Because universities take equity for different reasons, the way in which they structure how they receive their equity varies by institution.  This presents a challenge for investors looking to license university technologies because most investors wrongly assume that university equity arrangements are standardized. 

Given the lack of clarity around how universities acquire equity in their start-ups, I thought it might be helpful to explain the 3 primary types of equity structures – Upfront, Milestone, Phantom - that universities employ.

Upfront

The Upfront equity structure is the most common type, but also the one that varies the most between academic institutions.  In the Upfront structure, the university takes their equity in the start-up at the time of the company’s founding and the equity is typically baked into the pre-money value of the company.  I have seen pre-money values (note: includes management ownership and options) range from $2.3M to $7M for start-ups.  Those pre-money values directionally represent fully-diluted ownership of 2-40% for the university start-up at the time of its founding.    

The massive variation in the amount of equity a university receives Upfront is primarily dependent upon the value of “sweat equity” the university has put in, the stage of the product, the breadth of the patent portfolio licensed, and the amount of dilution the university foresees itself being subject to.  Sweat equity is typically the most controversial point when negotiating university equity because it is often hard to quantify and the quality of work in some cases is questionable.

Milestone

The Milestone equity structure is typically the most welcomed by investors, but can be quite risky for a university.  In this structure, the university takes no equity upfront, but takes equity at significant milestones such as entering human trials or submitting an NDA.   The equity given at the milestone is based upon the fully-diluted share count at the time of the milestone achievement.   For example, a university might receive 0.375% equity in the company at the time of IND filing and an additional 0.75% upon finishing Phase 2 studies. 

The challenge with the Milestone model for universities is that they only receive equity at 2-4 predetermined milestones.  If a company is sold before a milestone is achieved, then the university does not fully capture their potential equity in the company.  Some universities insert clauses to hedge their risk of an early sale, but that is not always the case. 

Phantom

Only a few institutions use Phantom equity, but it is a structure that has gathered quite a bit of attention over the last two years.  Phantom equity is an arrangement in which the school does not hold equity in a start-up until the time of the company’s sale.  For example, as part of their “Carolina Express License”, the University of North Carolina takes 0.75% of the start-up’s fair market value at the time of a liquidation event (M&A, IPO, asset sale).  Typical Phantom equity can range from 0.5-2% at the time of sale.

Most life science companies raise well in excess of $60M before they are sold.  Raising that kind of money results in massive dilution for early investors, making 2% Phantom equity for a university quite attractive.  The risk for the university is that the company is sold before it raises a lot of capital, resulting in the university leaving money on the table.

Equity & Start-ups

Negotiating university equity in a start-up is often a point of contention between investors and the tech transfer office.  To avoid misaligned expectations, both sides should be upfront in what they perceive to be fair market value and have data points in hand to defend their position.  Having a standardized term sheet outlining equity expectations may expedite license negotiations and align both the company and the university in the pursuit of creating shareholder value.    

For my last post of 2011, I will do my best to channel my inner Byron Wien.  As this is my first year, and I have no predictions from last year, I will first comment on what I think were the 10 major life science events of the previous calendar year.  In the second half of the post, I will make my very own “10 Big Surprises”.  But, since life science is a little different than analyzing financial markets, my predictions will come in the form of 10 contrarian trends for the upcoming year. 

2011 Life Science Review

1) Bye bye venture firms: For all the talk about venture firm consolidation, relatively few major firms have actually closed their doors over the last few years.  That all changed in October and November with news that ATV, Morgenthaler, Versant, Scale, Highland Capital, Prospect, and CMEA were all either jettisoning key members of their healthcare teams, spinning off their healthcare groups, or completely shutting down.  While the writing was on the wall for many of these venture firms, others like Versant Ventures caught most in the industry by surprise. 

As Bruce Booth of Atlas Venture has noted, life science investing provides stable, but not spectacular, returns for LPs.  It is unlikely that there will ever be a 10x fund in life sciences, but we can definitely return 2-3x (gross return on invested capital) and that looks pretty darn good these days given the current volatility in the equity and bond markets.

2) Gilead is the new sheriff in town:  With diversification in mind, Gilead made a major move into oncology in late 2010 and 2011 with the acquisitions of Calistoga and Arresto Biosciences.  This was followed by the announcement of a major collaboration with Yale University’s tyrosine kinase expert, Yossi Schlessinger (scientific founder of Sugen and Plexxikon). 

However, those moves pale in comparison to the company’s $11Bn acquisition of Pharmasset.  While I understand that HCV is hot, the numbers simply do not add up – Pharmasset’s lead program is not worth $11Bn (currently Hep C is a $3Bn market) even if it is interferon-free.  I wonder what Gilead saw under the hood of Pharmasset that the rest of us missed…

3) Rise of strategic VCs:  In 2011, Baxter and Merck both announced the formation of new venture units.  That news came on the heels of Eli Lilly, MedImmune, and Abbott confirming their support for their own internal venture funds.  The ability of strategic funds to augment the capital of VC funds is a welcomed surprise during a time in which capital risk for existing investments seems to be at an all-time high.  While I applaud the willingness of pharma to lend a hand in trying times, it is unclear what the effect will be of having so many well-funded strategic VCs around the table at a time when most VC funds are hurting.

4) Big wins for venture funds:  In May, Safeguard Scientifics (13x) and Canaan Partners (15x) made a tidy return on their investment in Applied BioHealing after Shire acquired the company for $750M in cash.  Unfortunately, the company’s sale occurred the same week as the LinkedIn IPO, and garnered little media attention.  Kudos to Applied Bio, Safeguard, and Canaan!   

What did get a lot of news coverage was the sale of Plexxikon to Daiichi Sankyo.  For the investors - ATV, Pappas Ventures, and Alta Partners - the sale returned greater than 10x (estimated) on invested capital.   

Having two phenomenal venture-backed exits in one calendar year is certainly something to celebrate and should help those funds, and others, go onto to raise their next vintages.   

5) Mobile health overhyped: Healthcare technology (HIT) investing by VCs has steadily increased over the last five years, as 138 new companies were funded in 2010 compared to only 52 in 2005.  While HIT investing is a hot trend, it represents a very small portion of all VC (3-4%) investing.

While the number of healthcare IT investments has increased, the lion’s share of investors’ capital has been directed toward start-ups focused on business end users.  Thanks to the iPhone, consumer health is sexy; however, it is still unclear how to engage consumers in a social way (see Fred Wilson’s blog post) and what consumers’ appetite is for managing their healthcare on a PDA device.  Consumer engagement is also limited because people do not want to have to pay out of pocket for mobile-based healthcare services.  For healthcare IT start-ups to succeed, they will have to figure out a way for insurance companies, and not consumers, to pick up the tab.

6) Orexigen, Vivus, & Arena – oi vei:  The FDA’s insistence on impossibly large clinical trials for anti-obesity therapeutics has quashed most investor interest in the space, even though it represents the largest and most underserved market in the country.  I have wondered over the past year if the FDA’s stance really relates to concerns over cardiac side effects or more to do with potential reimbursement issues. 

Obesity rates are highest in the low-income population, and depending on the state, obesity-related ailments already represent 5-10% of all Medicaid expenditures.  With obesity rates skyrocketing, especially amongst children, a broad coverage decision by CMS for a chronic therapy could be financially catastrophic for the government.  

I hate to say it, but 80-90% of obese Americans could self medicate by eating better and exercising more.  While I understand that insurance companies and managed care providers ultimately determine coverage, the FDA might be taking a stand against providing a drug that some might consider to be an easy way out for the majority of obese Americans.

7) Medtech Series A investing grinds to a halt:  While the overall amount of capital being deployed in medtech companies has held steady between $2.5 and $3 billion, the amount of that capital being allocated to Series A rounds has dropped precipitously.  From 2003-2008, venture capitalists pumped about 20% of their medtech capital in Series A rounds.  Since that time, Series A capital, as a percentage of total medtech capital, has decreased by half each consecutive year – meaning that in 2011, only 5% of all medtech capital went into Series A deals.

While many are quick to point the finger at the FDA, the reality is that the medtech industry is maturing and becoming less attractive to venture capitalists.  Cardiovascular and orthopedic devices, once the hottest areas of medtech investing, are no longer seeing explosive, or even incremental, growth. 

8) Antibody drug conjugates hit it big:  While many people were on summer vacation, Seattle Genetics ($SGN) made big news with the FDA’s approval of brentuximab vedotin (Adcetris) for a pair of rare lymphomas.  This was an exciting development for a field that had been toiling in the biotech backwater for almost 4 decades.  With the realization of the ADC concept, the floodgates are poised to open.  Genentech and Pfizer are leading the charge on the pharma side, with midcap Immunogen, and start-ups Ambrx, Allozyne, Redwood, and others on their heals. 

While the excitement is palpable, ADCs are not out of the woods yet.  Technical risks relating to linker chemistry and drug distribution are quite high, not to mention the likelihood that the FDA will look at future ADC drug submissions through a finer lens now that the agency has its feet under itself.   

9) VCs cool on industrial biotech:  In an effort to diversify their portfolios and hedge against regulatory risk, a number of traditional healthcare funds began investing in industrial biotech.  This strategy paid off handsomely for some early investors, but has been a slog for more recent entrants. 

Initially, venture firms put capital to work in biofuel start-ups, but fuel prices have held firm over the last few years, which in turn has marginalized the need for alternative fuel sources.  A stagnant biofuels market has forced most industrial biotech companies to switch tact and double-down on the specialty chemical market.  Unfortunately, the flood of start-ups into the specialty chemical market will result in its eventual commoditization.  The prospect of a commodity market has resulted in a stock slide for publicly traded industrial biotech companies, and since June, the market caps of Amyris ($AMRS), Gevo ($GEVO), Codexis ($CDXS), and KiOR ($KIOR) have been slashed in half.  Poor stock performance, and the potential of a closed IPO window, is a significant concern for VCs as the industrial biotech sector has limited M&A potential due to a lack of acquirers. 

10) Healthcare investors join social media in mass: I’m proud to say that I joined the Twitter & blogging bandwagon in 2011 and I wish more life science folks did the same.  I have found that engaging in social media has been a rewarding use of my time and a fantastic way to learn about the life science industry.  Each of us performs a particular function within the healthcare industry (I invest in university spinouts), and we rarely get to interact with other members of the community outside our particular niche.  Social media provides a special place where all healthcare stakeholders can meet to share their views in the form of water cooler conversations on Twitter, or more formal blog postings like those penned by Derek Lowe, Bruce Booth, or John LaMattina. 

10 Contrarian Trends for 2012

My best Byron impersonation - here it goes…

1) CNS investing by VCs increases dramatically: CNS drug development is incredibly risky and owns the highest failure rate for all clinical indications.  That is why the likes of Novartis, AstraZeneca, and GSK have recently announced that they intend to greatly shrink or shutdown their CNS drug discovery units. 

While pharma companies have fled the scene, I expect to see a dramatic increase in CNS investing by VCs in 2012.  The main driver for my enthusiasm in CNS is the significant progress basic researchers have made in mapping discrete cell populations within the brain and rationalizing receptor (eg. NMDA) structure and function.  Two university start-ups to watch out for are Envoy Therapeutics (mapping discrete cell populations) and NeurOp (receptor structure). 

2) Phase 3 investing becomes the new Phase I for VCs:  Over the last year, I reviewed fundraising decks for several dozen high-quality companies that were contemplating raising capital to fund $60-100 million Phase 3 trials.  Having to fund a large Phase 3 trial has become commonplace for start-ups as pharma companies have shown that they are content to wait for Phase 3 readouts before pulling the trigger.  That is a real problem for venture capital funds, which were not setup to support large, binary, and dilutive rounds to support Phase 3 trials.  I expect that several mega crossover (e.g. invest in both late stage VC and equities) funds will be raised in 2012 to invest exclusively in late stage companies. 

Assuming that a fund manager can raise $750 million, they can make over a dozen $50 million bets on late stage companies. I say bets because a Phase 3 investment is a card flip: positive data you win; and negative data you walk away.  If the fund manager attains a 50% or greater hit rate and appropriately prices the round, they can make quite a bit of money and provide a reasonable, mezzanine-like (12-15% IRR), return for investors.    

3) $700 million NIH translational fund gets approved, investors yawn:  The creation of the new National Center for Advancing Translational Science (NCATS) has always been a bit of a head scratcher for me as the NIH already has several translational groups such as the National Center for Research Resources (NCRR) and Center for Translational Therapeutics (CTT). While a noble idea, I am not sure NCATS really addresses the common issues, such as access to novel compounds and animal data, that stymie the development of academic technologies.  Instead of building a bulky bureaucracy, I would encourage the NIH to provide more funds to existing programs that are well run.  For instance, CTT has done magnificent screening work for a number of our portfolio companies – some of which were funded by grants, while others the companies’ paid for.   

4) Pfizer splits up: In 2011, Ian Read started to make his mark on the 162-year old company - most notably, the spin-off the Pfizer’s Capsugel unit to the private equity firm, Kohlberg Kravis Roberts.  More recent Pfizer news has centered on the company’s interest in spinning off its animal health unit and initiating a large stock buyback plan.  While all of this news is widely seen by equity analysts as a move in the right direction, it has done little to move the stock price, which has been on a steady decline since 2000.

2012 will be the year that Pfizer reverses its “bigger is better” mentality and breaks itself apart.  However, I am going to buck the trend and argue that Pfizer will not spinoff its non-pharma assets in a piecemeal fashion but instead the behemoth will split into two (similar to Abbott’s strategy) – with one business leveraging the company’s nutritionals, consumer health, animal health, and generics businesses, while the other will focus on small molecule and biologic drug development. 

5) Genetic link to Autism uncovered:  Currently, there are no treatments for Autism Spectrum Disorders, and very few targets have been identified for drug development. Autism is a relatively new and incredibly complex disease, with some researchers going so far as to postulate that each patient has their own slightly different version of the disease.  The prevalence of the disease, lack of pharma competition, and incredible need, means that Autism is an ideal area for venture capital investment.  Yet, Autism is a CNS disease and the diagnosis of the disease is often incorrect – making VC investment quite risky.

Given recent advances in brain imaging technologies, neurotransmitter receptor studies, and whole genome sequencing – the ability to discover a genetic or environmental link for the disease has never been greater.  Interestingly, many researchers believe that the key to uncovering the genetic basis of Autism might come from children afflicted with a very different disorder, called Williams syndrome, in which children are hypersocial.  The hope is that there is potential a gene, or series of genetic modifications, that upregulate the same pathway that stimulates hypersocial activity in Williams children as it does when downregulated in Autism patients.  This could very well be the year that a major discovery in Autism is announced, followed by a subsequent venture capital investment.

6) QALY begins to influence approval decisions: The recent health reform legislation strictly prohibits regulatory agencies from using the quality-adjusted life-year (QALY) threshold when making approval decisions.  Despite being legislatively prohibited from doing so, FDA advisory board panels are increasingly using QALY as part of their decision making process.  This is not really a surprise, per se, as panel members are key opinion leaders (KOLs) in their respective fields and are regularly exposed to the financial side of healthcare as many serve advisors to financial firms, start-ups, and pharma companies. So, the notion that these experts do not take a holistic view of balancing efficacy, safety, and the potential price of a drug during their decision making process is naïve. 

On a related note, the new trend in the VC world is to encourage start-up companies to focus on QALY from day one.  VCs and start-ups see the writing on the wall, and are preparing for a world where drug pricing does impact approval and coverage decisions.  So, while the government explicitly blocks the use of QALY, everyone is using it. 

7) Pharma-academic collaborations go out of style:  In 2011, pharma-academic collaborations were all the rage.  Pundits applauded the trend, arguing internal R&D units at pharma companies were not prolific enough to justify their existence.  Instead of working with “stale” internal R&D groups, pharma would increase their efficiency by turning to those people whose work was free from bureaucratic constraints, academics. 

This strategy makes little sense to me.  Post-doctorial researchers are generally the most productive and creative researchers at any university, and it is hard to believe that they would choose to work on a pharma project over their own work, which is necessary for tenure.  Thus, from the start, pharma companies are likely not going to be able to ride the best horses in the race.  Sure, pharma companies will get the best PIs, but they aren’t the ones doing the work or managing the day-to-day operations of a project.    

There is also the issue of project management between the pharma companies and academe.  The lack of a permanent ground presence by pharma companies within the labs of their academic collaborators will result in collaborations that are, at best, minimally productive.  Considering the amount of money pharma companies are spending, they likely would have been better served by completing dozens of licensing deals with great start-up companies that are developing university technologies.

8) Orphan drug VC fund:  Raising a new VC fund has never been tougher. My fund, Osage University Partners, was fortunate to have raised a new fund in 2011 and we accomplished this feat because of our novel investment strategy.  In fact, our strategy was so novel that none of our LPs had previously known universities had investment rights associated with companies licensing their technologies.  For new funds to be raised, they too will have to be a little different.

Because of a mix of government incentives, reasonable clinical trial sizes, and moderate development timelines, one of the hottest areas for VCs to invest in right now is orphan diseases.  With over 6,000 underserved orphan diseases, there are plenty of opportunities in this space.  I would not be surprised if some intrepid VCs go out and raise a fund dedicated to this area.   

9) DPP4 & GLP-1s will get black box warning:  It might not be an exaggeration to say that the FDA dislikes diabetes drugs.  Given the regulatory agency’s tough stance on diabetes drugs, this summer’s news of a potential link between the incretin modulators, GLP-1 and DPP4, and pancreatic cancer, could potentially be devastating for both drug companies and patients.  To use a comp, Avandia increased heart attack risk by 40%, resulting in the drug having onerous restrictions placed on it.  Imagine how the FDA is reacting to news of GLP-1 and DPP4s potentially increasing the risk of pancreatic and thyroid cancer by 2-7.5 fold.

10) Regenerative medicine investing picks up:  While I know people have been predicting this for years, 2011 really felt like a major inflection point for the regenerative medicine sector.  Two major M&A transactions - Synovis Technologies by Baxter and Advanced BioHealing by Shire - confirmed strategic interest in RegMed, albeit in revenue generating collagen-based products.  I believe that in 2012, M&A interest will trickle down from revenue generating products into riskier early stage assets. 

The FDA regulatory path has always been a major hurdle for investors interested in cellular products because of their drug-like approval path through CBER.  To add another ripple to the regulatory process, many cellular products are used as devices, which means their approval also requires consultation from CDRH.  Careful coordination between CBER and CDRH is a challenge for small start-ups and a concern for investors, but companies like Tengion have shown that it is possible and have blazed the path for other companies to follow.

Related articles:

• Financings of the Fortnight Wraps Up The Year With Rare Gifts
• Hey, where are all the healthcare investors going?
• 2011 M&A of the Year Nominee: Daiichi/Plexxikon
• Why Silicon Valley Is Running Scared From Health Care

Regards and Happy Holidays, 

Marc Singer

Managing Partner, Osage University Partners 

To Download: University Newsletter

While the symposium was incredibly well run and informative, I left being unable to answer the very question that drew me to the symposium in the first place – that is, should academic centers be in the drug discovery game?

“Pharma Drug Discovery is Inefficient”

I heard that refrain over and over at the symposium.  While that may be the case (I, for one, do not 100% agree), it did not strike me as though universities had solved the inefficiencies that plague pharma companies. 

I found it somewhat interesting that all of the universities that I met with had hired former pharma people to run their operations.  If pharma was inefficient before, I can only imagine how “inefficient” those same people will be on an academic budget.    

In hearing that refrain, I also wondered why academics would be so much better at drug discovery?  It is safe to say that all of the pharma companies are basically working with the same scaffold libraries, and it is hard to believe that academic centers would be any different.  So, if everyone is working with the same raw materials to answer pretty similar questions, how can one say with any confidence that one group is really better than the other?

Avoiding the Inevitable

Doing drug discovery on an academic budget is no small feat and many of the institutions that I spoke with had received large alumni gifts to establish their centers.  While a $20-30M gift is quite a substantial amount of money, it is not a whole lot of money within the context of drug discovery.  Therefore, academic drug discovery centers will have to figure out ways to bring in additional capital to fund their operations outside of alumni gifts and the NIH.

There in lies the rub.  All of the academic centers I spoke with were designed to meet the needs of their researchers.  Realistically, less than 5% of the researchers at any given institution are conducting research that lends itself to small molecule drug discovery.  As time goes on, academic drug discovery centers will quickly work through those researchers and have to start looking outside of their walls to find groups that need their services.

As academic drug discovery matures, institutions will begin to compete with each other to perform drug discovery work.  Working with outside groups will then put academic drug discovery centers in direct competition with CROs.  This will lead to price competition, which puts academic centers at a significant disadvantage given the indirect costs associated with their institutions.  

Some Creative Ideas

Frankly, I believe there is definitely a place and a need for academic drug discovery.  That being said, the whole academic drug discovery concept is still in its infancy.  As time goes on, academic centers could possibly consider the following strategies and options when positioning their services: 

• Collaborate: Academic drug discovery centers could achieve efficiencies of scale by banding together.  While some institutions are building significant molecule libraries, the reality is that those libraries pale in comparison to those of large pharma companies.  Furthermore, despite massive R&D layoffs, pharma companies still have a sizable staffing advantage over academic drug discovery centers.  Lack of molecule diversity and adequate staffing puts individual universities at a disadvantage against pharma companies.  One way to drive efficiencies of scale would be for institutions to collaborate around a particular disease area to leverage shared resources (ex: Hopkins and Harvard are both focused on CNS).  Creating large collaborative agreements between institutions could help drive greater program recognition which should help generate more grants and interest from outside investors. 
• Novel chemistry: Most pharma companies are using the same fatigued scaffolds in their screens because preclinical teams are not incentivized to work with novel chemistry.  While many approved drugs (e.g. lapatinib) break or bend common drug development rules (e.g. Lipinski’s Rule of 5), pharma has become rigid in it’s thinking about Lipinski RO5-breakers and their ilk.  Unless a molecule fits nicely within the Lapinski bucket, a preclinical drug developer will not go to bat for a molecule in a committee meeting.   Academics, working outside of the beuracratic constraints of pharma, could pick up the slack and work with chemists to validate novel scaffolds that break or bend the RO5.  A novel scaffold with some SAR data provided by the drug discovery core would likely be of interest to a potential licensee.
• Novel biology:  Academics have traditionally been very good at identifying novel drug targets and drug discovery centers are already working with the “squishy” science folks to help determine the druggability of those targets.  I would love to see drug discovery centers expand their work in providing assistance for the early validation of biological targets.     
• Underserved areas:  Pharma and VCs are moving away from high-risk and costly drug development (e.g. diabetes, cardiovascular, and neurological disease), and I would love to see academic drug discovery centers move aggressively into those areas. While I appreciate why pharma companies have moved away developing drugs that require mega studies to satisfy regulatory hurdles, it is unlikely that the FDA’s strigent regulatory requirements will stand in perpetuity.  As biomarker development gets stronger, adverse effects will be better predicted – thus, alleviating the need for massive trial sizes.  When the FDA turns the corner, academic drug discovery centers will hopefully have molecules waiting for eager investors. 

The Future

It is really still the early days of academic drug discovery.  Over time, centers will better define their roles in the drug development continuum and strengthen their value add.  As this occurs, a consolidation of drug discovery centers will lead to greater efficiencies and visibility in the marketplace.  Hopefully, this will lead to better and stronger academic drug discovery to find novel therapeutics.