Scarce talent meets abundant capital
Many people have an image of entrepreneurs as driven, dedicated, creative people who operate somewhat in isolation, maybe with a small group in a garage, maybe on their own, and who, come hell or high water, are intent on building the next big company, often with suffering and anguish along the way. It is viewed in many instances as an artisanal process, as if the entrepreneur is the business equivalent of the bohemian artist suffering for their craft.
The view of some of the most influential venture funds today is fundamentally different. Leaders in the industry, such as Flagship, Third Rock, Atlas and Arch, are pursuing a more systematic approach to the entrepreneurial process, that if applied with discipline and rigor, can lead to very surprising destinations. They all work by gathering a group of seasoned executives around an idea, often originating in university labs, then developed within their in-house incubators. The intellectual process is first about defining whitespace–areas of great unmet need, represented in therapeutics or advances in technology, or insights into science, where there has not been a dedicated or successful heretofore effort to figure out if there are ways of translating scientific ideas into value. If the hypothesis is deemed promising enough then a company is formed, financed and staffed by the VC.
“We focus on the lead asset and how robust the data it generated is in determining if it passes through our diligence process. That data might come from a patient cell line or a rodent model or other preclinical translational models. Either way, our job is to distill down that data set, synthesizing all the data generated to date, and figure out if it is de-risked enough and if there is enough of a preclinical proof of concept where Xontogeny can build on that.”
Chris Garabedian, Chairman & CEO, Xontogeny
The venture creation model has proven successful, producing strong returns for investors. Most venture capitalists look for returns that ultimately double or triple their initial investments, a 2x or 3x return multiple. In a report by stat news, it detailed returns of 9x on Flagship Pioneering’s fund launched in 2012. As a result of this success and a coming of age of the biotech industry mixed with a raging bull market, fund sizes have reached astronomical levels. Flagship’s latest fund, which closed in April 2020, raised US$1.1 billion, while Arch Venture Partners raised two funds totaling over US$3.3 billion in the past year.
Beyond those engaging in venture creation, the entire venture capital funding ecosystem for biotech not only hit an all time high, but it blew previous markers away. According to Pitchbook, over US$26 billion of venture funding went into US-based biotech firms in 2020. The prior high set in 2018 was US$19 billion. This is about 5x bigger than funding levels at the start of the biotech bull cycle in 2013.
These funds were raised on a much quicker timeline than historical norms — and pools of capital are much larger than ever before. All this makes for a particularly heady environment for startups in fields like cell and gene therapy that require a lot of expensive early work. Even for companies that are not as capital-intensive, more money usually means more options. If you have more money you can do more clinical trials and be generally more ambitious in pursuing moonshot programs. This much money floating around can also ratchet up the competitive tension between investors, as there is an excessive amount of money pursuing a finite number of assets and management teams.
Carolyn Ng, managing director of Vertex Ventures HC, who has stakes in portfolio companies such as Boundless Bio, Obsidian Therapeutics and Twentyeight-Seven Therapeutics, remarked: “It is paradoxical that it is actually more challenging for fundamentals-focused funds like ours to make new investments in the current bull market. The reality is that our biotech VC industry is facing an unprecedented level of competition where there has been a massive influx of capital into the sector from traditional and new players going after a fairly limited pool of high-quality investment opportunities”
Ng continued, cautioning that while most financings occurring today are centered on great science, there is still a limit to which a company’s pipeline can be derisked in terms of actual scientific and clinical risk, “We are witnessing a disconnect now between valuations and early-stage opportunities where scientific and clinical risks are still inherently very high,” Ng affirmed.
When asked if the science supports the growing size of venture rounds we are seeing today, Arch’s Keith Crandell offered: “I have gotten comfortable with it by observing the coupling of the capital with the quality and the track record of the managers that we are able to attract to help run these efforts. These are no longer single asset, single target projects that may have a finite amount of capital needed to take them through the project and then you are done. These are projects that are developing platforms, or in some cases multiple platforms with multiple compounds, often at multiple disease indications. To manage that and partner that effectively you need a very strong class of executive, and those executives basically have 360 degrees of opportunity with large biotech, large pharma, or smaller enterprises. If you do not have the resources to enable them to do the good work that they need to do, it is hard to recruit them.”
What happens when the merry-go-round slows?
More capital continues to flow into these funds creating one of the most auspicious environments for a start-up ever. The easy money with low interest rate theme along with outperforming IPOs has created a big feedback loop that incentivizes VC funds. However, as the cost of capital has dropped, the risks to the discipline of deploying it go up. As Atlas Ventures’ Bruce Booth analagizes: “The average health of the herd goes down with an over-abundance of food sources.”
Regardless of the environment, good management teams pursuing sound science will yield successful companies, but several factors, including a stricter regulatory environment around M&A deals, the adoption of price controls, higher interest rates, or failure on the part of payors to get on board with covering high-cost medications, could mean pain for companies that are mismanaged or pursuing some of the more speculative areas of science currently fueled more by hype than reality. “As long-term investors, we try to avoid herd mentality when it comes to chasing “hot deals”, because to us, successful financing is a means to an end – the end being the delivery of outcome benefits to patients in the clinic,” Ng concluded.
Image courtesy of Triston Dunn on Unsplash