophthalmology Other Pain Respiratory Diseases (General) Services Technology
Number of investments 14 38 4 9 13 4 7 10 71 8 21 13 7 5 4 10 12
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It is important to note that the disease area specified above does not have to be the only focus (or core competence) of the biotech company. The labels have been chosen after studying the press releases, corporate websites and reports on the companies gaining investment. They aim to reflect the primary focus of the company as of the date of investment, and are not static in nature. Figure 6.31: Preferences of top 15 venture finance investors, 2009
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Size of investments Number of investments
Biotechnology Ophthalmology Diagnostics
Medical Device Autoimmune Diseases R&D platforms & Drug Discovery
Oncology Central Nervous System Disorders Others
Figure 6.31 above further compares the percentage of deals within a disease area to the overall amount invested in those disease areas by the top 15 venture investors of 2009.
A large proportion of companies that successfully raised VC funding in 2009 have a focus on biotechnology-based approaches to medicine, oncology therapies and medical devices. Over 50% of total financing by value and over 50% of the rounds of financing
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fall under these three categories.
Nearly one-fifth of all money invested was targeted within oncology, but oncologys share in terms of number of deals is comparatively lower in proportion (<10%). This reflects the commercial importance of oncology as a therapeutic area and the potential for biotechnology based approaches to tackle its major challenges. It also highlights the fact that clinical development of oncology products involves large scale and expensive clinical trials.
Another area of focus for these companies is medical devices. Big pharmaceutical companies urgently need to bolster their product portfolios with successful drug-device combinations, yet this is not their core competence. VC investors are clearly taking on the responsibility to nurture the early stage medical device projects in the hope of successfully commercializing them via alliances with big pharma.
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Investment destinations by geography Figure 6.32 below captures the investment destinations of the 15 most active venture firms in 2009. Figure 6.32: Preferences of top 15 venture finance investors, 2009
Investment destinations
4.80% 9.20% 1.60%
Investment amounts
0.8% 12.6% 1.2%
84.40%
85.4%
Canada
Europe
Other
USA
It highlights the following trends: Most of the top 15 investors are from the US and hence invest primarily in USbased companies. This reflects their local investment mandates and the greater ease of dealing with companies located close by. European firms invest in a greater range of countries, not only within Europe but in other Asian and North American destinations. Deals in Europe tend to be fewer in number but greater in scope of financing. 9.2% of financing rounds were in companies located in Europe, which commanded a 12.6% share in terms of investment value.
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Canada is witnessing significant deal activity, but mostly for small amounts of capital. This reflects the highly evolved partnering mindset prevalent in the country but a lack of large scale capital injections.
Stage of investments As is apparent from Figure 6.33 below, only 2% of financing rounds that the top 15 investors participated in were for start-up and seed investments. This reflects the current preference for companies with late-stage R&D assets. 18% of the investments were meant for growth/ expansion activities, implying that the companies which gained investment had at least one established source of revenue. Series A, B and C investments have over 50% share in terms of money invested and number of rounds of financing. Figure 6.33: Number of deals by investment stage, 2009
Number of deals
2% 10% 12% 21% 10% 14% 15% 10%
Amount invested
18% 23% 12%
12%
10%
31%
Not Specified Series B StartUp & Seed
Growth Capital/Expan Series C
Series A Series D+
Source: Novartis venture Find portfolio analysis, Nature Biotechnology, ..
In terms of actual money invested, start-up and seed investments constituted 12% of
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the total. This implies that relatively few companies (2% in terms of rounds), managed to raise a relatively large share of the total capital invested by this group of 15 investors.
Two types of venture investors

Table 6.6 also distinguishes the active VC firms by their strategic orientation. It is important to distinguish between corporate venture capital (CVC) and independent venture capital. Chapter 4 deals with independent venture capital firms which are primarily motivated by financial returns. Corporate venture capital firms combine financial motivations with strategic ones.
CVC is defined as the "practice where a large firm takes an equity stake in a small but innovative or specialist firm, to which it may also provide management and marketing expertise; the objective is to gain a specific competitive advantage. Such funds raise money not only from their parent corporations internally generated cash but also from external sources such as pension funds, fund of funds, etc. CVCs invest it in entrepreneurial start-ups at all stages of development. As a group, the CVC sector mirrors the broader VC sector, with funds specializing by stage of development and industry. The distribution of investments across industry sectors for both independent and corporate VC investors is markedly similar.
Novo A/S and Novartis Venture Fund are two CVC firms highlighted in this chapter. SV Life Sciences and Texas Coalition for Capital are examples of two independent VC firms. The profiles of these four VCs are meant to provide a snapshot of the broader community.
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Corporate Venture Capital (CVC) funds

Corporate venture capital is not synonymous with independent venture capital; rather, it is a specific subset of venture capital. The parent pharma/ biotech company is investing, without using a third party investment firm, in an external start-up that it does not own. The following exclusions are important in differentiating CVC from other strategic investment vehicles. CVC excludes: Investments made through an external fund managed by a third party, even if the investment vehicle is funded by and specifically designed to meet the objectives of a single investing company. Investments that fall under the more general rubric of "corporate venturing"for example, the funding of new internal ventures that, while distinct from a company's core business and granted some organizational autonomy, remain legally part of the company.
Emerging role of CVC in Life Sciences The asymmetric access to finances in the aftermath of the credit crisis has created the perfect environment for big pharmaceutical companies to extend their capabilities beyond their core R&D focus via CVCs. On the one hand we have cash-starved biotechs which cannot generate money via IPOs and are faced with increasingly unattractive term sheets and highly dilutive investment structures from the few private investors that are still capable of investing. Other traditional investors such as hedge funds and VCs are hampered with high hurdle rates and long lead times to an exit. They clearly have a much reduced capacity to invest and are scaling back their operations.
Meanwhile CVCs backed by the low-leverage financial structures of big pharmaceutical companies do not suffer from many of the restrictions facing independent VCs. Firstly, their hurdle rates are lower. They have greater patience for the typically long lead times in biopharma R&D. Finally, and perhaps most
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importantly, their big pharma lineage gives them a better understanding of the challenges facing nascent biopharma companies. While the large pharmaceutical firms are externalizing their drug discovery and development in many ways (in/out licensing, M&A, collaborations, etc), CVC has emerged as a very effective way to achieve the same objective. As high hurdle rates temper the appetite of traditional VC for startup investments, investment funds set up by big pharma companies are beginning to dominate early-stage financing of biotech firms
CVC programs are clearly of interest to biotech entrepreneurs as a source of funding for start-up ventures. Some studies have revealed that the overall success rate of clinical programs is higher when a small biotech firm partners with a CVC fund (compared to deals with independent venture capital funds). Similar results are claimed in terms of long-term valuations. It has also been noticed that the most successful biotech-CVC deals are those that strengthen the parent companys core portfolio, rather than those that explore adjunct business areas.
Strategic motivations The reasons behind a large pharmaceutical companys intentions to utilize CVC are numerous and are clearly illustrated by looking at similar venture funds in the IT/ Telecom space. Big pharmaceutical companies are especially keen in hedging their bets across multiple lines of clinical investigation, in the hope that they hit upon the next big therapy. Internal R&D initiatives geared towards such an end require financial resources, management focus and time. CVCs offer a more efficient opportunity to achieve the same ends. A portfolio analysis of the Novartis Venture Fund compares the success of developing the R&D pipeline using the traditional internal approaches and a CVC fund; clearly illustrating the higher rate of success at a lower cost (Figure 6.34)
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Figure 6.34: R&D performance scorecard

TYPICAL MID-CAP PHARMA COMPANY
R&D spend: US$ 1800 million
Ph III / Registration Phase I / II Preclinical
6 16 19
EARLY STAGE VC (Novartis Option Fund)

R&D spend: US$ 300 - 400 million
Ph III / Registration Phase I / II Preclinical
2 29 42
Source: Novartis Venture Find portfolio analysis, Nature Biotechnology 2008
Many CVC funds were organized as evergreen funds, where investments are recycled into the fund and not transferred to the parent companys bottom line, indicating a primarily strategic rather than financial focus. Ostensibly, the parent company has less interest in short-term financial returns.
The motivation of the CVC typically involves leveraging and/or upgrading the core competencies of its parent pharmaceutical company, reserving its right to play in alternative markets/technologies and finally building a networked ecosystem.
118
Leveraging and/or upgrading the core may come from the transfer of resources from the corporation to the venture (leveraging) or from resource combinations or the transfer of resources from the venture to the corporation (upgrading). Resource combination: co-development of R&D assets or joint task forces; Resource transfer: of the venture leveraging the corporations existing distribution channels, gaining access to product development expertise, brand names, or supplier networks; Resource upgrade: new complementary technologies that could be used in corporations business units, transfer of key staff.
CVCs
can
also
provide
strategic
feelers
to
identify
early
substitute
technologies/markets and to co-opt them through minority investments. The minority investment (rather than a full scale acquisition or full scale development program) can be seen as a learning option/probe/hedge into a new technology or market that the parent company has not pursued internally but considers worthy of interest. CVC programs may not only realize value through leveraging and upgrading core competencies and reserving the right to play in alternative technologies or markets, but also through the network the company develops from the portfolio of investments.
Novartis Venture Fund The Novartis Venture Fund (NVF) was organized as an evergreen fund, where investments would be recycled into the fund and not transferred to Novartis bottom line, indicating a primarily strategic rather than financial motive. The fund was initially allocated a limited amount of financing in the belief that sources for entrepreneurship were situated both within the existing company and within local academic institutions. Academic researchers and former Novartis scientists founded most of the portfolio companies. Both of these groups possessed limited expertise in starting a business and welcomed the NVFs guidance in addressing key business issues.
119
Figure 6.35: Novartis Venture Fund investments in 2009

30% 25%
Product/ technology focus
20% 15% 10% 5% 0%
3% 6% 22%
Stage of investment
39%
30%
Not specified Series A Series C

Source MedTRACK Venture Finance database, authors analysis
Growth Capital/Expan Series B
Currently NVF operates two funds, the Venture Fund and the Options fund. The Options Fund seeds innovative start-up companies during their earliest stages. The initial equity investment is coupled with an option to a specific project, the scope/ duration of the option is limited and the subject of the option is not necessarily even an active program for the start-up at the time of investment. The options structure is meant to remain consistent with the new companys corporate development plans. In
120
addition to the non dilutive cash payment to secure an option to a specific program, license terms are negotiated at the time of investment and are based upon benchmarks that are relevant for the stage of the asset at the time the option is meant to be exercised.
NVF invests in areas of therapeutics, medical devices, diagnostics, and drug delivery. Its primary focus is on the development of novel therapeutics and platforms; with the intention of enhancing the therapeutic focus with investments in medical devices, diagnostics or drug delivery systems.
Investments in 2009 were spread over a wider range of destinations, reflecting the European headquarters of the parent company. There were roughly equal investments in European and US companies. Within Europe, Switzerland, UK, Spain and Ireland were among the investment destinations.
Novo A/S, Denmark Novo A/S approach to VC investments is unique due to its special ownership structure. Although Novo owns significant shareholdings in Novo Nordisk A/S and Novozymes A/S, its venture investments are fully independent of the two major Novo Group companies. Novos venture investments are structured as an open evergreen fund with a single investor. This unique funding structure allows Novo to take a longterm perspective in its investments and also has the advantage that it precludes some of the restrictions to which traditional VC funds are subject, for instance when they pursue investments in the interim between a fully vested and a newly raised fund.
121
Figure 6.36: Novo A/S ownership structure

Novo nordisk foundation
100% ownership 25% ownership
Novo Nordisk
Novo A/S
25% ownership
Novozymes
Novo seeds
Pre-seed and seed programs aimed at identifying unexplored commercial potential in academic and arly stage applied research projects
Novo ventures
Novo growth equity

Invests in late stage private or public life science companies emphasis on late clinical/commercial stage product
Novo finance
Responsible for financial investments, accounting and reporting, HR, IT , legal affairs
Source: Novo Annual Report and company website
Novo A/S seeks opportunities in which the financing amount varies from 1 to 15 million. The strategy is stage and location-agnostic, i.e. may occur at any stage of development of a business idea - from seed capital over private placements to IPOs and public companies, in any part of the world. Areas of focus include: Products for diagnosis, control, treatment, and prevention of disease Development and application of biotechnology Instruments and medical devices Improvement of food, nutrition and health for humans and animals Development of sustainable solutions for the environment.
122
Figure 6.37: Novo A/S investments, 2000-2008

Accumulated number of companies 2008 2007 2006 2005 2004 2003 2002 2001 2000 60 50 40 30 20 10 0 0 500 1000 1500 2000 2500 0 Accumulated investments in DKK million
Private Exits
Direct investments Venture funds
Source: Company website
In extraordinary situations, the firm provides funds on a smaller scale for embryonic start-ups. Due to the structure of the fund it can justify making investments with a longterm perspective. The exit strategy is determined on a case-by-case basis, in dialogue with the portfolio company, by the fund managers. Typical exit strategies could be an IPO, a trade sale or a merger.
In addition to financial support, Novo seeks to add value for investment partners by providing access to scientific and business expertise through board participation in the areas like: Intellectual property rights Scientific evaluation (through internal/external networks) Strategic business development Licensing and collaborations
123
Financing strategies Figure 6.38: Novo A/S investments in 2009

25% 20%
15% 10% 5% 0%
3%
13% 36%
Stage of investment
39% 10%
Growth Capital/Expan Series B Series D

Series A Series C
124
Independent venture capital funds

The motivations of independent VCs have been discussed at length in previous chapters. This section profiles two independent VC firms from among the Top 15 life sciences VCs in 2009. SV Life Sciences is a for-profit, more typical VC firm, whereas the Texas Coalition for Capital is a non-profit group with a more regional mandate.
SV Life Sciences SV Life Sciences Advisers LLP (formerly known as Schroder Ventures Life Sciences) is a venture capital firm with a focus on the human life sciences sector, including bio pharmaceuticals, medical devices and healthcare information technology. It has offices in Boston, London and San Francisco.
The firm invests in equity or near equity securities in private businesses, and sometimes in smaller public companies. SV Life Sciences currently advises or manages five funds with capital commitments of approximately $2.0 billion. The invest amounts of between $1m and $40m in North America and Europe, but they are open to considering innovative investments in other regions. Among the five funds is the International Biotechnology Trust ('IBT'), an investment trust vehicle listed on the London Stock Exchange into which both corporate and private investors may invest.
Like other VCs, SV Life Sciences invests in companies that combine good management talent and a business model that provides a strong increase in value while maintaining competitive positioning via strong patent protection.
Investment focus in 2009 All of the firms investments in 2009 have been in US-based companies. SV Life Sciences has maintained a clear focus on the ophthalmology therapeutic area with six of its 16 rounds of investment being in companies that either target diseases related to the eye (specifically back-of-the-eye diseases). Its investment in PanOptica highlights
125
this focus. Panoptica is a US based company which acquires late stage ophthalmology assets and finishes the clinical work to the next value inflection point. Figure 6.39: SV Life Sciences investments in 2009
60% 50%
40% 30% 20% 10% 0%
Biotechnology
Medical Device
Inf ections
Autoimmune Diseases
4% 2% 21%
Stage of investment
20% 53%
Later Stage
Series A
Series B
Series C
126
Ophthalmology
Series D
There is also a clear focus on medical devices, many of which are linked to the ophthalmology space. Six of its 16 investment rounds have been in companies developing medical devices. Other therapy areas of interest for SV Life Sciences include autoimmune/ inflammation and infections.
None of the investments have been in companies that focus on small molecule therapies, and most have clear big-pharma validation. For example, captive VC funds of big pharma companies are often seen as the co-participants in SV Life Sciences rounds of funding, as is Google Ventures in projects where computational biology plays a significant role.
Texas Coalition for Capital The Texas Coalition for Capital is a non-profit, statewide coalition of leaders supporting economic development and job creation through long-term access to capital for Texas entrepreneurs and emerging companies.
The Texas Emerging Technology Fund (TETF) was created by the Texas Legislature at the urging of Governor Rick Perry in 2005 and reauthorized in 2007. The TETF provides up and coming technology entrepreneurs in Texas with the support needed to develop and commercialize new technologies, many of which have ties to universities. To date, the TETF has allocated $127.5m dollars to Texas companies and partnering universities, thereby creating a deal flow infrastructure that will serve the state well for many years to come.
127
Figure 6.40: Texas Coalition for Capital investments in 2009

35% 30% 25%
20% 15% 10% 5% 0%
Biotechnology
Diagnostic
Medical Device
Oncology
Other
Autoimmune Diseases
Stage of investment
44% 56%
Not specified
Growth Capital/Expan
128
Technology
Chapter 7
Appendix
Research methodology
A combination of primary and secondary research sources were used to write this report. A list of sources used is given below. Global Private Equity Report 2010; Bain & Co US biotech firms line up for tax credits; NATURE Vol 465|17 June 2010 Beyond business as usual? The global perspective, 2009; Ernst & Young Swiss Biotech Report 2008 Recap Consulting Global Investor Attitudes to Private Equity in the UK 2009, BVCA A Guide to Private Equity 2010, BVCA The Role of Corporate Venture Capital Funds in Financing Biotechnology and Healthcare: Differing Approaches and Performance Consequences, James Henderson IMD MoneyTree Report 2009; Pricewaterhouse Coopers, National Venture Capital Association Valuing a Technology Platform ; BIO CEO & Investor Conference 2008 British Venture Capital Association National Venture Capital Association Health care reforms new $1 billion therapeutic research projects program; Ernst & Young
129
Updated US Private Equity Valuation Guidelines; Private Equity Industry Guidelines Group The rise of option agreements; NATURE Drug Discovery, June 2010 Biomarkers: the next generation; NATURE Drug Discovery, June 2010 Report concludes industryacademia partnerships on the wane; NATURE Biotechnology, Jan 2010 Avoiding premature licensing; NATURE Drug Discovery, Dec 2006 Seeking the biotech eBay; NATURE Biotechnology Mar 2010 Coming to terms; NATURE Biotechnology Feb 2010 Other ways of financing your company; NATURE Biotechnology Feb 2008 Trends in discovery externalization; NATURE Drug Discovery, Mar 2010 The lengthening handshake; NATURE Biotechnology Mar 2010 Biotech sector ponders potential bloodbath; NATURE Biotechnology Jan 2009 Beyond venture capital; NATURE Biotechnology June 2010 Avoiding capital punishment; NATURE Biotechnology May 2010 Coming to terms; NATURE Biotechnology Feb 2010 Deals that make sense; NATURE Biotechnology Exit strategies in Europe; NATURE Bioentrepreneur Aug 2006 Selling out; NATURE Biotechnology Apr 2010 Negotiation 2.0; NATURE Biotechnology Dec 2009 Six steps to successful financing; NATURE Biotechnology 2008
130
Where to float?; NATURE Biotechnology Oct 2008 When times get tough; NATURE Biotechnology Mar 2009 The valuation high ground; NATURE Bioentrepreneur 2009 Eight mistakes that hurt your biotech's valuation; Maureen Martino, Firece Biotech A new look at the returns and risks to pharmaceutical R&D. Management Sci. 36, 804821 How Merck plans to cope with patent expirations. Wall Street Journal, Febr 2000 The control of technology alliances: an empirical analysis of the biotechnology industry. J. Ind. Econ. 46, 125156 (1998) Financing R&D through alliances: contract structure and outcomes in biotechnology; Lerner, J & Tsai, A.I. Allicense 2010: The Deal Of The Year; SignalsMag Non-Dilutive Financing Alternatives for Biotech Companies; AVANCE- Corporate Finance in Life Sciences The Risk Premium; AVANCE- Corporate Finance in Life Sciences Scrip Annual Reports, 2008, 2009, 2010 Collateral Damage- Implications of the financial crisis for biopharmaceutical sector; Boston Consulting Froup PPRI Reports for Germany, UK, France
131
Index
Alliance, 49 Angel investors, 68, 71 Bill and Melinda Gates, 29 Board, 78, 79 Buyout investors, 73 Canada, 13, 90, 97, 107, 112 Capital, 14, 28, 38, 54, 55, 70, 81, 82, 106, 107, 114, 128 Capital expenditure, 81, 82 NHS, 21, 23 CEDD, 44 NICE, 21 China, 96 Non-dilutive, 27, 28 Common stock, 78 Novo A/S, 107, 113, 120, 121, 122, 123 Comparables, 54, 56 Options, 43, 54, 56, 119 Corporate venture capital, 113, 114 Preferred stock, 78 Discounted cash flow, 54 Real options, 54, 55 Due diligence, 45 Sales, 59, 64 France, 13, 31, 90, 95, 96, 130 Seed, 68, 92, 101 Funding, 1, iii Spain, 13, 90, 95, 96, 120 Germany, 13, 90, 95, 96, 130 SV Life Sciences, 107, 113, 124, 125, 126 Government, 31 TDR, 29 Grand Emprunt, 31 Term sheets, 76 Grant, 30 GSK, 44 India, 96 IPO, 10, 25, 36, 38, 70, 71, 94, 122 Italy, 13, 90, 95, 96 132 Texas Coalition for Capital, 107, 113, 124, 126, 127 Therapeutic Discovery Project Program, 31 UK, 13, 21, 90, 95, 96, 107, 120, 128, 130 Japan, 95, 96 Joint venture, 48 Kurma Biofund, 31 Licensing, 28, 41, 46, 48, 122 M&A, 10, 11, 18, 36, 50, 52, 115 Macroeconomic, 9, 15, 16 Medicare, 20, 23 Mezzanine investors, 72
US, 13, 14, 20, 23, 29, 31, 83, 90, 91, 94, 95, 96, 97, 106, 108, 111, 120, 124, 128, 129 Valuation, 53, 80, 129
Venture capital, 11, 52, 72
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H E A LT H C A R E

The Funding Landscape for Small Biopharma Ventures, 2010-2015

Macroeconomic trends and implications

Accelerating biopharma collaboration

Valuing investment opportunities in small biopharma

Priorities and preferences of private investors

Top-line trends in venture financing

Investment choices of most active firms in 2009

Accelerating biopharma collaboration

Valuing investment opportunities in small biopharma

Priorities and preferences of private investors

Top-line trends in venture financing

Investment choices of most active firms in 2009

Macroeconomic trends and implications

Macroeconomic trends and implications

Supply side factors- higher cost of capital

Demand side factors- Decreased earnings potential

500 400 300 200 100 0

10% of total expenditure was on Rx drugs

$ 234 $ 160 $ 138 $ 114 $ 69 $ 66 $ 65 $ 44

Prof essional services

Public health activities

Business Insights Ltd

Source: EGA Market Review, 2007

Business Insights Ltd

Short and long term implications

Boston Consulting Group, 2008

Non-dilutive funding in an era of excessive dilution

Source: authors analysis, secondary sources

Business Insights Ltd

They look for projects that:

What has been neglected?

Use preventive approaches

Where can we make the greatest change?

Promise significant and long-lasting change

Leverage support from other sources

Accelerate work the foundation already supports

Source: Bill & Melinda Gates Foundation

Business Insights Ltd

Accelerating biopharma collaboration

Accelerating biopharma collaboration

Accelerating biopharma collaboration

Source: Avance (Corp Finance in Life Sciences) survey, 2008

Business Insights Ltd

Proportion of assets (bar, %)

3500 3000 2500 2000 1500 1000 500 0

Top 20 companies Top 20 companies

Number of assets (line)

Rapidly evolving deal structures

Figure 2.8: Overview of partnering issues

Partnering now vs. partnering later

Partnership vs. fund raising

Are there sufficient data to build a reasonable risk/reward valuation

What are the chances of getting this product approved?

Corporate considerations (Licensee)

Whats the opportunity cost to putting money in this partnership

Source: authors research & analysis

Business Insights Ltd

product forward by itself.

Average upfront payment

Source: PharmaVentures, PharmaDeals

Business Insights Ltd

Figure 2.10: Reliance on the option model varies by company