Option to Buy: The New Face of Biotech Funding?

2/13/12Follow @arleneweintraub

When Cambridge, MA-based Warp Drive Bio launched on January 10, the startup was as notable for its financing structure as it was for its technology—maybe more. That’s because part of the $125 million in funding that Warp Drive received came from French pharmaceutical giant Sanofi (NYSE: SNY) , which received in return the chance to buy Warp Drive outright, sometime in the future, if certain milestones are met.

Such option-to-buy arrangements are growing more popular in the capital-starved world of biotech. Just one week after the Warp Drive deal, another Cambridge startup, Constellation Pharmaceuticals, formed a similar pact with Genentech, the South San Francisco-based unit of Swiss drugmaker Roche. Genentech pledged $95 million to Constellation—enough to fund three years of research—for the right to acquire the startup under a set of pre-negotiated terms.

The two deals differ slightly in their structure—Sanofi’s actually includes an obligation to buy Warp Drive, for example—but the basic idea is the same: The startups are giving up the right to independence down the road in return for financial security now. “You will see a lot more of these deals that include an option to buy downstream,” predicted James Sabry, vice president of Genentech Partnering, in an interview about the Constellation deal.

Remember how a decade ago just about every biotech startup CEO dreamed of building the next Amgen—the next giant, independent innovator of biologic drugs? Those days are long gone. That’s because despite some signs of an upswing in life sciences venture capital investing, the IPO market is still iffy for biotech startups. For every Verastem (NASDAQ: VSTM) —the Cambridge-based biotech that recently raised $55 million in an IPO—there are countless companies that can’t scare up enough interest on Wall Street to even attempt an offering. Granting an option to get bought out by a deep-pocketed partner “solves the main problem in the biotech community—lack of liquidity,” Sabry says.

Some biotech dealmakers are also finding creative ways to lock up certain assets without requiring the smaller party to agree to a full-on acquisition. That’s what happened last June, when Genentech paid an undisclosed sum to Cambridge-based Forma Therapeutics for rights to an early-stage cancer drug. Genentech agreed to support the research and development provided it couldeventually acquire the drug. If Genentech exercises that option, Forma and its investors will receive a payout and potentially milestone payments if certain sales goals are met. But Forma won’t get royalties on sales—so in essence it would be selling off what could conceivably be its biggest asset.

What’s notable about today’s option-to-buy deals is how early in the development process they’re happening. Just a few years ago, biotechs struggled to attract interest in any program that wasn’t at least approaching the pivotal Phase 3 human clinical trials needed for FDA approval. But the Forma deal was announced as “a pre-clinical small molecule program against a single undisclosed cancer target”—meaning the drug was still in animal trials.

As for Warp Drive Bio, what Sanofi is buying into is still largely an idea. Warp Drive’s strategy is to develop a genomics technology platform that can find new drug candidates from species found in nature. Alexis Borisy, a partner at Third Rock Ventures, one of the company’s other investors, admitted at the time of Warp Drive’s launch: “It is blue sky. The company needs to demonstrate what it can do.” Sanofi did not provide a comment to Xconomy, but in a presentation to investors on Feb. 8, CEO Christopher Viehbacher said, “Sanofi is gaining accesses to potentially very innovative products from Warp Drive, but also maintains a close involvement and can therefore ensure that the products are developed to a pharma quality standard.”

One advantage for Warp Drive and Constellation is that, in addition to gaining vital funding for early-stage research, they will maintain some degree of independence—at least until they get acquired. Warp Drive is retaining the rights to many of the assets it is developing, and it is free to partner those with other companies. Constellation, which is developing so-called epigenetic drugs to treat cancer and other diseases, has retained exclusive rights to its two most advanced drug programs. “This structure gives our translational science group the independence and responsibility to drive our lead programs,” says Constellation CEO Mark Goldsmith. “It’s a structure that accommodates our interests.”

Some experts in life sciences financing are watching these newfangled deals with interest. Mark Kessel, a partner at Symphony Capital, a biotech private equity firm in New York, says there are pros and cons for all parties involved in option-to-buy deals. The potential acquirer “can risk-adjust the likelihood of getting to proof-of-concept,” he says, in essence paying less up front for assets that could be worth much more in the future. But VCs who invested in the startups early on “are giving up better economics should the companies get to those value-inflection points,” he says. “Should the [Constellation] drugs work, Genentech gets a great deal. It’s an arbitrage on each party’s part.”

Sure, VCs that were early investors in biotechs that take option-to-buy deals may not get as high a return in the end. But the opportunity to achieve liquidity without having to worry about an IPO could be priceless. Says Kessel: “There’s a benefit in certainty.”

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