San Diego’s Avalon Ventures has had some noteworthy success in the past couple of months. The 28-year-old firm raised $200 million for its ninth fund, which was oversubscribed by 33 percent. Avalon, which invests in both life sciences and Web technologies, also took some winnings off the table with the recent sale of a portfolio company, Boston, MA-based BioVex Group, for $425 million (with another $575 million in potential milestone payments). In addition, two other Avalon portfolio companies were acquired in December (reportedly at significant multiples of invested capital): San Francisco-based Cloudkick went to Rackspace and AOL acquired New York’s Pictela.
And then there is Avalon’s Series A and B round bets on the Zynga Game Network, which was recently valued at $7 to $10 billion and is expected to be the firm’s best investment ever.
With Avalon riding high, there may be no better time for Avalon founder Kevin Kinsella to raise a matter that he finds deeply troubling.
“There have been numerous instances of what I refer to as bad behavior—combined with short-sighted, brass-knuckle negotiating tactics—by some pharma companies that really go to the heart of whether this partnership between Big Pharma and biotech can really continue,” Kinsella says. He maintains that the pharmaceutical industry is doing enormous damage to the life sciences venture capital ecosystem. “Their predatory business practices,” he says, “are pushing the sector almost to the point of extinction.”
Kinsella concedes that Big Pharma CEOs might not even realize how their companies have been undermining the well-being of the biotech startups that Kinsella says are their chief source of new drug candidates. Talk to a Big Pharma CEO, Kinsella says, and he or she will glibly tell you that the next generation of products is coming from biotech, “while two floors below in business development, they are wreaking havoc on biotech startups.”
How is this happening?
In a series of interviews over the past three months, Kinsella has talked with me in detail about some of the egregious business practices in the pharmaceutical industry that he’s encountered, which he likens to overfishing by commercial fisheries. As a respected biotech investor with a 30-year record, Kinsella says he’s seen industry cycles come and go. But he contends the pendulum has gone too far this time, and it may be too late to set it back on its bearings. He’s calling out Big Pharma, and arguing for a more sustainable ecosystem for drug development. It’s not the whole story, but rather the opening fusillade in a debate that’s long overdue. Here at Xconomy, we welcome your response.
Kinsella lumps Big Pharma’s bad behavior into several piles:
—Structuring Completely Back-Ended Deals: During one buyout negotiation, Kinsella says, “The acquiring company spent more time asking questions about the cap table [to decipher the amount of venture capital the company had raised] than about clinical trial data.” The first buyout offer that came in was exactly equal to the total venture capital invested in the company. Kinsella contends that the industry’s “default” offer has become a buyout that just returns investors’ money in the up-front payment, with everything else in speculative back-end milestone payments for hitting certain future goals. “It doesn’t take a financial genius to tell you that having money in the ground for three to six years, and your upside is just getting it back—and this is for a ‘success’—is not a sure-fire recipe for venture capitalists to raise follow-on funds from their LPs,” Kinsella says. As a result, the aggregate number of biotech venture funds is shrinking, and the survivors are raising smaller follow-on funds. “While this hasn’t affected Avalon’s fund-raising,” Kinsella says, “it is doing great damage to the ecosystem in which we all live. Avalon would get no pleasure from being the last man standing.”
—Bad Faith Negotiations: Kinsella says Big Pharma companies are routinely walking away from buyout deals that have been fully negotiated. Kinsella says his first brush with Big Pharma’s new imperious ethos came in 2005. “We had a fully negotiated deal with [a major Pharma] to acquire a company. But because of their CEO’s travel schedule, the deal didn’t get signed before the Christmas holiday. When the CEO came back, he had changed his mind. This was a signature-ready buyout that took at least six months to negotiate. And [the company] just walked away. No explanation.” Since then, Kinsella says, “There have been numerous instances of pharma companies walking away from deals that were fully negotiated. So this behavior is not a blip; it’s been going on for over five years.”
He cites another example of bad behavior that occurred in 2006 while an Avalon portfolio company, Sytera Ophthalmics, was negotiating with a major pharma. Sytera was simultaneously negotiating with the Harvard Technology Licensing Office for rights to a related technology that was viewed as a potential backup to Sytera’s own technology. The pharma argued that it could negotiate a better deal with Harvard than Sytera itself. Kinsella says he was worried that the pharma might step in front of Sytera and run off with the Harvard technology—leaving Sytera at the altar—but he was reassured by one of the pharma’s representatives that the “ethical” company would never do that. Yet Kinsella says that’s exactly what happened. “Their well-deserved comeuppance was that the Harvard technology didn’t work, and the $3 million the pharma paid went down the drain,” Kinsella says.
—Partnerships Without Risk: Kinsella maintains that another consequence of Big Pharma’s mercenary mindset is a refusal to assume the risk that goes with early stage drug development. “If you try to partner with Big Pharma on anything earlier than Phase III data, then you are almost always going to get a crappy deal,” Kinsella says. “And many of these partnerships seem to be aimed more at pharma tying up proprietary biotech products and research teams than in carrying new technology forward.”
Kinsella sees a confluence of forces that came together after the tech and biotech bubble burst in 2000, and has continued with the mortgage meltdown and ensuing capital crisis. As financial institutions scrambled to save themselves, they shed much of their payroll—including most of the Wall Street banking talent that had focused on the biotech sector. The investment banks that biotech built—Hambrecht & Quist, Robertson Stephens, Montgomery Securities—did not survive, and Kinsella says no “serious” banks remained to serve life sciences startups, or to underwrite biotech IPOs.
Another consequence of the Wall Street meltdown, Kinsella says, is that Big Pharma companies have been hiring the biotech bankers laid off during Wall Street’s financial purges. As he puts it, “The sell-side guys were going to Big Pharma [companies] and saying they can cut better partnerships or buyout deals since they have an ‘inside baseball’ understanding of venture-backed biotechs, and they know how to wring the most concessions from a biotech’s board.”
Their influence has wreaked havoc on VCs, according to Kinsella. “Unfortunately, there really hasn’t been an IPO market in biotech since 2000,” says Kinsella. And the bankers-turned-business-development mercenaries “correctly perceived that the IPO exit doesn’t really exist any more. So Big Pharma companies—whose numbers have been halved in the last 20 years—are now really the only game in town.” And Kinsella says Big Pharma has been exploiting its “oligopolistic advantage” with ruthlessness.
“One might say that all this is just the way capitalism works, and on a micro level, I can’t argue that,” Kinsella says. “But on a macro level, I’m gravely concerned about what it means for the venture-biotech ecosystem. The providers of venture capital need to see a return, as do all participants in any ecosystem.”
In calling for an end to the hardball mercenary tactics, Kinsella says Big Pharma’s conduct is comparable to predatory overfishing by the Atlantic bluefin tuna industry. And in calling for a more sustainable ecosystem in drug development, he says, “Sometimes individuals don’t stop their behavior until all the great Atlantic bluefin tuna are gone.”
One consequence of not being able to rely on Big Pharma to play fair, Kinsella says, is that venture syndicates are less willing to take on the risk of developing drugs for chronic diseases. The current ecosystem is such that a drug must get approved pretty quickly, which rules out clinical trials with thousands of patients. It helps to explain why so many venture-backed biotechs prefer to develop new treatments around drugs already approved by the FDA, and why they are so reluctant to develop novel drugs for heart disease, neurological disorders, osteoporosis, and other chronic conditions.
“Almost anything of that genre is absolutely not financeable today because it requires too much capital, too much time, and pharma is so predatory and unreliable,” Kinsella says. An increasing number of biotech venture funds won’t fund a deal unless there is enough money around the table in the venture syndicate to finance the typically one-product biotech through Phase III or even NDA approval. At that point, Kinsella says, the pharma companies know how to properly value a biotech asset and will have to participate in an auction to buy the product or company.
“This is actually a terrible position for the Big Pharma companies to be in, having now shot themselves in the foot through their now not-so-clever deal-making tactics,” Kinsella says. “If venture-backed biotech companies shrink in number, go after small markets, and won’t partner earlier-stage products because of the predatory economics offered, the pharmas will have no dependable pipeline with partnered products at various stages, won’t know from one year to the next what new products in which therapeutic sectors they will be marketing, and will be just ‘hanging around the hoop’ with the required fat wallets to try to outbid the next guy to grab a product ready to go to market. This obviously only favors the largest and most well-capitalized pharmaceutical companies and will leave the already shrinking, innovative, far-seeing smaller pharmas out in the cold, further down-sizing the sustainable ecosystem.”
In the golden days of biotech, Kinsella says Wall Street viewed biotechs’ partnerships with Big Pharma as a much-prized stamp of approval—a sign that the underlying science made sense and that the target molecule was worth pursuing. Now, after decimating their internal research programs for failing to deliver approvable drugs, Big Pharma has turned to biotech to supply its new product pipeline. But Kinsella says the industry’s aversion to risk is forcing venture capital syndicates to provide all the risk capital.
As a result, Kinsella says venture-backed biotechs are increasingly wary about entering into pharma partnerships. The partnership deals, like Big Pharma’s buyout offers, are virtually always skinny in the up-front, and the milestones are so long in coming that biotechs must repeatedly return to the venture capital well for more working capital. The result is what Kinsella calls “a dreadful liquidity trap” that requires more venture money to be poured into the biotech company—whose products are ultimately committed to Big Pharma’s pipeline—without building inherent value in the biotech itself, or providing a return for its venture investors.
“The end game is ugly,” Kinsella says. “The biotech’s best products are tied up by crappy deals with Big Pharma; the biotech beast has been continually fed to sometimes enormous size by venture capital, but the company is not an attractive acquisition candidate since its key products are tied up with other pharma companies—who become the only potential buyers in a diabolical oligopoly situation.”
By the time venture capitalists are six years into these investments, Kinsella says they begin to scramble for the exits, since venture funds typically have a 10-year life. The pharma companies then pounce with their default, “we’ll give you your money back” deals, (with all upside on the back end).
In short, Kinsella says he’s never seen the startup biotech ecosystem as challenged as it is today. By behaving, in his estimation, unethically and unpredictably, offering lousy deals to partner biotech products, trying to outwait venture capitalists to force them into negative-return exits, the pharma companies have created and are fueling a vicious cycle that will leave the ecosystem with fewer venture capital funds, less capital to invest, fewer biotech companies, fewer critical and creative therapeutics, and far fewer innovative drugs for pharma’s own pipelines. By their predatory and destructive behavior toward the ecosystem in which they live, Kinsella says, big pharmaceutical companies “will shrink and wither and die. And society will have to bear the brunt of their greed—as it always does—this time by having a paucity of innovative therapeutic products for medicine.”
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