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 it has a “revolutionary new cancer cure” or even glib talk like it has “a tiger by the tail” with some new drug candidate, then I know it’s not a serious company. Sometimes you’ll hear a company say it wants to be the next Genentech or the new flavor of the moment, without any solid data to back up such a grandiose assertion. Or maybe they’ll set unrealistically aggressive timelines for reaching milestones, and then hope nobody notices when they miss the goal by a year. Some will always brag that a Big Pharma partnership is right around the corner, but they never get around the corner.  The biotech scrap heap is littered with companies that overpromised and underdelivered. The best ones are humble, and do what they say they’re going to do. When they nail a Phase II, placebo-controlled, randomized clinical trial they will describe it, appropriately, as an encouraging development that they must confirm in a Phase III. Sadly, some companies prefer to take shortcuts, and indulge in excessive hype. Smart investors see through this fog pretty easily. “It is an incredibly bad sign if there are multiple YouTube videos of a CEO participating in paid, mock interviews. Things like that are disingenuous and reek of desperation, so it is impossible to consider companies that resort to them for any type of serious investment money,” says Brad Loncar, an individual biotech investor in Lenexa, KS.

Too much yakking about the problem, not enough about the solution: If a company spends a lot of time talking in its presentations about what a big problem breast cancer is, and not much time talking about hard data to support its allegedly important new treatment, then they are wasting everyone’s time.

Insider selling: If a CEO is selling large blocks of shares in his or her own company, particularly after a big run-up in price, it’s usually a good indicator that investors should do the same. Remember, management knows a lot more about the company’s operations and prospects than outsiders do.

Family members in key management roles: There are companies out there led by siblings, or husband-and-wife teams, or with boards packed with relatives or cronies. Are we really supposed to believe these people are the best in the world for tackling the hardest challenges in biomedicine?  “These aren’t family businesses,” Henney said in his 2009 talk. “If you see a board dominated by siblings, or a couple of siblings in key management roles, I’d run, not walk.”

Does the company have enough money to create value? Many biotech companies are undercapitalized. They don’t have enough money to achieve their goals. If a company only has $10 million to run a single Phase II trial, then no one should be surprised when it cuts corners in trial design with a study that doesn’t have enough patients, or an adequate control group to provide a definitive answer on whether its drug works. Often, you’ll see a company run one of these shoestring trials, make unsupportable, desperate claims about positive results, and use that to try to raise more money. It’s better to raise enough money from the start to run a well-designed trial that yields a clear answer. Essentially, each experiment needs to help build a strong body of evidence that creates value, and reduces risk. Anything less is a waste that will come back to haunt a company. “If a venture syndicate advances a clinical program through Phase II but can’t credibly fund the Phase III, strategics [Big Pharma companies] will use that against the company in partnering or M&A negotiations,” said Ashley Dombkowski, a managing director with San Francisco-based Bay City Capital.

Can this crew demonstrate real value to payers, or are they living in the ‘90s? I’m amazed by how many biotech executives seem to cling to strategies of the past. They seem to think all they need to do is win FDA approval of a new drug, set the price wherever they want, and count the money. These companies ignore that the Affordable Care Act is established law in the U.S., and skyrocketing healthcare costs are putting tremendous pressure on insurers to save money wherever they can. Biotech companies need to figure out how to prove their products are not just effective, but cost-effective. The healthcare world has changed, and biotech companies need to change with it. “Insured patients were once largely shielded from health care costs,” Dombkowski says. “But health insurance re-design is leading to higher co-payments and more patients with higher deductibles.  In an increasingly consumer-driven system, price transparency for patients and caregivers will be ubiquitous, outcomes will be measured with unforgiving precision, and comparative assessments of value will be the rule not the exception. The company’s product better be able to stand up to that kind of scrutiny. Better yet, it should benefit from that kind of scrutiny by so obviously outperforming legacy interventions.”

Companies that can’t explain how they’ll make money for investors: Sometimes people get so wrapped up in the science and clinical trial plans, that they lose sight of an ability to explain how this will provide a tangible return on investment. “If a timeline to commercialization is not evident, you might as well be donating your money to an expensive science project,” says Loncar. “While there isn’t necessarily anything wrong with that, you shouldn’t confuse a good cause with a good investment.”

Lack of focus: Biotech companies, especially in their early days, often get drunk on their own hype, thinking anything is possible, and they can cure just about every disease under the sun with their new technology. They can’t. Is this a company with eight new drug candidates in Phase II? That’s OK if you’re Amgen or Genentech, but does a little company really think they can execute on that many programs? There’s only so much time and money, and by the way, biology is still incredibly mysterious. No company can do everything. Focus is a must. “While there are times when multiple programs are a sign of strength—I think of great companies like Moderna, Adimab, etc.—there are also plenty of sad stories about companies that parallel processed so many activities or programs that they blew through capital without advancing anything well,” Dombkowski says.

Focus on the wrong thing: If a company is concentrating on some new innovation for pancreatic cancer or Duchenne Muscular Dystrophy, that’s one thing. Those are deadly and debilitating diseases crying out for innovative new therapies. If the company is focused on enlarged prostate, and thinks it can help old men go to the bathroom a couple fewer times per day, don’t we already have drugs for that? Is that really how you want to spend your resources? Who cares? Even more importantly, who’s going to pay for these non-essential medications in a world of limited resources?

Exaggerated communications around the FDA: Investors should beware of any company that tries to imply they are in like Flynn with their pals at the FDA. Some companies try to play up things about FDA actions that don’t mean anything. The FDA may in fact give a company an “Orphan Drug” a “Special Protocol Assessment” or a “Fast Track” designation. None of those designations mean the FDA is likely to approve a company’s drug. That will come down in the end to the data, the data, the data. “Buyer beware of any company that throws around the often-used phrase, ‘We are excited to report that we now have a clear path to approval.’ FYI, there is no such thing,’” Loncar said.

Too many VCs: The famous venture capitalist Vinod Khosla recently said that 70-80 percent of venture capitalists add negative value to startups. Whether it’s from meddling, boardroom in-fighting, high-handed arrogance, or whatever, these are negatives that small companies can’t afford. Look for boards with people who have experience operating successful companies, or at least a few independent people with specific domain expertise.

Hey, look at the Nobel laureate on my scientific advisory board!: Some companies think they can impress people by pointing to a few smart scientists on their scientific advisory board. But investors should know that this is mostly about marketing, and these bigwigs of science often have little to do with the company. “If you need to make an appointment to meet the guy who’s bringing you your science, then you don’t have much of a business,” Henney said.

Geographic remoteness: It’s true that great science can come out of most any university or research institute around the world, but it’s extremely hard for a biotech company to emerge from a place with no community around it. A successful biotech company needs connections to skilled lawyers, accountants, regulatory consultants, and on and on. It needs to be able to recruit superb employees. Most of that action happens in top industry clusters like San Francisco, Boston, San Diego, and New York/New Jersey.

Who’s backing this company anyway? Has this company attracted a smart group of investors, or a bunch of people you’ve never heard of? Does it have a reputable law firm? Does it have a major accounting firm auditing its books, or some firm owned by the CEO’s brother-in-law? Have any of the major pharma companies supported the company in any way with a partnership? Getting backing from these actors is no guarantee of success, but you have to wonder about companies that can’t attract any credible backing.

No worries: Investors should find out what the management team worries about, what keeps them up at night. The answers can be revealing about the world this company lives in, and also can serve as a credibility test. “If they say, ‘I sleep like a baby,’ that’s a big red flag,” Henney said in his 2009 talk. All companies have their problems, and top management had better know them inside out, he said.

Thou dost protest too much: When I was getting started on the biotech beat, I remember a company that insisted it was “focused on commercialization” in every public communication. It wasn’t. It was more like a loose grab bag of science projects, an operation with multiple “shots on goal,” in the hopes that one might stick. If a company is trying too hard to make you believe something, chances are good that they’re just trying to cover up a great weakness.

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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….