VCs Share Keys to Success in Early Stage Biotech Investing
By Trista Morrison
In the first two parts of BioWorld Insight's Innovation Analysis, we explored how although the creation and funding of new biotechs is not necessarily synonymous with the creation and funding of innovation, there are signs that venture capitalists are more willing to invest in innovative, early stage biotechs than they were five or six years ago.
That interest is critical, because a Harvard Business School analysis showed innovation typically gets funded during periods in which venture capital is abundantly available – i.e. not necessarily at the present time. But despite the current upheaval in the venture world at large, several VCs who specialize in risky biotech start-ups say they, too, are seeing increased interest in innovation.
"Capital flows to where it thinks it's going to get the highest returns," explained Terry McGuire, managing general partner with Polaris Venture Partners. Five years ago tech looked less attractive and funds shifted to life sciences; now some of that capital is shifting back into tech. "Things ebb and flow," he said, but there remain "big life science problems to be solved."
Kevin Starr, partner with Third Rock Ventures, pointed to two other factors that bode well for the funding of innovation. "What we've seen at Third Rock, which gets us very excited, is the innovation coming out of academia is the greatest we have ever seen in our lifetime," Starr told BioWorld Insight. He also noted a willingness by big pharma to "embrace the model of outsourcing innovation," cutting its own research in favor of buying programs out of biotech.
Third Rock: High Risk, High Reward
Third Rock is one of the most active investors in the start-up biotech space, launching some 27 companies in the last five years.
The firm was founded specifically to pursue high-risk innovation. Starr said the goal was to take advantage of three external factors: The first two, mentioned above, were a renaissance in academic innovation and pharma's increasing reliance on biotech to fill its pipeline. The third was the fact that other venture capitalists seemed to be abandoning early stage biotech investing.
Third Rock's success proves that the "early innovation model works, but you have to staff yourself a little differently to do it," Starr said. He noted that the firm has about 40 employees, and most are not VCs – they are scientists and entrepreneurs who know what it's like to start a biotech. That empathy allows them to be a good partner to entrepreneurs and to "roll up their sleeves" and take roles as CEO, chief scientific officer or chief business officer right alongside a start-up's scientific founders, Starr said.
Third Rock's large staff also allows it to build an internal pipeline, much like a biotech or pharma company. The team works with academics on early stage ideas that are several years from becoming a company, and it helps to mature those ideas over the following years until they are ready for prime time. "We are constantly deploying our team through the academic interface," Starr said, and the strategy has allowed Third Rock to create five or six new companies per year. That would be "very hard to do" in a traditionally structured VC firm with a focus on investment management, Starr said.
While many VCs shy away from the financing risk associated with start-ups that will require multiple rounds of financing over multiple years, Third Rock addresses that issue by funding its portfolio companies heavily on the front end. "We like to do $35 million to $40 million A rounds to make sure the companies are at critical mass," Starr said.
But perhaps the most important pillar to Third Rock's success is "knowing who our customers are – i.e. pharma – and building a company for them or with them," Starr said. Third Rock has not shied away from innovative deal structures; it's most recent was genomics firm Warp Drive Bio, which was created in partnership with Sanofi SA.
And Third Rock isn't just funding early stage companies, it is looking for innovation – "a disruptive new focus in science," Starr said. That might be epigenetics, cancer metabolism or new forms of protein engineering. Yet it might also be a product licensed out of pharma, if there is a high potential benefit to patients.
"That, at the end of the day, is what venture is really about," Starr said. "Taking high-risk capital and deploying it on high-return initiatives."
Atlas: Setting the DNA
Atlas Venture also focuses on early stage start-ups, both in life sciences and in technology. Like Third Rock, Atlas likes to roll up its sleeves and get hands-on with its portfolio companies, and that's a big part of what has made it successful, explained partner Bruce Booth.
"Some things have hurt biotech in the past," he said, pointing to too much money raised, capital intensity, diluted returns, and governance challenges stemming from too many board members with different priorities. Playing in the venture creation space allows Atlas to prevent its companies from falling into those same traps by "setting their DNA" from the very beginning, Booth explained.
Going hand-in-hand with Atlas' focus on company creation is the VC firm's policy of taking a hefty ownership stake in each biotech.
"Significant ownership is a really important driver for venture returns," Booth said, noting that an average ownership stake of 10 percent in biotechs under a $100 million fund with a 3-x target means the portfolio has to create $3 billion in value, while a 25 percent ownership stake would give the same returns on just $1.2 billion worth of value creation.
The final secret to Atlas' success? "Really thinking through the right touch points in the ecosystem," Booth said. "How do we get pharma engaged early in these companies? How do we get the buyside acquainted with them well before they need to get public?"
Atlas has proven it's willing to take risks and pursue unconventional business models, as evidenced by its deals with Shire plc to identify and fund rare disease start-ups and with Monsanto Co. on agricultural biotech investment opportunities, as well as its launch of Atlas Venture Development Corp. to derisk assets through virtual development. It's all about optionality, for venture firms and for their portfolio companies. Booth pointed to Avila Therapeutics Inc. as an example of a biotech that did a "fantastic job playing optionality as a strategic game," getting lots of options on the table and eventually choosing a $935 million buy-out by Celgene Corp., which brought Atlas a nice 5-x on the upfront and up to 15-x including earn-outs.
Polaris: The Human Element
Polaris has also been successful investing in early stage companies. The firm has seen eight life science companies in which it was an early stage investor exit over the last three years – years in which exits were not easy to come by. And over the past 15 years, the firm has generated a 22 percent to 24 percent premium to the market on life science returns, according to McGuire.
Like Third Rock and Atlas, Polaris looks for "disruptive science," McGuire told BioWorld Insight. "We aggressively mine university science," he said, looking for companies that have both a broad platform and an initial application – not just unfocused science, but not one-trick-ponies either.
But for Polaris, "the human factor" also plays a big role in helping the firm be successful with its early stage investments. That's true on the company side – like many VCs, Polaris likes to work with entrepreneurs it has previously backed – but it's also true internally.
"Our team has been together for a long time – we've made north of 250 investments as a firm," McGuire said. "Investment and company building is a combination of analysis, effort and ultimately judgment, including a honed intuition. This typically comes with time."
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