Biotech Venture Capital’s Uneasy Future–The Fed’s Impact On Innovation

Disrupting the disrupters: Rising rates make investing more expensive. The cost of startups is already too high.

In the late 1980s in an office in Boston a venture industry pundit pressed his forefinger into the chest of a newly fledged associate and said, “You can’t call yourself a venture capitalist until you’ve been in the business at least 10 years.” His message was harsh but the rationale simple. Ten years was sufficient time for a complete venture business cycle from investment to exit, at least in IT—biotech hardly existed then. During that time a manager would see up and down markets and learn how to guide companies through both. Today, many venture capitalists and the CEOs of portfolio companies have never seen a down market.

With the Fed talking about raising interest rates over 200 basis points or more this summer to combat the highest inflation since the 1980s and the stock market signaling a possible recession, what lies ahead for venture managers and their companies?

Financial markets sneeze; biotech catches pneumonia.

Tight money can be particularly hard on biotech. With no products and no prospects of revenue for years, if not decades, these companies are totally dependent on financial markets. When markets seize up, funding may not be available for early-stage biotech at any price. The earliest companies with the most innovative—i.e., riskiest—products often go begging. Yet, these are the medicines on which the industry depends for next-generation products and patients turn to in times of crisis.

A recent article in the Wall Street Journal described current conditions in the innovation sector. “Many big money managers have fled startups. Venture capitalists are steering clear of high valuations and demanding that companies spend less. …In March, startup CEO Doug Ludlow cautioned his fellow founders on Twitter: ‘If you haven’t already started on a path to break-even, start immediately. In 2022, VC’s are going to pull back massively.’”

He is talking about high tech. Biotech companies have no path to break-even.

Since the real estate bubble burst 15 years ago, the economy has been in recovery, and the Fed held interest rates low. A constantly rising market reinforces risky behavior. Uninvested capital held-back for emergencies does not make money for investors. Managers who minimize reserves outperform their peers. But crashes come on suddenly. Venture firms caught late in an investment cycle, low on cash, can find themselves without access to the funds needed to sustain their companies and ultimately their firms, as happened to more than half the industry in 2007-8.

When companies get into trouble, CEOs and VCs have few variables that they can adjust to dial back costs or reduce overhead. Biotech is the business of converting money into clinical (human) data, which in turn can be used to raise more money. Managers can’t save their way to success. Each round of financing must be sufficient to reach the next value inflection point—the results of a study or a critical mass of patient data. Pay-as-you-go is not an option. A company cannot risk running short in the middle of a trail. The FDA will not treat kindly a sponsor who puts patients at risk with no prospect of meaningful results from an incomplete study.

Early-stage companies must spend to stay alive. A corporation with sales can lock down to weather the storm. A startup that tries to hold still loses value quickly. Patents last for 20 years. Products with a 10+ year development cycle have limited shelf-lives. Competitive technologies continue to advance. If a company runs out of cash, shareholders must come up with more money or face a washout—when new investors take over the company for pennies on the dollar. As a result, venture managers can find themselves carrying the companies far longer than they had planned. To make matters worse, in a down market all the companies in a portfolio get into trouble at once.

Caught in a squeeze, VCs first stop considering new opportunities to save the investments they have. As money dries up throughout the industry, they can find themselves facing a Sophie’s choice of deciding which companies to feed and which to let go. For those trying to gage how long tough times will last, the famous economist John Maynard Keynes advised, “markets can remain irrational, longer than you can remain solvent.”

Conditions that “strengthen the herd” can cripple biotech.

In conventional markets, periodic bouts of tight money weed out the weaker players to the benefit of the stronger. Established venture firms with pedigrees stretching back decades, will survive, even prosper as the beneficiaries of washouts. Strong relationships with institutional investors and long track-records enable them to raise money when others can’t. But for newer firms and the earliest or most innovative startups, the situation can be very different.

It doesn’t take a recession to impact biotech. Even a modest increase in rates will raise the cost of money. Both public and private markets experience a “flight to quality,” as investors pull their money out of speculative high-risk-high-reward investments for “safer,” more familiar names. Newer venture firms with limited history and early companies with unfamiliar, innovative products are the most vulnerable. The companies perceived as “weak” are frequently not the ones with the least promising products but those farthest from market with novel ideas. Had the current pull-back occurred prior to the pandemic, companies like Moderna might not have survived in anything close to their present form.

In established industries, good teams can often acquire products from struggling competitors, strengthening the herd. But in biotech consolidation doesn’t increase efficiency. Each molecule requires its own trials, diagnostics and supporting science. Costs tend to be additive and synergies few. Virtual companies already have minimal corporate overhead. Gathering several under a single management provides limited savings. An acquisition requires that buyer and seller agree on a price. A business is worth potential profits, discounted for time and risk. With a 90+% clinical failure rate and an uncertain market, years in the future, valuations are speculative, to say the least. As a result, boards and managers typically over-value their own technology and under-value that of potential merger partners.

Companies in public markets have a particularly difficult time when rates are high and markets down because the generalist investors, who have driven biotech valuations to record highs over the last decade, are the first to leave the sector. The life-science specialists who remain rarely roll up their sleeves to reorganize promising young companies in financial trouble, as private-market venture managers do.

Today’s tough times are far better than the good old days.

The Great Recession of 2007-8 nearly killed bio-venture. The bio-venture business model of the 1990s, inherited from Silicon Valley that emphasized lean operations left biotech companies under-capitalized. The industry is far stronger today than at any time in the past. Recently venture capitalists have raised record amounts of money. Portfolio companies are better financed, even to the point of excess.

The biopharma ecosystem also has greatly improved. Treatments for conditions like cystic fibrosis (Kalydeco, Vertex), cancer (Keytruda, Merk) and the RNA vaccines (Moderna and BioNtech) for COVID, all of which originated in venture-backed companies, have demonstrated the industry’s potential and the urgent need for new drugs. The FDA that used to pride itself on keeping thalidomide off the market, now works with developers to accelerate approval of the most innovative drugs. Contract research organizations (CROs) and consultants enable startups to operate in a virtual mode. In the 1990s, when each company had to have its own laboratory, the ultimate cause of failure was often foreclosure by the landlord.

Today, the industry can test more drugs, more quickly and lower cost than ever before. This downturn, as bad as it might be, will not threaten its future as the last recession did. However, 1980s-style inflation and a subsequent recession could have a lasting impact on biotech. When the industry contracts it becomes clubbier and more narrowly focused. Recovery will be slow because venture is an apprenticeship business, and managers must learn over multiple cycles. The loss of diversity will reduce innovative capacity. The remaining firms tend to work with each other and can develop a consensus mentality in a business that depends on finding outliers. If the government expands research budgets in the wake of the pandemic, the industry may not be able to take full advantage of the most innovative technologies coming out of academic labs.

At the same time, startups launched in tough times tend to do well. It is much easier to instill fiscal discipline from the outset than try to impose it on an organization with sunshine spending habits. Michael Gilman, CEO of Arrakis, put it recently in an article for Biopharma Dive, “The strong and/or adaptable will survive.” However, the gains will come at a price—needed treatments that never get to patients, technologies that are delayed or lost entirely.

Experimental innovation is at once the most creative and least efficient process in the commercial world. Even in the best of times the failure rate for startups rivals that of the drugs they are trying to develop. Venture capitalists have never been afraid of taking the losses necessary to drive progress, regardless of market conditions. The innovation has thrived because managers launch ten companies where one is needed. That creative excess enables the community to respond in times of crisis—an individual’s diagnosis of cancer or a global pandemic.