It’s a little known-stat, but one that is highly vexing in biotechnology venture investing: Better than 60% of “B” rounds are down rounds. Translation: More than half the time when the second major chunk of capital is put into a biotech company it is done with the company being valued lower than what it was when the first slug of money went in.
It is a big problem. After all, what’s the incentive to be an “A” round biotech investor if you can, more than half the time, show up 12-24 months later and get a piece of the same company for a lower price? While you could argue that there is a free-rider problem — if everyone took that view then no companies would ever make it to that lower “B” price — you won’t convince many venture investors that they should do “A” rounds just to keep the venture market functioning. So, why the lower “B” prices? Well, here’s Ralph Christofferson of Morgenthaler:[While the company will have generally made progress], investors still don’t know whether the proposed technological solution will affect human biology the same as it affects animal biology. Nor do they know whether the biological effect will translate into efficacy in a disease setting. To answer those questions the company must complete final animal studies and Phase I safety trials and then establish proof of principle in at least small numbers of patients. All that — plus a financial cushion that lets the company seek subsequent funding from a position of strength — is what makes Series B rounds expensive, anywhere from $25 to $40 million.
You might argue, as Chris says, that down “B” rounds don’t matter. They are, after all, just a step in a long march to market, and many companies have had down rounds only to produce heady returns for their investors. But the trouble with that view is that partners beat each other up about down rounds, and limited partners beat up funds about it. Saying “Shhhh, it will be okay” doesn’t get you far in the face of mad partners and even more mad investors.
So, is there a solution? While a cynic might call this self-serving, or say it’s just a venture guy saying he’s value-add and his competitors aren’t, the following is still a legit argument:Make creative use of drug development domain expertise. Domain expertise, to me, refers to drug development experience that is obtained after working with dozens of potential pharmaceutical products in many product pipelines aimed at specific disease states. It’s seeing what can go right and what can go wrong over a period of many years. It’s also knowing how to design “killer” experiments that either stop organizationally popular projects in their tracks or validate them, qualifying them for accelerated treatment. Above all, it’s learning where the short cuts are to getting products into the clinic and achieving early proof of principle for the company and investors. Generally speaking, drug development domain expertise leads to taking on projects with clear-cut clinical endpointsinfectious diseases, for example, where one can be certain that a bacteria or virus is really dead. It tends to avoid projects with lengthy, expensive trials such as those involving metabolic or central nervous system diseases. More narrowly, it may mean targeting specific indications when possible — e.g., pancreatic cancer rather than breast cancer — where trials are relatively shorter.
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Interesting. Even more interesting would be to know whether or not the average return on A rounds in biotech is sub-economic.
If the nature of the game is that round A is used to finance activities that have a greater than 60% chance of failure, but the price of buying into those real options makes economic sense, it really is a touchy-feely issue.
Communicating the “many options expire out-of-the-money, a few win big” in advance seems easy, but the prospect theory/behavioural finance folks would tell us that people *hate* that return profile.
In addition to Brent’s discussion of real options, consider this:
According to the article, the key is in having deep pocketed series A investors. This allows them to maintain valuation at series B.
Perhaps many of the A rounds that go on to see down B rounds are marginal companies that could not find deep pocketed investors for A rounds. Instead, the deep pockets understood the risk and stayed on the sidelines until critical questions were answered and/or the price reflected the risk.