A Primer to Biotech VC

By Elisa Huang, James Bole Pan, Steven Wang

~8 min read

1. VC Fundamentals

There are a few key components about VC that can be generalized across the board, for funds investing in Biotech and also other sectors. First, VCs, just like startups, need to fundraise. VCs fundraise from limited partners (LPs), essentially convincing the LPs that it would be a good idea to let them manage the LP’s money. The people running the VC fund are called the general partners (GPs), and often the GPs are LPs as well, where they put some of their own money into the fund.

Workflow of VC

Once the fundraise is completed, VCs enter a workflow that typically goes like this: deal sourcing, conduct diligence, negotiate investment terms, and investment decisions. Sourcing deals simply means identifying promising companies that are looking to fundraise from VCs, and in early stage biotech investment this often means “stealth mode” lab spinouts, founded upon a key research breakthrough. Conducting diligence means acquiring the necessary information to understand what the company is working on, the target market and competitors, and whatever else is needed for decision making. Negotiating investment terms usually comes after the VC has an inclination to invest, conditional upon whether the terms of the investment is amenable. A detailed discussion of different terms of the investment can be found in other online resources. Lastly, once the negotiation is done, the VC fund often has an internal decision process, commonly known as investment committee, where people gather together to discuss and vote on the investment opportunity.

Principles of Early-Stage Investments

The fundamental principles of VC are really the same as trading stocks: acquire shares at a low price and sell shares at a higher price. One of the major differences, however, is that VCs (and angel investors) need to work with much less liquidity. As an investor in the primary market (non-publicly trading companies), the opportunity to sell your shares is rare and requires effort to locate a buyer. In fact, the growth of Biotech startups is often discrete (instead of continuous), where value inflection points are reached after key success, such as the production of strong preclinical data, strong readout of clinical trials, or particular R&D achievements. Therefore, exit opportunities (to sell your shares) often exist at these inflection points, concurrently with additional rounds of fundraising.

Waterfall Scheme

Now, let’s say that the VC fund made money. How is the profit split between the different parties? The most common scheme is a 80/20 waterfall scheme, where, in general, the LPs who contributed the capital receive 80% of the profit, and the GPs who contributed their talent and time receive 20% of the profit. A small caveat is the concept of preferred return, which is a common but not mandatory component. The preferred return, or “pref” in short, refers to LPs receiving the first 8% of the profit, and the GPs receiving the next 2% of the profit. Anything beyond 10% return gets split exactly 80/20 (LP:GP). In other words, if the fund made less than 8%, the GPs don’t receive a single penny.

2. When does Biotech VC make money

Drug Discovery Process

To understand this, we have to first take a look at the process of discovering a new drug, as the very definition of a biotech startup is a company that engages in novel drug discovery and clinical research.

Before anything remotely business-like shows up, there’s the lab-based research. In an academic setting, professors and PhDs engage in curiosity-driven research to explore ideas, generating papers and IPs. On average 10 million dollars are spent on any drug before it is approached by any VC. The funds that support these researches come from government and charity foundations.

After this, the preclinical phase begins. This is when the technology is ready to be used to generate therapeutic assets. It includes two subphases:

1) Development phase: this goes from having some novel data to exhaustively understanding the mechanism of action in model systems. It also includes the conducting of animal testing to demonstrate the proof of concept in vivo.

2) IND-enabling studies

§ Evaluate potential toxicity risk

§ Estimate starting doses

Completing all these allow the startup to file an Investigational New Drug (IND) Application, which marks the beginning of clinical trials. On average 3-25 million dollars are spent in the preclinical trial phase.

Clinical Trials are the study of the therapeutic asset on human subjects. It includes three phases:

· Phase I: find the correct dose and test for toxicity

· Phase II: prove the concept and show beneficial effects

· Phase III: compare the efficacy of the new drug against standards and conduct tests in different locations (Market Authorization trial)

Each phase, compared to the previous phase, has an increased number of participants, and increased investments. If the drug passes all phases successfully, the company can file a market application (New Drug Application, NDA) to the FDA. If it is approved, we would have a new drug! In addition, there’s also Phase IV: post-marketing safety monitoring to continuously test for whether there are potential side effects. Phase I+II combined would generally cost around 100 million dollars, and Phase III would cost around 100 – 500 million dollars.

Schematics of what it takes to develop a novel medicine (Source: 4Bio Capital)

Above is the process of developing a new drug.

When do VCs come in

VCs invest at discrete timepoints, often aligning with the discrete phases of drug development. For example, VCs could come in after animal testing results and before Phase I, or come in after data from Phase I trials are available. Either way, VCs want to discover value before everyone else and invest in it.

What is value? It is defined by the sum of all future cash flows discounted to the present date. Decreasing the risk of future cash flow increases the present value. In Biotech, market risk is low: people would definitely want an Alzheimer’s drug if it’s available on the market. However, technical risk is high: the drugs under development might turn out not to be effective.

Therefore, the value of pre-revenue startups come from how “derisked” the drug is. To determine this, VCs often look at experimental data and recognize value from it. For example, understanding the pharmacokinetics and toxicology profile from animal studies, or understanding a drug’s mechanism of action using in vitro experiments. They invest in these companies and support them to help move the assets (the drugs in discovery) forward in the pipeline.

For the Seed round, the amount of investment would be 5-10 million dollars. Series A would be 15-50 million, and this amount of money would pay for a few drugs of the companies to get to Phase II. In addition to capital, VCs often help connect the company to resources (legal & regulatory professionals, academic guidance, etc.), provide marketing support, and so on.

Should the trials be successful, VCs have the chance to cash out. VCs could exit (sell their ownership) when the portfolio company is purchased by big pharmaceutical companies or if they go through an IPO (Initial Public Offering). This doesn’t necessarily mean that the drug must reach the market, as many exits today take place well before the end of Phase 3 trials. In fact, many biotech companies go public when they have one or a few drugs in Phase II of the clinical trials.

VC-backed startups drive the innovation of drugs. For every six novel drugs approved in the US, five are developed by VC-backed startups, while only one is developed by a big pharmaceutical company.

What Drugs do Biotech VCs Invest in?

It’s then useful to look at what underlying assets Biotech VCs are investing in - three generations of drugs that currently exist.

1. Small molecules (made from synthetic chemistry)

We have all taken them, and they are manufactured in metric tons by big pharmaceutical companies. They go everywhere in the body, and there is no way to control their action. As a result, they can prove to be destructive.
An example of a drug from this category is Ibuprofen.

2. Large proteins

They are usually made using microorganisms (yeast, bacteria, plant cells, etc). Examples would be antibodies.

3. Advanced therapeutics

Examples would be gene therapy, cell therapy, and RNA therapy.

The graph from McKinsey & Co. shows that VC capital in recent years is concentrated in advanced therapeutic assets and platform technologies (including precision medicine, cell therapy, gene therapy, etc.), reflecting the applications of the most innovative technologies in the industry in recent years.

3. Case Study: Kleiner-Perkins and Genentech

Genentech co-founders: Herb Boyer and Bob Swanson (Image credit: Kleiner Perkins)

This VC investment is one of the largest payoffs in VC history. Kleiner Perkins was a pioneer in VC industry, while Genentech was regarded as the first biotech company. Together this investment laid foundation for biotech VC and still has many valuable insights to offer.

Investor-Kleiner Perkins

Kleiner Perkins is a Silicon Valley venture capital firm founded by Tom Perkins and Eugene Kleiner in Menlo Park, CA in 1972. It has invested in many world-famous tech companies including Amazon, Twitter, JD, Google, Spotify, Slack, Airbnb, etc. Its current portfolio includes Doordash, Handshake, Instacart, etc.

Co-founder: Tom Perkins (Image credit: Vox)

Invested company-Genentech

Genentech was one of Kleiner Perkins’ first investments. The name of the company is a combination of “gene”, “engineering” and “technology”. This biotech company was founded by venture capitalist Robert A. Swanson and biochemist Dr. Herbert W. Boyer in 1976. It is known for recombinant DNA technology to produce commercial medicines. Some of its transformational discoveries include the first targeted antibody for cancer and the first medicine for primary progressive multiple sclerosis. It became a member of the Roche Group in March of 2009 and the two combined their pharmaceutical operations in the United States. More information about the development of Genentech can be found in Sally Hughes’ Genentech: The Beginnings of Biotech.

Book cover of *Genentech:* *The Beginnings of Biotech* (Image credit: Amazon)

Growth of the company

Development of Genentech (Image credit: InT)

Genentech has come a long way, from its initial investment of only $250K, to an IPO valued for $300 million and eventually acquired by Roche for $46.8 billion. What could be the reasons behind the success of legendary biotech company?

Breakthroughs

When Genentech was first founded, there was a lot of skepticism in both the scientific and VC communities on the commercial feasibility of genetic engineering, Genentech’s main focus. Even Perkins thought the investment would be a loss, so the company was extremely prudent about every step they made and strategic about how to spend the money in the initial stage.

Instead of spending huge amounts of money on buying new equipment and doing the experiments on their own, they subcontracted the research and put up more money after they confirmed that recombinant DNA technology could synthesize a relatively simple human protein, somatostatin.
In terms of intellectual property, they chose license over patent.
- Patent gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of time.
- Licensing is an agreement that lets someone else commercially make, use, and sell your invention for a specified period.
- The reasoning behind this choice is because their technology was very basic that they would be in endless patent litigation and spend a lot of money on lawsuits.
They partnered with pharmaceutical companies that would underwrite the costs of marketing and sales in return for marketing rights and a share of the profits.
- e.g. cooperated w/ Eli Lilly on human insulin developed from recombinant DNA technology to save the cost of building an expensive sales and marketing effort
In terms of human resources, they broke the convention of life science researchers only operating in academia, hired scientists and gave them the freedom to publish their work without having to worry about writing grant proposals, which can be very strenuous. With that approach, Genentech were able to have many academic superstars on board and became a biotech powerhouse.
These strategies were not only applicable to Genentech. Kleiner Perkins later duplicated these strategies when establishing another company called Hybritech, which focused on monoclonal antibody development, and it was also a success.

The Role of Tom Perkins

Tom Perkins invested in Genentech, not only in terms of money, but also guided the company as the chairman of the board.

He saw market potential for an emerging scientific field. But instead of relying on validation from other investors or companies, he sought out scientific advice from specialized researchers and used that to inform his investment decisions on Genentech.
- He identified the technical questions that he felt underpinned the potential success of the company. Then he submitted these questions to experts in the field, and didn’t commit his $250K investment until he received positive feedback.
Perkins nurtured the company’s unlikely vision from the firm’s very beginning and helped it to become the success that it is today. He did a lot of hands-on work as the chairman and this mode of venture capital defined what we know today as entrepreneurial venture capital.
As a financial expert, when he saw the company start to lose employees to its competitors, he invented junior common stock to attract and hold key employees.
When encountered failure in research, he came up with the idea of converting stock into bond for stabilization of stock price and prevention of hostile takeover.
He was also very insightful about consumer reaction. When Genentech first synthesized bovine growth hormone, which is a drug for cows to increase milk production, Perkins predicted that consumers would not react positively t this product. So they sold it to Monsanto, which got into trouble for this controversial drug.
Even though he was not a biology expert, he still attended all the research meetings and tried to learn the science as best as he could so that he could make informed decisions for the company.

For more details on Genentech’s story, check out https://oac.cdlib.org/view?docId=kt1p3010dc&brand=oac4&doc.view=entire_text

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