Biotech VCs Aren’t Lemmings Anymore. They’re Lone Rangers

Xconomy National — 

A certain song has been running through my head the past few days. Lately, it strikes me as an anthem of sorts for biotech venture capital in 2013.

It’s Fleetwood Mac’s classic break-up song, “Go Your Own Way.”

Allow me to explain. Biotech venture capital has been going through a shakeout now for a couple years, which I’ve written about quite a bit. If you want to be charitable, there are maybe half as many venture firms investing in life sciences companies today as there were five to 10 years ago. There are maybe only a dozen firms left in the U.S. who can say with a straight face that they still are active investors in early-stage biotech startups. It may be harder now than it’s ever been to raise money for a new biotech idea.

That’s a problem. What fewer people seem to have noticed, though, is just how the shakeout has fundamentally changed the venture capital business model, and how the firms who are left standing relate to each other. Venture capital firms have traditionally formed tight little cliques known in the business as syndicates. The idea here was to find a great entrepreneur to back, call up 3-4 of your buddies at other VC firms, and get them to co-invest for the next decade. The conventional wisdom said that it was a good way to make sure a startup drug- or device-maker would have enough capital to reach the desired “liquidity event” of an acquisition or IPO. Along the bumpy journey, each VC firm knew it had between 12 and 20 percent ownership in the startup, and could take solace knowing the network limited their risk. A couple bad bets on startups, in other words, wouldn’t wreck an entire fund.

Critics have long scoffed at the groupthink that emerges in these syndicates. VCs often get criticized for behaving like lemmings who blindly run together off of cliffs.

But VCs are behaving less like lemmings today, and more like lone rangers. There are a number of reasons. So many venture firms have been slowly going out of business that there aren’t many players left to syndicate with. The few healthy firms remaining have been freaking out about what they call “syndicate risk.” That’s a fancy way to describe the fear VC firms have that their peers will run out of cash in the next few years, leaving their portfolio companies high and dry when they need more money. Increasingly, the surviving venture firms are figuring out ways to start companies on their own, hold onto a bigger piece of the equity ownership, and hold their breath until this especially high risk/high reward proposition pays off.

Recently, we’ve seen a string of stories in which VC firms are proving they can place winning bets on their own, without the support of a syndicate. Take a look at some recent examples:

Third Rock Ventures—The Boston and San Francisco-based venture firm is not opposed to joining syndicates, as it has welcomed some big-name friends (Bill Gates, Yuri Milner, et al) to co-invest in one of its gems, Cambridge, MA-based Foundation Medicine. But Third Rock often prefers to have its partners involved in incubating companies it starts in-house, enabling it to retain operational and financial control for young company’s formative years. Once its hatchlings emerge from the incubator, Third Rock has shown a tendency to commit $30 million to $40 million of its own money in Series A financings, without any syndication.

The go-it-alone strategy paid off in a big way with its bet on Lotus Tissue Repair. That company was acquired in January for about $49 million upfront, plus $275 million in milestone payments. The deal represented a three-fold return on Third Rock’s investment on the upfront payment alone, and could end up being a 20-fold return over the long haul. Why was it such a big winner? Third Rock, the lone VC in the deal, retained a whopping 73 percent ownership stake in Lotus Tissue Repair.

Flagship Ventures—the Cambridge, MA-based firm takes a lot of pride in its history of active investing, not just passively putting money into companies and sitting on the board. This week, one of the alumni from Flagship VentureLabs came out of nowhere to create huge value. Cambridge, MA-based Moderna Therapeutics, which Flagship incubated and backed with a $40 million Series A financing round in 2010, struck a partnership with AstraZeneca that brought in a $240 million upfront cash payment, and much more than that in future milestone payments. The deal was extraordinarily rich for a company with a new technology platform—messenger RNA-based drugs—that hasn’t yet advanced into clinical trials. Flagship isn’t splitting this baby with any other VC firm, and it didn’t even give up any equity to AstraZeneca. CEO Stephane Bancel talks a good game about building a great, big company. You can be assured that chairman Noubar Afeyan, Flagship’s managing partner, wants to make sure he remains the dominant owner as Moderna enters that growth phase.

Domain Associates—The Princeton, NJ and San Diego-based firm has a long history of syndicating with other VC firms, but it recently reduced its need to syndicate. That’s because it found one extremely big friend from Russia. Rusnano, a nanotechnology investment arm of the Russian Federation, agreed to put $760 million into life sciences startups in the U.S. and Russia, with Domain’s help. Domain has used some of that Russian cash to support companies like Lithera in San Diego and Regado Biosciences in Basking Ridge, NJ, as my colleague Bruce Bigelow has reported.

Aside from its Rusnano alliance, Domain recently struck a deal with Lexington, MA-based Cubist Pharmaceuticals (NASDAQ: CBST) that gives Cubist the right to acquire one of the companies that was a Domain solo act—San Francisco-based Adynxx. Cubist agreed to pay $20 million upfront for the option to acquire Adynxx, and will pay another $40 million if it exercises the option, Cubist said in a recent regulatory filing. Domain put $18 million to a Series A financing of Adynxx in 2010, which means it has already gotten its money back, could get a 3x return if Cubist exercises its option, and Domain still has upside potential left if Adynxx hits certain development goals.

Avalon Ventures—The San Diego-based venture firm is known for its recent investment success with Zynga, the social game company. But it has put together what it calls a “hat trick” of three straight wins from its life sciences portfolio. Two companies primarily backed by Avalon—RQx Pharmaceuticals and AFraxis—were sold earlier this year to South San Francisco-based Genentech, a unit of Roche. Another company Avalon started, San Diego-based Zacharon Pharmaceuticals, was acquired by San Rafael, CA-based BioMarin Pharmaceuticals (NASDAQ: BMRN). Details on these deals are limited, but they appear to have been structured to provide a small amount of money to the little company upfront, allowing shareholders to get a lot more later if the little company hits certain goals. Zacharon raised about $4 million with a post-money valuation of $7.5 million, according to VentureSource data cited by Bruce Booth on his LifeSciVC blog. BioMarin paid $10M upfront and a set of undisclosed milestones. That’s not a windfall in VC terms, but Avalon should have doubled its money on the upfront payment alone. It’s harder to pin down Avalon’s returns on the other acquisitions, because of a lack of disclosure.

Just scanning those headlines alone, it’s pretty easy to conclude that VC firms who go it alone can make money.

Bijan Salehizadeh of NaviMed Capital

Bijan Salehizadeh, a managing director with Navimed Capital, there’s a pattern that you can expect VC firms to continue to follow. “Part of it is a reaction to the sense that there’s a lot of syndicate risk, so people are saying ‘let’s just take that off the table,’” Salehizadeh says.

Another reason VCs are going it alone is they just aren’t that into each other anymore. It’s based on a growing realization that the old model, of 3-4 venture firms pooling resources in a $30 million to $40 million Series A round, often ends up creating dysfunction. When a number of VC firms get board seats at a startup, the firms sometimes end up disagreeing about strategy. Research from Correlation Ventures suggests that startups with multiple VC board members tend to have lower odds of success. Another factor is the simple math. If you’re a VC firm and you are syndicated in a portfolio company with 15 percent ownership of a company that might someday be worth $100 million to $150 million, that’s not a big enough return to move the needle in a VC fund with $300 million or $400 million, Salehizadeh says. Owning a bigger piece of the company is one way to get a bigger return, he says.

The advantages are pretty clear. A go-it-alone VC keeps more ownership, retains more control, and can make board-level decisions quickly. Less time gets wasted on boardroom politics, or analyzing whether your pal at another VC firm will still be in business five years from today.

There are disadvantages, of course, with this approach. There’s more risk. If you have a $300 million venture fund, and want to invest $30 million each in 10 companies as a go-it-alone VC firm, the margin for error is slim. You can only have one or two portfolio companies fail in a basket of 10 companies, before you start putting a lot of extra pressure on the remaining portfolio companies, Salehizadeh says. Scalability is an issue, too. If you’re going to do this roll-up-the-sleeves-and-go-it-alone style of investing, you better have partners who have operating experience and really know what they’re doing. You can’t just hire bright young associates out of Harvard Business School and turn them loose. If you’re a firm like Third Rock, Flagship, Domain, or Avalon, you have experienced people who can do this, but there aren’t that many.

I’ve said before, I’m concerned about the lack of venture capital investment that’s going toward innovative life sciences startups, but I will say that some of the adjustments VCs are making to this reality are encouraging. A few firms will survive. And when they hit it big, they’re really going to hit it big. Venture capital may be becoming a less clubby, less cliquey world, which might be disappointing to some. But if the industry ends up with a small group of really strong VC firms that can dare to dream big, that’s not all bad. Cue up the Fleetwood Mac!

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5 responses to “Biotech VCs Aren’t Lemmings Anymore. They’re Lone Rangers”

  1. Margaret Anderson says:

    Luke-at the peak, how many VCs were in this space if 12 remain?

  2. Margaret—I don’t know the precise answer to that question. I do know the NVCA has said there were more than 1,000 active venture firms overall in 2000, and it was down to 462 by 2010. Those numbers include tech, biotech, and cleantech focused firms.

    I’ve heard one healthcare VC tell me that a private analysis of VentureSource data shows that 2/3rds of the most active healthcare funds from 2004-2008 have switched over into what you could call “inactive” or zombie funds. That sounds about right to me. If I had to take a guess, I’d say there were 25-30 early stage healthcare investors at the peak in 2006-2007.

  3. Pi Shaped says:

    The solo, hands-dirty approach makes a lot of sense, and, RE: the Monday morning twitter debate between @adamfeuerstein @johncfierce @matthewherper etc about TRV, I would be willing to bet this approach will pay off in the long-term.
    Let’s look at some numbers using assumptions from NVCA with the $300 million fund investing in 10 companies. The NVCA states it is estimated 40% of the companies fail, 40% produce modest returns, and 20% produce high returns. So, out of the $300m fund, 4 companies will fail, so there’s $120m gone.

    4 companies will produce modest returns (let’s call that 1.5-2x), so those 4 will return $200 million total (avg exit $50m from $30m investment – modest, no?).

    In order to hit a multiple of 3x your fund, those 2 companies will have to hit exits over $300 million each.

    Think you can call 2 out of 10 companies to become the next Enanta or Tetraphase? Are you feeling lucky?

    Obviously, this assumes you don’t lean into your winners and back off your laggards, but I think it’s helpful anyhow.

    This is exactly what Bruce Booth was saying about the math problem in life science vc. I think the only way you’ll truly realize the potential of the companies is if you really lean into them and build them from the ground up, a la TRV, and go it alone to avoid the complications as you mentioned of a multi-headed board wanting to go in different directions.

  4. Cornelius Diamond says:

    Luke, please tell me why VCs, especially in biotech, should exist at all? It is clear that most money is raised from angels these days, and corporate/foundation partnerships for later rounds. Most entrepreneurs would be wise to avoid these fools, who kill innovation and think they are the horse when they are just the saddle. We are moving to a ‘verified’ crowd-sourcing platform, where LPs can directly invest with companies, hiring a consultant to select which ones their funds should put their ‘risk’ pool of money in. This way, they pay just salary, and avoid the 2% management fees that partners enrich themselves with while doing nothing. And they keep 100% of the return. They can also accept less equity, which benefits the entrepreneurs as well.