So You Want To Be A Biotech Investor? Here’s what you need to know to succeed in this high-risk / high-reward sector.

Introduction

The recent surge of interest and investment in the biotech industry has catapulted the number of IPOs, VC-backed investment, and company acquisitions to unprecedented levels (U.S. biotech startups raised $29.66 billion in venture capital last year, a 50% increase from the year before, and more than 100 biotechs collectively raised $15B via Initial Public Offerings in 2021). The market has (thankfully!) cooled off and biotech stock prices have overcorrected down to undervalued levels, presenting hungry investors with the opportunity to scoop up biotech stocks for pennies on the dollar (contemplate Warren Buffet’s advice: “be greedy when everyone else is fearful”). Accurately pricing privately-held, pre-revenue biotech stocks is tricky business, but there are a set of tell-tale signs that the company is on the right track to maximizing shareholder value. These indicators include, but are not limited to, drug development projects that employ novel mechanisms of action to address unmet clinical needs, a Board of Directors with Big Pharma experience and capital raising expertise, a balance of PhD/MD advisors with Wall Street experience, and management’s track record of accomplishing R&D milestones that they promised to investors.?

Biotech's formula for success

Fortunately, drug development follows a formulaic path with well-delineated milestones, allowing new investors to quickly scan press releases to position their potential investment within the drug development lifecycle and the valuation curve:

1. First, preclinical (animal) data supports the safety and efficacy of the drug prior to experimentation in humans. Convincing preclinical data is packaged in an Investigational New Drug (IND) application and sent to the FDA for approval to begin a Phase 1 human study.
2. First-in-human Phase 1 studies are designed to support the safety of the drug in a small patient sample (usually less than 50 participants), and often provide some evidence of drug efficacy in treating the disease as a secondary endpoint.
3. Once safety is established, Phase 2 trials provide a robust analysis of the drug’s efficacy in a large patient (hundreds) population, often by exploring the dose-dependent effects. Big Pharma players scour promising Phase 2 trials for drugs to acquire.
4. Finally, a large Phase 3 trial is conducted to support the safety and efficacy of the drug in a very large sample (thousands of patients). Phase 3 data is packaged in a New Drug (NDA) application and sent to the FDA for final approval to begin manufacturing and selling the drug.

This well-charted course also benefits biotech companies, allowing them to plan their capital raises around key valuation inflection points with a reasonable degree of certainty. For example, Cytonics only raises funds once a significant value-add milestone has been accomplished, and it is time to spend more cash to knock down the next one. This iterative process of raising capital predicated on a foundation of achievement is core to the overall investment thesis that the enterprise value of the company increases exponentially as the drug’s risk of regulatory failure rapidly declines.?

Risk factors

Many biotech companies have no intention of becoming a fully-fledged pharmaceutical company, complete with in-house research and development, manufacturing, distribution, and sales capability. Instead, many biotechs' end goal is to out-license or sell their intellectual property once they can justify a high enough valuation to make the shareholders happy. This model of increasing shareholder value is a process of "de-risking" the development of their drug asset until it becomes an attractive acquisition target for Big Pharma.

This risk comes in two distinct flavors:

1. Biologic factors related to the drug and disease:

• Lack of understanding of mechanism of the new drug
• Lack of understanding of the pathophysiology of the disease
• Lack of translatability between preclinical models of disease and the actual human

2. Non-biologic factors related to clinical trial design:

• Inadequate study design (number of participants, primary and secondary endpoints)
• Improper dose selection and time course
• Inappropriate efficacy metrics/endpoints
• Inappropriate statistical analysis of data

Looking at historical drug approval data, discretized by disease area and stage of development, can help inform risk analysis:

The overall probability of successfully bringing an Investigational New Drug to market is only 14%. But with great risk comes great reward.

Valuations and ROI

Quantifying the magnitude of that reward is tricky business. Typically, financial analysts value a biotech company based upon the commercial potential of their drug development pipeline. This is accomplished by estimating the cumulative future income generated from each drug over their patent lifetimes, and then discounting the cash flow to account for the inherent risks and opportunity cost of investment. This is also how acquirers (e.g. Big Pharma) determine the ballpark purchase price for a new drug asset to add to their development pipeline.

From an investor perspective, a key consideration in this analysis is how your investment will appreciate over time. Three questions come to mind:

1. Why will the value of my investment increase? I.e., what is the plan to increase shareholder value?
2. How will I go about selling my shares for a profit? I.e., what is the exit strategy?
3. When can I expect to sell my shares for a profit? I.e., what is the timeline to exit?

When it comes to biotech, this value is almost entirely determined by the clinical trial data. Positive data equates to a more valuable company, and an increased likelihood of an "exit event". Exit events come in two forms:

1. Investors realize a return on their biotech investments when the company is bought by a larger pharmaceutical company in a private acquisition.
2. Investors are able to sell their stock after the company completes an Initial Public Offering (IPO) and their shares are tradable on a stock exchange (e.g., NASDAQ, NYSE).

Private acquisitions have become common practice in the industry since the early 2000's, when "patent cliffs" began to erode Big Pharma's revenue streams. Rather than develop drug assets in-house, Big Pharma relies on acquiring drugs that are being developed by small biotechs.?Investors should expect at least 5 years to develop a novel drug candidate through Phase 2 clinical trials. That seems like a long time to have cash tied up in an illiquid vehicle... but the upside in biotech is non-linear (see below).

Successful discovery of a novel drug candidate is a significant accomplishment, but real value is created once a company advances the drug asset through pre-clinical trials and into Phase 1 human clinical trials. Biotech valuations follow an exponential curve, which is a function of the reduced risk of regulatory failure as the drug asset proves both safety and efficacy in clinical trials. Valuations "kick-off" in between Phase 1 and Phase 2 clinical trials, after the drug asset has demonstrated a strong safety profile and efficacy signal. Typically, "strategics'' (e.g., Big Pharma) look for drug assets to license or acquire after Phase 2b, once the efficacy data significantly reduces the risk component.?

Conclusions

Investing in pre-revenue biotech companies is as much an art as it is a science. The lack of balance sheet multiples and matrix of comparable transactions makes assessing the economic weight of drug assets difficult, and requires a more detailed analysis of commercial potential on a drug asset-by-asset basis. The entire drug development process is rife with risk; some of which attributable to the inherent unpredictability of science and the complexity of disease, while other risk factors are found in the minutiae of clinical trial design and statistical analyses (which, once proposed to the FDA, cannot be adjusted on an ad hoc basis). The savvy investor must understand all the risks of drug development to place reasonable constraints on their valuation analysis and temper ROI expectations. They must also possess a firm grasp of the R&D catalysts that foment market fervor and generate alpha on an exponential scale. My goal in writing this article is two fold; first, to cut through the opacity of the biotech industry and get you excited about biotech investing, and second, to provide you with the basic tools to identify and evaluate the next under-the-radar investment opportunity.