21 Red Flags to Watch for in a Biotech Company

10/21/13Follow @xconomy

Nutty things are happening in biotech. Irrational exuberance has returned. Generalist investors with lots of money are suddenly buying these stocks first and asking questions later. Companies can fire off meaningless press releases, and be rewarded. I heard a big-time money manager talk the other day about a recent biotech IPO being one of the “best performers” in the market. It had a two-week track record, and had done nothing fundamental to earn its tag as a “best performer.”

If markets are driven by cycles of fear and greed, and I believe they are, we are in the greed cycle.

Anybody who’s been around a few years has seen this before. Only one out of 10 drug candidates that enter clinical trials ever goes on to become an FDA-approved product. Companies often spend a decade of work, and $500 million or more, before finding out if they have a viable business at all. It’s the riskiest, most speculative business on the planet. When one of these products hits, it’s awesome. But it’s rare. Many investors buying today are going to regret it tomorrow.

Given that so many new investors are piling into the sector, I thought it would be helpful to compile a list of “red flags” that people should watch for before investing in biotech. When thinking about this column, I remembered a talk that entrepreneur Christopher Henney gave to generalist investors during the dark days of the recession. Like Henney, I think biotech is important and interesting and fun. People need to invest in it to make the whole ship float. But they also shouldn’t fall for the half-baked companies, the hopeless wishful thinkers, or the snake-oil salesmen, who unfortunately consume too much oxygen in this industry.

So, without getting into deep weeds of how to evaluate biostatistics and clinical trial design at biotech companies (bookworthy subjects on their own), here are some simple red flags to look for in evaluating these companies. As always, if you have any more suggestions of red flags you look for, please send them my way.

Weak science: Anyone who follows scientific literature knows a shocking number of studies look groundbreaking when they first appear in top peer-reviewed journals, but the findings can’t be reproduced by anybody in outside labs. Investors should be aware of this, and do some digging to find out if they are investing in established science that has been verified and reproduced by outside groups. An analysis done by Amgen’s Glenn Begley last year, published in Nature, found that only 11 percent of the results from 53 published biology papers could be reproduced. If a company has weak science, “there’s nothing that can correct for this,” says John Maraganore, the CEO of Cambridge, MA-based Alnylam Pharmaceuticals (NASDAQ: ALNY).

Story too complicated for an elevator pitch: If the company’s management team claims that the science is hard to understand, and they can’t explain the basic concept to an educated non-scientist in an elevator pitch, watch out. It could mean they are incompetent. It could mean the exec is just a lousy communicator, and therefore a lousy fundraiser. Troy Wilson, the CEO of Wellspring Biosciences and Avidity Nanomedicines in San Diego, says an executive should be able to explain the company’s story in 60 seconds or less.

Denial about competition: All investors need to know where a company stands in the competitive landscape. If a startup executive says he or she “doesn’t really have any competitors,” then he or she just failed a big credibility test. If a company is being honest, it should acknowledge who else is trying to do something similar, and be able to explain why their product is differentiated and bound to thrive even if it has to face down tough competitors.

The Emperor Syndrome: Biotech attracts a lot of odd characters, but one that surely ought to give any investor the heeby-jeebies is the “emperor” CEO. These are the control freaks who purport to do it all, and sometimes have the title of chairman, CEO, president, chief scientist, chief financial officer, chief pitchman, chief cook and bottle washer. You get the idea. They don’t let anybody else on their management team make a real decision. Oftentimes, their management team is too weak, timid, or afraid of the CEO to ever speak to an investor. If biotech companies could succeed on the back of a lone genius, then maybe this model could work, but that’s not how biotech works.

Weak management team: This one is related to the point above, but different. Maybe the CEO isn’t a controlling jerk, but he or she just doesn’t have the charisma or the confidence to hire standout heads of finance, operations, business development, R&D, or other functions. Investors should read the biographies of the entire management team carefully, and look to see if the company has management depth, people with proven track records. When I covered Genentech back in the day—and even today—it was never all about one or two executives. I am almost always impressed with the caliber of person there I’m talking to. This isn’t to say a good management team always gets it right, but the overall strength of the management team is probably the single most important factor for investors to consider. If a company has weak management, it can have great science and still fall flat.

Too much hype: If I hear a company say things like … Next Page »

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  • Argo

    Very very few companies have these right. Only a hand-full have some of these right. Moreover, there are no more mentors in the industry. There are no more people looking at best practices, no more people wanting to do the right thing. Everyone is looking for the next big thing. Even recruiters and managers who hire into these companies are looking for hires who fit the “culture” – well what they don’t tell you is that the culture is about hype and not about doing the right thing. Thanks Luke- always a pleasure reading your articles very sobering.

  • guest1

    When senior leadership has similar profile / background as the CEO. e.g., CEO a chemist, head of clinical operations a chemist, clinical scientists past chemists.

  • Plain

    Gilead Sciences
    CEO = organic chemist
    President = biochemist
    CSO/EVP = organic chemist

  • http://www.xconomy.com/ Luke Timmerman

    Biotech investor David Sable offered up a few more red flags of his own in a blog post. Worth a read.

    http://www.dbsable.com/1/post/2013/10/a-few-more-biotech-red-flags-ht-luke-timmerman.html

  • Satchmo

    Luke, I’m playing the devil’s advocate here. You know how it’s said that past performance is not a guarantee for future results. I understand that approval rates for drugs that enter FIH is 0.1, but what’s to say that it won’t change over the next twenty years. We are picking up more specialized targets over the last few years, and my hope is that it will bear fruit to the industry as a whole and approval rates could be higher with each drug catering to a smaller population.

    And to Argo, that is a pretty bold statement. ‘No more people doing the right thing’. Do you have insight into every company, every department, every team that develops drugs? Certainly, I can vouch that my heart is in the right place, and my highest goal is to get top quality products approved. I feel the same way about my department where folks also know a thing or two about getting a product out. We have changed lives and we are inspired by it. Please refrain from making such egregious remarks.

  • Victoria Romney

    I would add the state of a company’s IP protection to the list. Does it have issued patents, filed applications, or just provisional applications? Patent pending is a start, but only an issued patent can be enforced against an infringer. And does the company have a realistic war chest of enforcing its patents? What about freedom to operate? Is the company’s technology free of the prior art or do they have the necessary licenses?

  • Bob

    I know a company in Miramar, Florida called Altor Biosence, both the CEO and his wife who is the head of clinical had major in zoology from Taiwan and computer in US, had formed a biotech company to cheat investor’s money and government grants for last 10 years. They claimed that they had more than 10 anti-cancer drugs in phase I or phase II clinical trials where the CEO’s wife with few fellows from Taiwan cook fake data to cheat government grants each every year.

  • itc

    Definitely a great and sobering read. Don’t agree with some of these, but they are valuable points to keep in mind. Coming from a scientific background, what’s hard to explain to VCs and journalists alike, is that you may have a great clinical trial design but if you’re only going to get $10 million dollars to run the trial and you have to let some things slide, what are your other options? On the one hand, you don’t have enough money to do “the trial” and on the other, further funding somewhat depends on the success of your first trial… soo….