When it comes to biotechnology startups, venture capitalists typically cash out when the new company goes public. Buying that newly issued stock, however, can be risky for investors.
"Usually, VCs make three to five times their money, and the public sees their money going down the drain," said Alan G. Walton, senior general partner at Oxford Bioscience Partners in Westport, Conn.
Nowadays, stocks sold in initial public offerings might not be so risky for the public, Walton noted. That is because the market value of newly public biotech companies is so low that it is the venture capitalists who lose money on the IPO.
The difficulty of taking companies public, especially at values they find attractive, has become a lament of biotech venture capitalists, and it is forcing changes in their strategies.
Instead of a way to cash out, the initial offering is now a chance to keep a company going until, it is hoped, the venture investors can sell their stock.
"IPOs are no longer liquidity events, they are financing events," said Lowell Sears of Sears Capital Management, a venture firm in Los Altos, Calif.
Only 17 drug development and diagnostic companies went public in the United States in 2005, down from 30 in 2004, according to Recombinant Capital, a life sciences financial consulting and research firm in Walnut Creek, Calif.
Several companies, most recently Prestwick Pharmaceuticals, based in Washington, and Voyager Pharmaceutical, in Raleigh, N.C., have canceled planned offerings, blaming poor market conditions.
Specialists say public investors are being more conservative because they were burned by a spate of genomics companies that went public in 2000 and then foundered.
There are now a relatively small number of biotech-oriented funds willing to buy stock in initial offerings.
"Because it's so concentrated, the buyers have more leverage," said Andrew J. Weisenfeld, head of biotechnology investment banking at Banc of America Securities. "The values have to be low enough that they are willing to take the risk associated with development-stage biotech."
For venture capitalists, the problem is not only low IPO prices but also a higher level of investment needed to get a company to the stage where it can be taken public.
In the past, companies could go public on sheer technological promise. Nowadays, they usually have to show effectiveness of at least one drug in clinical trials.
$100 million threshold
Brian G. Atwood, a managing director of Versant Ventures in Menlo Park, Calif., said that venture capitalists have to put about $100 million into a startup biotech company before it can go public, compared with $60 million for companies that went public in 2000 and $30 million for those that went public in 1995 and 1996.
In some cases, as with Avalon Pharmaceuticals of Germantown, Md., companies are going public at valuations that are less than the money the venture firms have put in.
Or the valuation is only slightly above that amount, certainly not the three- to fivefold return of the venture funds' investments.
"Even at a $200 million IPO valuation, if you can get it, you're not getting anything like venture-like returns," said Mark Edwards, president of Recombinant Capital.
So venture capitalists have changed tack.
"As the exit valuations have gone down, the only variable left in the equation is how much money you put in before you exit," said Drew Senyei, managing partner of Enterprise Partners in San Diego.
Enterprise ran Celladon, a start-up developing gene therapy for heart disease, as a "virtual company," farming out laboratory work and animal testing.
Only now, with human clinical trials approaching, is Celladon recruiting full-time management.
Exit strategies
Exit strategies are also changing. More companies are looking to be acquired by big pharmaceutical companies, which want to bolster thin pipelines. Peninsula Pharmaceuticals and Salmedix were acquired this year by Johnson & Johnson of New Brunswick, N.J., and Cephalon of La Jolla, Calif., respectively, after they had filed to go public.
Some companies are going public through reverse mergers. Advanced Cell Technology of Worcester, Mass., known for its stem cell research, went public last January after merging with Two Moons Kachinas, a company formed to sell Hopi Indian dolls over the Internet.
Some private companies are merging with public biotech companies that have suffered severe setbacks, with the business going forward being mainly that of the private company.
One example of that is privately held AlgoRx Pharmaceuticals of Secaucus, N.J., which merged with publicly traded Corgentech of South San Francisco, Calif.
Jonathan MacQuitty, a partner at Abingworth Management in Menlo Park, Calif., predicts several American companies will go public on European exchanges next year rather than on the Nasdaq market, where they hope demand would be greater.
