17 Oct The challenge of financing today's Midwest life science companies
In our world of Midwest life sciences, one of the most difficult issues has been achieving funding to successfully propel companies along a pathway to commercial launch of products and some kind of positive cash flow.
There are now 48 Midwest VC groups in 16 states with combined capital of $2 billion under management that are affiliated with the ever-growing Mid-America Healthcare Investors Network.
Aside from the traditional eight states that form the Midwest (Illinois, Michigan, Ohio, Wisconsin, Iowa, Minnesota, Indiana and Missouri), this additional group includes Kansas, Kentucky, Pennsylvania, Alabama, South Dakota, Nebraska, Arkansas and Tennessee.
The problem is that only a small segment of this group (my estimate would be about 20 percent to 25 percent or about 10 to 12 VCs) invests in the earliest stage of companies (the seed stage). This is compounded further if you look to see how many of these VCs are actually in a stage where their funds are in a position to invest (given the cycle of their fund).
This factor limits the group even further as many are out trying to raise new funds. By my estimate, only about one-third of these VCs are in “funding mode”. This means that about 16 VCs and using the 20 percent to 25 percent estimate to position for early stage companies and there are about four early stage VCs in active funding mode in the U.S.
If you further take into account each group’s investing philosophy (the types of companies or technologies in which they invest), we drill down to a smaller available group of VCs for any given company that’s looking for funding. Another factor is that the typical size of a Midwest VC fund is relatively small compared to the East and West Coast funds.
We’re talking about $25 to $50 million as compared to $100 to $200 million.
As a result, it’s critical that some kind of deal syndication takes place. Deal syndication means that there’s usually at least one or two lead funds on a deal that help bring in two or more VCs. A recent example of Midwest deal syndication is the successful financing round of Missouri-based biotech company Kereos, which raised $20 million.
So where does that leave an early stage company? There a couple avenues aside from seeking VC money. These include angel groups, state and federal grants, state loans and city-based tax increment financings (TIFs).
I have covered the growth of life science-based angel groups in prior columns this year. Fortunately, this is a trend that is growing. Having said this, we probably need five to 10 times as many groups as we currently have. Recent moves by both Missouri and Wisconsin to create special tax considerations for angel investors could increase the number of angels.
The downside is that such angels will be limited to state-centric investments. Another issue with angels is that they usually only like to invest in companies where they can drive and physically see the company. Though I’m told this limit is 100 miles, I think it’s more likely to be 30 to 50 miles.
With respect to state and federal grants, Midwest companies have been successful in raising money in both areas. The wonderful part about grants is that they are non-dilutive (no stock is issued). The danger zone here is that SBIR Phase I grants are limited to $100,000 in funding and are a prerequisite to getting the more lucrative Phase II grants.
Another danger is that companies typically relying on state and federal grants as their main source of income often have their products and technology skewed toward what the NIH wants to see get funded versus what the marketplace is calling for, which isn’t necessarily the same. Therefore, the company becomes almost an academic pursuit for research.
The third area is state loans and TIFs.
There have been some creative efforts undertaken in this area in a number of states (particularly in Illinois, Michigan and Wisconsin). The problem is that most of these efforts are limited to $200,000 or less. While TIF financing can be higher than this amount, it usually involves some kind of multimillion-dollar construction effort and is usually city-centric.
Another source of biotech funding: Partnering
There is another pathway I haven’t mentioned and that is one related to partnering. Most life science companies will never have the wherewithal to reach the marketplace themselves.
They need to find commercial or even development partners to reach the commercial goal line. This is the usual rule: the earlier the development stage of the product, the less value is on the table for the innovator (or inventor) company. Often the innovator company has to “give away the first baby,” which means the value of the first deal struck with a commercial partner may not be optimal.
Even stellar biotech company Amgen had to deal away significant rights with its first product to get the money and help it needed to get EPO (erythropoietin) to the marketplace. The partner in this case was Johnson & Johnson, which received all the international marketing rights as well as U.S. marketing rights for the larger market. This limited Amgen to a co-marketing role in the U.S.
One biotech adage I’ve heard from savvy biotech entrepreneurs is: “Partner early and frequently in order to progress technology and products.” While a potential partner may not put up significant funds in terms of licensing fees, milestones and equity, picking up critical development activities may in effect be helping the innovator company in a significant way by its development expertise as well as by covering development expenses.
The traditional way to measure the benefits of a deal with a partner company is to look at the profit coming out of a deal and using a net present value (NPV) calculation of the profit streams to look at how much money is going to the innovator company and the partner company. The earlier the stage of development of the company’s product, the lesser share the innovator company will pick up.
The closer the product is to the market, the more the innovator company’s share of NPV profits increases.
I am reminded by a very recent article (“It’s All Academic”) in the October 2005 edition of Pharmaceutical Executive that an additional factor that’s critical to evaluate the appropriate deal profit split is called the “risk-adjusted NPV”. This means you need to factor in the likelihood of failure and the development risk.
This factor can dramatically shift the profit split as the partner company may be spending more in total funding of the product development costs. According to another article in the same magazine (also on business development deals in biotech), not only does the profit shift under the risk-adjusted approach but the mix of revenue from a deal also changes.
Still another article (“Asking the Right Questions”) in this same magazine provides an 11-step program to navigate the twists and turns of biotech partnerships:
• What do I want?
• Don’t forget your strategic plan
• Develop an IP management strategy
• Assess the commercial potential
• Evaluate your portfolio
• Gather and analyze data
• Identify and prioritize key partners
• Develop presentation collateral
• Assess commercial interest and attractiveness
• Finalize the partnership model
• Understanding partnering models
While some of the above is self-evident, some explanation is needed. With respect to the first step, the authors insist that there must be perceived equal value by the partner company. Some of the key questions the authors raise here are:
• How does this partnership further my company toward its mission?
• How do we effectively evaluate the viability of a commercial partnership?
• Is partnering the most desirable strategy?
Regarding the third step, usually a partnership results in new and unexpected intellectual property as a result of the deal. You also need to make sure you are proactive on your existing patent filings to make sure they are issuing as anticipated as often the deal (and royalty level) is predicated on issued patents.
Step No. 6 also deals with an analysis of your IP in comparison with patient populations, customer adoption, target pricing and reimbursement levels.
Step No. 7 also involves taking into account your IP in terms of a screening mechanism for identifying key partners. Step No. 10 involves clear identification of due diligence steps for each company needed to complete a deal and making sure that both companies are working off the same perspective in the financial modeling of the deal.
Finally, step No. 11 helps you to identify the right deal structure in alignment with the degree of control you want over your product or technology. The table below gives us an idea of the spectrum of deal structures.
According to the biotech deal-making Web site of Recombinant Capital, which has gathered deal-making information for the last 10 years, the number of biotech deals (out-licensing products from biotechnology companies to Big Pharma) has increased from about 300 deals in 1995 (with an average deal size of about $12 million) to about 600 deals in 2004 (with an average total deal size of about $31 million).
This number is obviously lower for devices and diagnostics than drugs.
While the number of biotech companies and products under development has increased significantly during this period, so has the appetite for new products to fill the product pipeline of Big Pharma. Even Amgen and Genentech now in-license a significant portion of their products from other smaller companies.
So while you’re trying to raise money from diverse sources, don’t neglect the prospects for partnering with another company to source funding or for cost avoidance (cutting down on your own burn rate) as well as for providing substantial product development and commercialization expertise.
See you next week!
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