[Ed. This is the seventh part in Wayne’s series. You can access the whole thing by clicking here. Please leave comments or questions on the blog and Wayne will address them in future posts in this series.]
Assuming that the average direct cost of developing a new drug through regulatory approval will be at least $200 million, how and where do small companies get that funding? While these companies should access all potential sources of funding including government agencies and disease associations, the major sources of funding will likely be capital markets and pharma partners.
I am not aware of any company which was handed $200 million and given complete freedom to develop its novel drug. The funding will be handed out on a step by step, trial by trial basis. If the money has not been raised yet, the capital markets will be looking for positive data before giving any more money, or looking for a lower price to compensate for the extra risk of not having that positive data yet. If the money has been raised, the Board of Directors should be looking at the data before allowing management to proceed with the next clinical trial. Pharma partnerships are really option agreements, with an upfront fee to acquire a series of options on a product and milestone payments each time that pharma accepts the option to move to the next stage of clinical or commercial development.
How does this relate to valuation? If a company needs to obtain additional funding for clinical or commercial development, capital market conditions will impact the ability to obtain or the valuation for that next round of funding. In fact, valuation is defined by the lead investor in that next round of financing.
How does a company get its initial funding? When the initial development of a technology or product occurs at an academic institution, the funding primarily comes from academic research grants. It is interesting to note that pharma companies are now forming broad partnerships with these institutions which are not technology or product specific. When a product reaches a point where academic funding is no longer available or sufficient, the potential sources include the 3Fs, non-academic government funds, angel investors, private venture capital (VC) funds and public venture capital.
The 3Fs is an old term which stands for friends, family and fools. This potential source of funds is usually not sophisticated, either from a capital markets or technology perspective, and has limited capital resources. There may be some industries where this group could provide short term funding for some business needs but not for the huge capital needs, long time frames and high failure rates of new drug development.
Non-academic government funds differ from academic research funding because their focus is commercialization and they usually require either a royalty or equity stake to provide a potential return on investment. They usually provide only `getting started` funding and there are some important considerations, including:
- Is the funding tied to conditions such as location and company activities which may impact future funding and business decisions; and
- Can these funds lead or significantly participate in future financings.
Angel investors are individuals who have a small amount of money which they are willing to invest in private companies. An investment in an individual company is probably in the tens of thousands of dollars per angel and the company will likely be in their local community. Angel investors are generally looking for investment time-frames of less than five years. This source of funding may be suitable to start some healthcare companies but is generally not suitable for novel drug development companies.
Historically, most drug development companies have been started by VC groups. Although each VC fund is unique, the following list will help you to characterize a VC fund.
- Industry or technology focus – usually one or a small number of related industries
- Stage of development focus – the investor’s risk profile will define the stage of development focus
- Private or public company focus – private companies generally but some have flexibility
- Geographic focus – historically focused on a home territory, especially where government funding or regulation is involved, but this has been changing
- Fund structure – usually limited partnerships
- Investors – pension plans, other investment funds, governments, very high net worth individuals or families, VC fund managers, industry
- Management fees – annual fee and success fee
- Funds from exits – usually distributed to the LPs on each exit although some may allow reinvestment
- Fund life – invest all the funds, with a reserve for follow-on funding of companies within the portfolio, within two to four years and exit all investments within seven to ten years
For healthcare VCs, there have been major changes in the sector in the last few years which we will address in the next blog.