Exploring the intersection of biotech and VC

Biotech is one of the most unique, interesting, and high-risk corners in venture capital. Across the VC landscape, there are very few sectors in which companies are striving to save lives, and even fewer that can provide the same level of outsized returns. At the same time, there are not many industries in which companies can burn through hundreds of millions of dollars without any proof of concept—almost all biotech companies fail. Yet, investors continue to flock to biotech, viewing the space as the next frontier of high-impact, high-return opportunities.

Here we examine the biotech venture capital landscape, exploring how venture capital has influenced the sector’s growth, along with how biotech VC endeavors are distinguished from other areas in venture.

What is biotech?

Biotechnology involves the manufacturing or manipulation of living organisms—like bacteria, or molecular substances such as mRNA—to produce or perform a certain process. Biotech companies leverage biotechnology to research, develop, or produce commercial products that typically serve a medical or agricultural application.

One of the biggest areas of focus within the sector is the development of biopharmaceutical drugs or biologics, which differ from standard pharmaceuticals manufactured using synthetic chemicals as opposed to organic materials. From targeting rare diseases to finding breakthroughs in cancer and arthritis, biologics have spawned revolutionary treatments across the medical spectrum. AbbVie’s Humira, Johnson and Johnson’s Remicade, and Roche’s Avastin are just a few of biotech’s blockbuster drugs treating diseases like rheumatoid arthritis, metastatic cancer, and Crohn’s Disease—and bringing in billions of dollars in revenue while doing so.

How do biotech startups get funding?

While a handful of biologic drugs boast big success stories, biotech companies still face significant hurdles bringing commercial drugs to market. For one, the research and development costs associated with biopharmaceuticals are incredibly high, involving long, expensive clinical trials. And while a company is in the R&D stages of a potential drug, there’s typically no revenue—as a result, it’s not uncommon for biotech companies to burn through millions of dollars of capital before the commercial viability of a drug is even determined.

The high capital costs and associated long-term R&D processes in biotech are increasingly attracting interest from venture capitalists, whose investment endeavors are similarly marked by a long pathway to profitability and high capital intensity. While biotech companies can also pursue capital from government grants and university funds, venture capital is a growing funding avenue in the space due to the asset’s class search for asymmetric returns, tolerance for high burn rates, and ability to service short-term financing needs.

Biotech industry growth can partly be attributed to an emerging VC ecosystem

The growing biotech venture capital landscape can be attributed to a variety of factors.

Scientific innovation has been one of the biggest influences. In the early 20th century, the pharmaceutical industry was developing small molecule drugs manufactured using medical chemistry techniques. Drugs like Aspirin, Valium, and Prozac were some of the biggest breakthroughs of this period. However, as innovation in molecular biology techniques began to emerge in the 1980s, scientists began to discover ways to produce biological molecules and turn them into commercial drugs, shifting the industry’s focus to the creation of biologics.

Revenue incentives have played a role, too. In the US, legislation enacted in the 1980s encouraged the production of generics for drugs with expired patents, drastically affecting the business models of many large-cap pharmaceutical companies who had traditionally relied on strong market share of their drugs long past their patent’s expiration. But legislation spurred the growth of generics, with many able to capture as much as 90% of market share upon patent expiration. This also contributed to the industry’s shift towards biologics, which are much more difficult to mimic than small molecule drugs, and therefore, more attractive from a revenue standpoint. Although, this is beginning to change with the creation of biosimilars, or drugs that are very close in structure to a brand name biologic.

The biotech venture capital ecosystem of today

The industry shift to biologics is largely responsible for the growing biotech venture capital ecosystem today. The hefty costs behind the production of biologics led R&D costs at pharmaceutical companies to skyrocket. Drug discovery and pre-clinical research costs $6.5 million on average, and once a drug goes into clinical trials the average cost reaches $13 million and $20 million for phase 2 and 3, respectively. Greater costs coupled with the low success rates of pre-clinical discovery, long drug development pipelines, and growing expenses associated with clinical trial administration have left many pharmaceutical companies unable to justify the pursuit of these drugs—on their own.

As such, pharmaceutical companies have essentially offloaded these risks by acquiring biotech VC-backed startups. Consequently, M&A activity within the biotech sector has become commonplace, as large incumbents use acquisitions as their strategy for building out their drug pipeline while minimizing the downside risks associated with failed products.

With a strong M&A environment for exits, venture capitalists continue to fuel biotech industry growth. According to PitchBook’s Q2 2022 Venture Monitor Report, VC deal activity saw $17.8 billion of capital invested through the end of Q2, H1 valuations reached a record high of $114.6 billion, and the average deal size grew by more than 25% YoY.

The top 5 biotech venture capital firms by number of investments

*According to PitchBook data as of February 9, 2023

How are biotech venture capital endeavors different from other venture opportunities?

Biotech VC investing is distinct from virtually all other sectors in venture capital due to its unique company lifecycle, long product timelines, highly regulated environment, and uncoupling between end users and payers.

To start, since biotech startups are in the business of producing drugs, they are subject to rigorous testing through clinical trials before a drug can be approved. The go-to-market strategy for a drug is determined by successful progress through clinical trial phases, with the ultimate gatekeeper being the US Food & Drug Administration (FDA). Few other areas in VC face such stringent regulatory considerations and processes in their journey to commercialize.

Additionally, not only do clinical trials require significant scientific labor in terms of the effort required to identify a novel drug compound or technology, but they also take years, with many phases required to determine a drug’s safety and efficacy. And the capital required to fuel this drug pipeline is far greater than what many other VC sectors face in their nascency. For example, in tech, the costs of developing software are nothing compared to the capital required for clinical trial administration, lap equipment, staffing, etc. As a result, biotech startups usually require larger early-stage capital raises and typically return to their investors faster than most other VC sectors.

Another unique element of the biotech venture capital ecosystem is that payers and pharmacy benefit managers largely determine which drugs will be successful and therefore, the ultimate revenue trajectory of a drug. They decide which products they will reimburse and how much a patient will have to pay out of pocket. They also choose whether a doctor can prescribe a certain drug initially or first try a cheaper alternative.

These are just a few of the ways biotech VC investing is distinct from other industry sectors within venture, and all these unique characteristics play into biotech companies’ ability to successfully raise capital.

What do investors look for in biotech companies?
Like any due diligence process, there are a variety of factors for investors to weigh when determining whether to commit capital to a biotech VC startup. Some of the biggest considerations include a drug’s revenue potential, its underlying technology, if it solves an unmet patient need, and any competitor drugs currently in other companies’ pipelines.

Investors will weigh certain elements of due diligence differently depending on whether they are pursing early or late-stage opportunities. For example, investors looking at early-stage biotechs will prioritize de-risking scientific or clinical barriers above estimating a drug’s future revenue potential, as they will likely see a liquidity event before the drug ever hits the market. In contrast, investors whose strategy targets drugs later in their clinical pipeline maturity are more concerned with ensuring manufacturing reimbursement and building out discounted cash flow (DCF) models to forecast future drug sales.

These are just some of the factors investors consider when examining biotech opportunities and ultimately, the most important elements in a due diligence process vary depending on an investor’s strategy in the space.