Biotech VCs Have a Problem, and it Will Get Worse Before It Gets Better

10/24/11Follow @xconomy

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signs in many of these notes. Some junior venture partners sent in resumes, and more senior partners sent more subtle job-hunting notes. Quite a few of the folks at these firms don’t have much to say about their future plans, he says.

“There are many groups out there who if you say to them ‘Hey guys, what’s the plan, what’s the future look like for you?’ and they’ll say something like ‘We’re going to work on our existing companies for a while, a year or two, and once we get some exits, then we’ll fundraise.’” Powell says. He adds: “Some of those groups will fundraise, and some will not fundraise.”


Mike Powell of Sofinnova Ventures


Powell’s estimate is that by the end of the year, we’ll see five to 10 more biotech venture firms do something to adjust or restructure. These deals could come in different forms, like what CMEA did by splitting off $20 million for Velocity, he says, or in some cases, firms will merge. “You won’t see that many people just roll up the carpet and say ‘we’re not raising a new fund,’” Powell says.

The Column Group’s Svennilson said he thinks biotech VC shrinkage could be a good thing, as long as the surviving firms are able to pump a similar amount of overall money into startups. “When we started, we felt there were way too many companies getting started,” Svennilson said. “We felt the best ideas should get funded, not all of them.”

I think there’s some wisdom in that approach, that the pressures VCs are facing today will force them to adapt to the new environment. There are some interesting and healthy experiments going on today in new biotech venture models. But the trend in venture capital today is tilting away from life sciences, and toward IT, in a worrisome way. If biotech VCs don’t really can’t find a way to adapt, then in a few years we can expect thousands of Facebook wannabes crawling all over the U.S. and hardly any Genentech wannabes.

Given how much opportunity there is in biology today, I’ve got to believe that entrepreneurs and investors will find a way to harness it over the next few years to reinvigorate the whole industry. Taxpayers will invest billions in basic research at the National Institutes of Health over the next decade, and somebody needs to figure out how to apply the discoveries that will come out of that work in the business world. It will be a real shame if it’s not the venture capitalists who do that.

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  • http://xconomy j. Keeney

    Luke – As I keep stressing to you, why would venture capital funds, or even the companies themselves, continue to invest in drug R&D when the current regime is so pro-generic by threatening to shorten future marketed-drug exclusivity to seven years from an already intolerably short twelve years? The ongoing curtailment in venture capital into biotech area is simply following that of the older pharmaceutical industry. In reality, there very little difference between the two industries when it comes to marketing their discoveries. All this could be cured if the government would adopt “perma-patents”, as you recently called them. For that, we will have to await hopefully for a change in administrations.

  • Jonathan

    Hi Luke,

    Nice article. I think one of the keys will lie with the FDA and its ability to improve its transparency and give industry guidance that is timely vs on a case by case basis. It is amazing how the FDA relies on or cites “non binding recommendations” for years or even decades, and how some divisions of the FDA have never issued a guidance to industry for major therapeutic areas. This would only help start-ups get their preclinical and clinical package together for a Ph1/2 esp in new therapeutic areas where unmet medical need abounds.

  • Kevin

    Great article — I sure hope this is not a long term trend. Biotech is one of the few areas remaining where we lead the rest of the world, and it sounds like we are putting that unique innovation at risk. Meanwhile, emerging countries (from a technical sense) such as China are pouring money into new biotech ventures and initiatives. Maybe corporate (large pharma) venture funds will have to play more of a leading role moving forward.

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  • Angel investors rock

    You get what you pay for: a good, hard look at 2 and 20

    Somewhere along the way, LPs and their investment committees largely abdicated the responsibility for creating and negotiating compensation structures that pay VCs to do what they promise to do: generate returns in excess of public equities. Many LPs state that their minimum target return for venture capital is 300 to 500 basis points above a public benchmark.

    Yet, they don’t structure compensation based on that outcome. Instead, institutional investors allow VCs to “charge” them based on the “market
    standard” 2 and 20. Here is how a typical 2 and 20 compensation model works:

    VC firms earn a 2 percent per year management fee on committed capital during
    the first five years of the fund (the investment period);

    After the investment period, the annual fee usually steps down but continues
    through the fund’s life (e.g., 2 percent on the lower of invested capital or market
    value of the portfolio);

    The VC firm earns 20 percent of all investment profits on a deal-by-deal basis
    when a portfolio company is sold.

    This structure has been the industry standard for so long that it’s difficult to trace its origins or rationale. The same 2 and 20 model remains nearly universal today. One study analyzed compensation from ninety-three VC funds raised from 1993–2006 and found that 90 percent of the funds charged a 2 percent or more fee, and 95 percent of funds charged a 20 percent carry.

    It’s interesting that VCs have positioned themselves as supporters, financers, and even instigators of innovation, yet there has been so little innovation within the VC industry itself. There have been changes—more funds, more money, bigger funds, and bigger deals—but very little ‘creative destruction’ around how funds are structured, capital is raised, or VCs are paid. For more than twenty years, most LPs have accepted the

    following terms:

     A ten-year fund;

     A five-year investment period;

     A 2 percent management fee on committed capital;

     An 80/20 LP/GP split of any profits on investments;

     One percent GP capital commitment invested in their own fund;

     Serial fundraising every twenty-four to thirty-six months.

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