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The term “Valley of Death” has come to describe the period of transition when a developing technology is deemed promising, but too new to validate its commercial potential and thereby attract the capital necessary for its continued development1. During this transition, there is often a funding gap due to the weariness of risk-adverse investors. This is especially true today with the depressed market, creating limited exit strategies for early investors.

Drug discovery often begins in academic research labs; many of today’s best selling and leading edge products have their roots in academia. These include Byetta, Copaxone, Geldanamycin, Emtriva, Alimta, Taxol, and Rapamycin. But the process of translating a laboratory discovery into a drug is fraught with difficulties. There is a tremendous gap between the time of the original discovery and the time to market.
Only 0.03% of VC funding goes into the seed stage due to the very high risk of failure2. For many researchers, the initial source of funding for discovery work often comes from the NIH in the form of SBIR grants. In bioscience research, the initial phase I grant can be around $150,000 for pilot research. The number of applicants for these grants has grown significantly in the past decades. In 1983, fewer than 1000 grants were sought, by 2006, there were more than 3000 applications; in that time period the percent approved remained between 20% and 30%, leaving an increasing number of applicants looking for alternative funding sources.
Universities and non-profit organizations (NGOs) also support early stage research, though for different reasons. Universities can receive millions of dollars in royalties if a product from their lab is developed. By spending small amounts and coaching their researchers, small investments may pay off handsomely in the long run. Many universities have formed technology transfer centers to help take discoveries from research labs to the hands of private companies for commercialization. NGOs typically invest in specific disease areas at an early stage in promising technologies to accelerate research toward the development of cures. Without pressure for financial payoffs, NGOs are able to take on these riskier investments.
The NIH also provides larger phase II grants of over $1 million each through the SBIR for proof of feasibility studies to assess the commercial viability of a project. Venture funding is often sought in conjunction with phase II grants. After these grants, the NIH provides no other funding for these projects. VC, angel investors, private equity, collaborations, or other government grants can all be sources of future financing.
Venture capital and biotechnology have worked hand in hand since the formation of Genentech and has been crucial to the development of the biotech industry. Between 1986 and 2008, VC biotech investors averaged net returns of 20.7%, although suffering a loss in 2008. In high risk biotech investing, 44% of VC investments ended in total or partial losses while two-thirds of winners required holding periods of five or more years3. Historically, about 18% of VC money has gone into the sector.
VC funding has dropped 33% in 2009 from 2007’s all time high, and investors have become especially conservative. While VCs have always tended to favor more de-risked assets- that is, after the proof-of-feasibility stage- they are now waiting even longer before pulling the trigger. This has left entrepreneurs in a bind, stuck between seed funding and VC funding. VCs are asking for ever-more data before investing, but money is needed to generate that data- a sticky situation indeed. Just at the point in development when costs are beginning to increase significantly, financing has become increasingly scarce4.
Money is flowing disproportionately to top-tier companies, with little left over for companies in the lower tiers. This has served to widen the chasm in the Valley of Death. There may be a renaissance in biotech VC investing, but until then, the industry may need to undergo some changes to ensure its continued growth.
The biotech sector is in serious need of consolidation and rationalization. Worldwide, there are 4000 private and 600 public biotechs, half of them in the US, very few profitable. In 2007, there were 2742 compounds in the clinical pipeline. Surely some redundancies can be eliminated. As we have seen, more compounds does not equate to more drugs approved. Not every idea is a good idea and deserves funding. Consolidation will ensure the best ideas will receive sufficient funding to succeed.
With the weeding out of biotechs that is likely to come (I say likely because biotechs have a way of hanging on like zombies), two business models look to strengthen in today’s business environment:
1) Hybrid biotechs with strong platform technologies, well financed, with the ability to take drugs to market. Hybrids will have strong IP in a broadly applicable enabling technology with the potential to create improved drugs. Hybrids both license this technology to others and use it to generate their own pipeline. They have a high burn rare from their operations, which is partially offset from their technology licensing.
2) Virtual biotechs are comprised of a core management team with completely outsourced operations, and maintain their focus on speed and cost, which fits well with the mindset of many VCs today.
Virtual biotechs may be well suited to take inventions from labs to a validated stage where additional capital can be found to complete development of a project. A validation point can be successfully developing a compound through Phase I or Phase II POC. Compared to laboratory startups, they have the advantage of strong management teams and the ability to lower risk by taking on multiple projects at once. Lean operations provide greater flexibility and a better chance of bringing a project to POC on a low budget. Most of all, they have the financial muscle to bridge the translation gap- the Valley of Death.
With virtual biotechs, there is no need to constantly form new companies for the purpose of developing a single invention- both risky and a highly inefficient use of resources. Spinning off a company from an academic institution requires the build up of infrastructure, no matter how small. The researcher also bears the cost and risk of a project’s failure, lacks expertise in navigating regulatory pathways, and management of outsourcing contracts. Allowing a dedicated drug development company to take over a project allows the academic researcher to offload significant risk while maintaining the ability to participate in the upside.
References:
  1. Venture Funding and the NIH SBIR Program, National Academies Press (US); 2009.
  2. Challenges in a Biotech Startup, Kellog School of Management 2006
  3. The Cost of Capital of Early Stage Biotechnology Ventures, Boston University, Harvard Universty
  4. Desperately Seeking Cures, Newsweek, May 15, 2010



Disclosure: Long OTC:RHHBY

Source: Crossing the Biotech 'Valley of Death': From Innovation to Cure