Biotech Startups: Move Slow and Fix Things

Mar 10

Startups are the primary source of biotechnology innovation. But funding for biotech entrepreneurs has been on a risky trajectory. What lies ahead? In our latest Biotech Insights blog, Joel Bateman, first-year MBA student at the Stanford GSB argues that incorrect parallels to the tech industry and perceived falling costs associated with biotech startups have led to riskier and earlier funding for biotech startups. He outlines implications for the years ahead and offers ideas for biotech entrepreneurs to navigate the bumpy terrain and build successful startups.

Joel Bateman, MBA Student, Stanford Graduate School of Business

Startups are the primary source of biotechnology innovation

Innovations delivered by the biotechnology industry are like something out of a science-fiction novel. Turning human skin cells into stem cells to deliver cell therapies, harnessing the body’s own immune system to attack cancer cells, directly reading and writing desired DNA sequences - these are all realities today which would have been genuinely unthinkable just 20 years ago.

With such excitement and momentum, many almost accept as a foregone conclusion that the next 20 years will continue to deliver mind-blowing discoveries. I’m not so sure. None of my doubts stem from the talents of scientists in the lab - all my concerns relate to how we are funding and incentivizing people to become life science entrepreneurs.

Start-ups are overwhelmingly the primary driver of innovation and growth in the biotech ecosystem; in 2018, biotech startups were responsible for 80% of the total biopharma drug development pipeline [1]. It is critical that the industry continues to create an environment which encourages scientists to become entrepreneurs and convert their academic findings into real commercial applications that reach patients.

That’s a difficult task and, quite frankly, it’s surprising that any life science entrepreneurs exist today. The so-called ‘valley of death’ in biopharma startups is unlike any other industry - only 0.02% of drugs in preclinical development get commercialized [2]. Even this figure doesn’t do justice to the full rate of failure - progressing a company from an academic lab to secure sufficient IP and raise venture funding in order to get a preclinical trial underway is in itself a difficult obstacle. Adding to the challenges, if it takes 10-20 years of development before a therapeutic is on the market, entrepreneurs are also expected to dedicate a substantial portion of their career to a venture before it, in all probability, fails.

Here, I synthesize a few trends in the biotech startup space, outlining its evolution from a venture creation model to one where perceived falling costs have led to a frenzy of early-stage investment. Incorrect parallels between biotech and internet company trends have led capital investment growth to rapidly outpace the number of new ventures being formed, and we are starting to see the market contract as a result. Next, I outline expected short-term implications of reduced revenue and profitability, along with longer-term implications for the entrepreneurial landscape becoming more fused with in-house VC approaches and focused on platform technologies. Finally, given these trends, I suggest how life science entrepreneurs should be navigating this landscape to be successful - by de-risking in the lab for as long as possible, working with non-profit accelerators that are addressing the issues in the industry, focusing on platform approaches, and carefully selecting smart-money VCs to partner tightly with.

Funding for biotech entrepreneurs has been on a risky trajectory

Right up until the mid 2000s, biotech startups tended to operate within a classic “venture creation model” in which entrepreneurs would take an idea, as progressed along as possible from an academic lab, to a variety of venture capitalists and assemble a sufficient syndicate. Early rounds of financing would be high CapEx - purchasing a standalone physical labspace and hiring a dozen scientists - and when such ventures failed, it was especially costly [3]. Once the technology was proved out, venture firms who took this upfront risk would bring in an experienced executive team to help grow the company. While other technology industries tended to be founder-led, biotech maintained a more classical model somewhat detached from the original scientific experts. Some have argued that the success of Genentech is what laid the groundwork for this model - Bob Swanson was a venture-capitalist while Herb Boyer maintained his position on the UCSF faculty [4].

From 2005-2020 this trend changed dramatically and biotech startups began shifting to a founder-led culture featuring postdocs and graduate students. Inspired by the success of Silicon Valley internet start-ups, many saw a parallel to the biotech industry. Tech startups took off as the cost of launching an internet company decreased dramatically, and many believe the costs of launching a biotech startup have been undergoing a similar trend. For example, contract research organizations have become more available and competitive (accelerated as pharmaceutical companies reduce in-house R&D activities), flexible lab space arrangements are becoming more commonplace (e.g. MBC Biolabs), DNA sequencing costs have fallen dramatically, ‘virtual’ experimentation is becoming a reality (e.g. Emerald Cloud Labs), and other companies are addressing costly regulatory hurdles in IP and FDA pathways (e.g. CognitionIP, Enzyme).5

As a result, we have seen the market respond in a similar way to the tech boom, with a frenzy of investment activity. Biotech venture capital funding increased from $3.6B in 2012 to $16.8B in 20206, and the amount of money going towards seed rounds quadrupled between 2016 and 2021 - up to $2.1B [7]. COVID and the impact of mRNA vaccines have accelerated this frenzy, and over the past few years IPOs have been the core driver of returns for many biotech VCs, not M&A - further seen in companies conducting more and earlier IPOs. In 2020, 149 biotechs went through IPOs, almost a doubling of the 83 biotech IPOs which took place in 2018 [8]. While biotech companies tended to IPO 3 or more years after their Series A in 2018, that average has now dropped to 2-2.5 years [9]. In case the parallels to tech culture weren’t obvious enough, technology VCs themselves have been entering the space, in some cases branding themselves as ‘techbio’ firms [10].

In line with the expectation that upfront biotech de-risking costs are being reduced, this funding has shifted to earlier and earlier stages. In 2018, 18% of biotech startups which went through IPOs were in the preclinical stage; by 2021 that number had risen to 32% [11]. It is now commonplace for Series A valuations to be over $100M and it is very possible to launch a biotech company today without a proven technology, even having a problem to solve is sufficient [12].

This trend now appears to be catching up with the industry. After a sugar-high on the tail of Moderna’s success through the peak of the COVID pandemic, the past 12 months have been rough for biotech investors. The SDPR S&P Biotech ETF (XBI) dropped 45% from February 2021 to February 2022, by far the most dramatic and continued decline since the index fund began in 2006 [14]. The trends are especially concerning given the prior trend for venture capital returns to be driven by IPOs - by the end of 2021, more than 80% of companies that went public that year were trading below their offering price [15].

There are a few different theories about trends which might be driving this decline. Some have attributed this to the risk of regulation on drug pricing by the Biden administration, the declining pace of M&A in biotech, surprising regulatory decisions by the FDA, and an ebb as investors shift away from the public to private biotech markets [16]. All of these factors are likely contributing to some extent, but there appears to be something much more fundamental happening which should cause concern.

Ultimately, there aren’t enough biotech entrepreneurs. Tony Kulesa of PIllar VC outlines this shortage by observing the extent to which early stage financing growth has radically outstripped growth in Seed and Series A financing rounds. Since 2012, venture funding for biotech startups has grown by a factor of 3.5X, while the number of first round financings has only grown 1X - with a particularly sharp divergence occurring around 2018 [17]. With too much money chasing too few startups, it’s perhaps unsurprising that series A valuations have been breaking so many records.

Part of the solution here is undoubtedly to encourage more people to become life science entrepreneurs, to increase competition for early stage financing. While the tech boom involved a rise in both financing and number of startups, the rise in biotech valuations has been characterized primarily by the former [18]. But the far more important change will be for investors to realize that the evolution of the biotech industry is going to follow a very different trajectory from the tech industry. The thesis that you can launch a biotech company at earlier and earlier stages with minimally validated tech is proving wrong, for a variety of reasons.

First, at least for therapeutic companies, R&D is not truly becoming that much less expensive. Bruce Booth of Atlas Ventures sees the ‘virtualization’ of early stage R&D as enabling greater flexibility for early stage companies, but underscores that the timelines associated with navigating complex biological questions and proving clinical efficacy remain long and risky [19]. Second, software tech startups are characterized by high levels of information sharing and open source software, while biotech ventures are more secretive and siloed in order to protect IP, a defining aspect of the biotech competitive landscape which does not apply to internet companies to the same extent [20]. Third, while tech entrepreneurs often proudly drop out of university, those who have found repeated biotech success are strong proponents of de-risking technology in university labs for as long as possible - Bob Langer is a strong advocate of this approach [21].

The road ahead will involve a contraction and a return to biotech fundamentals

Over the next few years, we are going to be seeing the delayed impact of this historical trend of inflated earlier stage valuations as more and more moonshot technologies unfortunately fail. There are likely a tough few years ahead for biotech startup revenue and profitability - very few biotechnology companies are profitable to begin with; numbers vary but tend to range about ~10-30% of small to mid cap biotech companies being cashflow positive. These percentages are likely to drop further as companies with large capitalizations funded over the past 5+ years without cashflow-generating technology continue to become the majority of players.

As a result, the attractiveness of biotech startups is likely to decline from both investor and entrepreneurial perspectives, and we’ll see a continued flattening or even decline in the number of new ventures being formed. This is especially unfortunate, and the efforts of various non-profits to help bridge the existing challenge of commercializing a life science technology will become even more important. Financing will also have to adjust accordingly - series A valuations will decline back to more reasonable levels, and we’ll see the rise of ‘smart money’ dominating biotechnology funding again. Tech firms which have attempted to pivot into ‘techbio’ firms will start to see their returns suffer as lifting and shifting tech software approaches to biotech fail, and I suspect they’ll pivot towards the digital health space instead, where parallels to tech are much more applicable.

Of the VCs which remain, we’ll see two major trends - less syndication and closer partnerships with founders. Firms will need to find a way to increase their returns and with term-sheets already relatively strong in terms of ownership for financiers vs. founders, VCs will need to individually take a larger share of the pie in any of their portfolio companies [22]. In conjunction with this trend, we’ll see partnerships between funders and founders become much tighter - not as a return to the old ‘venture creation model’ but rather as an evolution of existing in-house venture models where investors are more actively involved in helping to focus entrepreneurs on the most critical de-risking experiments. Indeed, Atlas, Flagship Pioneering, and ThirdRock Ventures are all pursuing a tighter model where entrepreneurs are brought ‘in-house’ so the firms can contribute to value creation. I think this is a very positive trend; given the value of serial entrepreneurship in biotech, placing first time founders alongside experienced mentors is likely to make a big difference in the success rate of firms. It also represents an appropriate departure from the ‘spray and pray’ approach that many tech VC firms apply.

With these closer partnership models, the industry is likely to experience even further geographic concentration than it already does. Biotech startups are already heavily dependent on having an existing ecosystem to build from, as they rely on access to advisor and funding networks, access to lab spaces, the ability to hire from exceptional universities, and opportunities to contract out discrete R&D tasks, to name just a few factors. As a result, Boston and San Francisco are lightyears ahead of the rest of the country in terms of biotech venture formation, and these cities are likely to be responsible for an even greater share of new biotechs over the next 10 years. The importance of physical proximity for VCs in supporting startups has become even clearer throughout the course of the COVID pandemic, and venture capitalists are increasingly ensuring that their portfolio companies are located within their physical neighbourhood [23].

Finally, the types of biotech companies being funded are going to continue trending away from therapeutics and towards platform technologies, with a preference for companies that are able to generate cashflows in the short-term to drive their own long-term growth. Platform technologies can be sold as research tools or operate B2B as services, avoiding the regulation and timelines associated with clinically-facing technologies. Beyond the early revenue advantage this provides, it also enables companies to validate, iterate and establish technologies live in the market to de-risk them before exploring longer term clinical applications. The success of Gingko Bioworks and Twist Bioscience are two great examples of how effective this model is becoming, and most of the exciting innovations of the past 5-10 years have been in the platform arena - whether that be the commercialization of CRISPR genome engineering, single cell multiomics, or protein structure prediction through AlphaFold.

Successful life scientists will commercialize gradually and carefully

Given this outlook, what should those of us who are passionate about life science entrepreneurship do? Despite the challenges that face the industry, I think the solution ultimately lies in having more and more academics with genuine, real, intelligent technologies to have the conviction to become entrepreneurs. As challenging as the path is, there are three key approaches that can dramatically improve chances of success - de-risking in the lab and accelerator programs, taking a platform-based research tool approach to commercialization, and carefully selecting VC partners.

First, scientists should validate technologies in the lab as much as possible before looking to commercialize. Academic labs provide the perfect environment to do so without the pressure of commercial timelines; indeed, this is a core principle of how Bob Langer runs his lab [24]. In parallel, there are an increasing number of early-stage equity-free accelerator programs arising to address the exact challenges the industry is facing, such as Nucleate Bio and Petri Bio. These provide another space for early stage founders to further validate technologies in a risk-free environment before seeking seed funding, and entrepreneurs should take full advantage of them.

Second, entrepreneurs should focus on the platform applications of their innovations where possible and plan commercialization accordingly. Instead of creating companies that take advantage of a given technological advantage to immediately attempt to develop therapeutics more effectively, life science companies can bring revenue in the door quickly by commercializing the advantage as a research tool while still retaining the IP for that tool in-house. By structuring as a platform play rather than a therapeutic play, companies can start funding their own long-term growth, avoid the need for costly clinical approvals, and take advantage of lower R&D costs.

Finally, when forming companies, biotech founders should situate themselves primarily in San Francisco or Cambridge and carefully choose a VC partner who has deep expertise and networks in their area of interest. With the market awash with capital today, it’s become increasingly important for founders to be discerning about which experts to partner with in early stages. Founders should be actively involved in conversations about what the evolved structure of venture funding will look like, to create a balanced model where VC networks are leveraged but the excitement and energy of a founder’s conviction and drive is maintained.

Ultimately, talented scientists will continue innovating through these obstacles

All in all I believe that, while there may be a bumpy few years ahead for biotech startups, the industry will continue to grow over the long-term as long as we create further structures to support early stage entrepreneurs. Some of the trends we’ve seen in recent years are part of the typical ebb and flow of the biotech funding environment and should not be a cause for severe concern. That being said, anyone who’s interested in ensuring that biotech innovation continues to grow should be deeply invested in thinking through how to better incentivize life scientists to become entrepreneurs, and how to ensure VC funding evolves in a way which reflects the dynamics unique to the biotech industry.

About the author
Joel Bateman
Joel is a first-year MBA student at the GSB. Prior to Stanford, he studied Human Developmental and Regenerative Biology at Harvard University where he spent three years working as a research assistant in the Whited Lab, focusing on axolotl limb regeneration. Joel previously worked for Boston Consulting Group (BCG) in Australia, primarily in the healthcare practice, working with a range of clients including health departments, pharmaceutical companies, private hospital groups, and private equity businesses. Prior to BCG, Joel worked for IDinsight, a non-profit in India, supporting monitoring and evaluation work across a range of projects, primarily in health and agriculture.

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