Biotech Investing: Five Basic Questions to Ask

There have been 51 healthcare IPO's this year, nearly triple the amount of IPO's of the next most active sector, technology. This is partially symptomatic of the market environment, as the NASDAQ Biotechnology Index has nearly doubled since 2012, attracting many new investors to the sector. However, the run up is leading to many questions, not the least of which is sustainability. Is this a classic bubble, characterized by issuers taking advantage of frothy multiples? Or is it a function of much more fundamental and profound changes in the sector? And how is the risk matrix in the sector changing? For new investors interested in biotech exposure, here are some basic things to consider:

We believe the growth is a function of fundamental changes in the way research is being conducted. In terms of drug discovery, three major factors have contributed to unprecedented advances. And all three are available because of historically cheap and dramatically increased computer processing power. These technologies have played a key role combined with genome sequencing to significantly increase the rate of medical biotechnology innovation.

HTS or High Throughput Screening is a concept that has been around for decades. It basically involves testing a vast number of synthetic or biological compounds for ability to modulate a biological target using a quantitative assay. Researchers have adopted HTS as a standard protocol as they sift through a daunting number of compounds looking for the next "blockbuster drug". The difference between HTS of thirty years ago and HTS of today is the level of technological innovation that has reduced the testing cycle time for a single compound from over one year to as little as four days. HTS is one fundamental change that has contributed to the increased number of potential drugs being identified, correlating directly to biotech capital markets activity.

Bioinformatics is a second major factor contributing to acceleration of drug discovery. Imagine data mining of large networked databases that contain everything from genome sequences to detailed pharmacological properties of virtually every known compound. Bioinformatics software allows researchers to access vast amounts of information about molecules curated from published and unpublished bench research to understand the characteristics of specific compounds for potential modulation of a biological target. For example, bioinformatics gives researchers access to pharmacokinetic data to "model" potential interactions with targets and to predict potential toxicity.

Genome sequencing is the third major innovation, through increased efficiency. Genome sequencing is the foundation that has enabled researchers to make tremendous strides in understanding advanced biomolecular functions. The net effect of these three capabilities is increased efficiency in the research process resulting in a fundamental increase in drug discovery and therefore, capital markets activity.

Many early stage R&D companies are taking advantage of momentum in the public markets and completing microcap financing rounds through reverse merger transactions, SB1 and EGA IPO filings. We anticipate that Reg A+ will become a popular public financing pathway as the structure gains acceptance with buy-side investors and the SEC approval cycle is better understood.

With fundamental industry changes accelerating the rate of discovery, and more and more biotech companies popping up in the microcap markets, how can microcap investors take advantage of these trends? First and foremost, address the basic fundamentals.

Five Basic Questions to Ask

1. What's the burn rate?

That's the infamous question always asked by VC's, but for most early stage biotech companies that means cash on the balance sheet available to keep the company running to the next milestone. This should be a key critical risk indicator when considering any biotech investment. For issuers and investors alike, the primary risk in biotech is cash. With the full FDA clinical trials cycle often exceeding $800 million dollars, it's one of the first due diligence items an investor should consider. Major biopharma companies such as Merck, Pfizer, Novartis and Sanofi, typically carry several billion of cash on their balance sheets. Pfizer for example carried roughly $35B as of 12/31/2014 and for the same period Merck, Novartis and Sanofi carried $15B, $14B and $11B of cash, cash equivalents and short term investments respectively. And to put the tremendous R&D cost in even better perspective, keep in mind that they maintain those cash balances even though they are all already profitable.

Some of the more exciting recent IPOs such as JUNO and KITE carry significant cash and maintain a market cap and trading profile that ensures continued access to capital. Although these companies are R&D companies, they are not microcap companies by any means. As of 12/31/2014 for example, Juno had roughly $355M of cash on the balance sheet. And Kite had roughly $368M of cash and short term investments as of 12/31/2014. In addition to liquid trading profiles, in many cases these companies have effective shelf registrations and powerful alliances such as the recently announced Juno – Celgene alliance.

By contrast microcap biotech companies, defined as those with market caps less than $300M, maintain substantially less cash. As a result when analyzing potential targets, future dilution should be considered a major risk.

2. Who are the institutional investors sponsoring the deal?

Dilution can be mitigated if a target has strategic agreements in place with larger biopharma companies. Additionally, several early stage biopharma R&D companies have gone public with significant equity investors such as VC's on board. In many cases, these equity partners can serve as sources for R&D capital infusions at competitive multiples when the funds are needed. Where this can be considered a risk mitigant, it makes sense to take a close look at financing documents, investment intent etc. to understand the investors longer term commitment to subsequent rounds. Rights of first refusal in term sheets are possible indicators of future intent. Of course it's stating the obvious that if the companies fail to achieve their goals, it's safe to assume the money will not be there regardless of original intent.

3. Are partnerships in place or being considered?

Strategic joint ventures and licensing are additional risk mitigants that can address low balance sheet capital for microcaps. We like strategic partnerships and joint venture partnerships a lot! Not only do they provide microcaps with a way to potentially finance the regulatory process, they provide management access to significant knowledge capital in terms of best practices in areas that many small companies lack experience in, such as manufacturing and commercialization.

4. What are the costs of Phase 2 & Phase 3, and how will that be financed?

Many biopharma companies are purchasing their pipeline in lieu of in-house research. And licensing deals are being cut earlier in the R&D cycle. If management are intending to out-license IP to a major during phase 2 or earlier, evidence of those discussions can verify likelihood of this type of deal. Licensing is becoming more and more popular, and in 2012, roughly 25% of licensing took place during phase 2. Understanding licensing terms will also provide an understanding of financial viability, and provide a basis to understand forward valuation.

Understanding the regulatory pathway is critical. Not all pathways are the same. For example, testing drugs for cardiac therapeutics are notoriously complex and expensive. Does management have a comprehensive plan post phase 1? What are projected costs for Phase 2, 2b and Phase 3? And what are management's plans for financing those activities?

5. What is the competitive landscape for the specific therapeutic focus?

Understanding the science is also a key due diligence point. Molecular biology is becoming increasingly complex, and there is an information asymmetry between biotech and finance that significantly impedes ability to effectively price risk. Hence we recommend that investors contract expert networks to do the scientific analysis. The broader the network's expertise, the more likely there is the ability to provide specific insight and comprehensive understanding of investment risk. A "PhD" doesn't necessarily qualify as an expert unless the PhD is in the specific therapeutic focal area. There are several expert networks that can provide the necessary insight.

Where to look

With a clear knowledge of cash on hand, sponsorships and partnerships, financing milestones, regulatory pathway and the underlying science, the risk matrix starts to become much clearer. There are approximately 163 sub $300M microcap biotech companies listed in the US, almost half of which have market caps under $100M. And there are many private biotech startups, some of which will inevitably take the microcap pathway to obtain capital for R&D. Compared with the multi-billion dollar plus market caps of Juno, Kite and other, the microcap subsector of the biotech market clearly has its allure for some as they search for therapeutic analogs.

Armed with some basic fundamentals, here are a few areas to further stack the odds in your favor. Orphan drugs, repurposed drugs, and biologics represent areas where investors can potentially find value. Repurposed drugs offer developers the benefit of significant clinical data from prior studies to shorten the regulatory approval cycle for a particular therapeutic application. Orphan drugs that are designed to treat rare disorders are also an interesting area. The Orphan Drug Act, ODA has provided many incentives for biotech developers. And the clinical trials are less costly than non-orphan drugs due to trial sizes.

Biologics, defined as anything derived from or synthesized from biological sources, are also making major headway. Several CAR-T developers have reported significant efficacy for certain type a leukemia such as ALL. CAR's are chimeric antigen receptors. This type of exciting breakthrough therapy reprograms a patients own immune system to attack specific types of cancer cells that were not recognized prior to reprogramming. Larger companies such as JUNO, KITE and Novartis are all working on areas such as CAR-T. And there are a number of microcap and small private companies working on similar therapeutic approaches. TCR's or T Cell Receptors, Mab's or monoclonal antibodies and certain stem cells based therapeutics are also biologics that hold significant potential.

Editor's note

Karl Douglas is an investor and director at Unify Biotechnologies LLC, a biotech investment company. This article was co-authored with Andre Ragnauth, PhD — Director, Unify Biotechnologies, LLC; Director, Bio-Behavior Laboratory and Behavioral Core Facility, Sophie Davis Medical School at the City College of New York.

This article is not making any specific recommendation of any kind, and is not an offer to sell securities or investment advisory services.

My full 2026 retrospective on this article is published in Thinking: Biotech Investing — Eleven Years Later: AI and the Changing Economics of Drug Development. It revisits what this 2015 thesis saw and missed, and updates the five questions for a drug pipeline that AI may reorganize by stage.