Venture creation in biotech is witnessing a sustained contraction. After the pandemic bubble’s over-indulgence, the venture ecosystem appears to have reset its pace of launching new startups.

According to the latest Pitchbook data, venture creation in biotech hit its slowest quarterly pace in eight years during 1Q 2024.  With just over 60 new biotechs raising their first round of financing, the sector’s company formation activity has slowed 50-60% from its historic peak in 2021.

Overall, this contraction is a strong positive sign of healthy discipline, and should be good for the sector’s mid- and long-term prospects.  Back in April 2023, in the midst of the second year of the market pullback, I shared some reflections on why it was likely to be “for the better.”  At the risk of revisiting those points, here are a few reasons for why I still believe this contraction in venture creation is a healthy dynamic for the sector:

First, venture creation is hard to do well, and even harder at scale. Beyond simply backing great science (separating the wheat from the chafe), setting a company up properly is critical, and early choices can get locked into the DNA of the company.  I’m often reminded of Peter Thiel’s law: “A startup messed up at its foundation cannot be fixed.”  Back in 2013, I opined on this concept and many of the pitfalls highlighted around messing up venture formation remain salient today: unreproducible science (or poor target selection), inexperienced founders/”founder-itis”, poor Board governance, unwieldy syndicates, odd founding agreements, off-market capitalizations, etc… These are all no less relevant today than in the past, and in the pandemic period of irrational exuberance for big science many startups incorporated lots of these mutations into their founding DNA. Some continue to do so today, unfortunately, but there appears to be less of it happening.

Second, great teams of truly experienced leaders are scarce.  Catalytic executives, rather than stoichiometric ones, can change the trajectory of startups but are in very short supply.  Some grey hair is often, although not always, important. Fundamentally, even during tighter markets like today, great talent is always a very constrained resource, and spreading it too thinly across too many companies isn’t good for the ecosystem. Great scientists need great business partners, and vice versa, in order to be effective leaders in biotech – which means that concentrating the scarce high-quality talent in fewer companies will collectively be a good thing for the sector.

Third, with the proliferation of startups, we’ve seen incredible crowding in hyper-competitive therapeutic categories and modalities. This has long been a feature of biopharma (see 2012 and 2016 posts on oncology and immune-oncology, respectively), but has been exacerbated by the creation of so many new companies. Further, this lemming challenge has also moved well beyond oncology – think of all the “not-so-fast follower” autoimmune programs or metabolic disease stories. While it may help shake out some incremental advances for the therapeutic armamentarium, this dynamic also clearly creates inefficiencies and waste – both in terms of capital deployment, but also for patients’ engagement and clinical trial activity.  Further, the competitive intensity in certain areas makes the “clinical do-ability” too challenging, even if those drugs could likely be beneficial. Fewer startups over time should ameliorate this crowding dynamic to some extent.

Fourth, the venture exit environment circa 2027-2030 for the new crop of early stage startups being created today will likely have structural supply/demand elements more favorable than the backdrop in recent years. With venture creation activity peaking in 2020-2022, the sector was awash in too many startups – much like the tech VC sector a few years back.  In macroeconomic terms, a glut of startup equity (over-supply) in the face of fixed demand (M&A), or less demand (IPOs), means an unfavorable pricing dynamic. I explored this in a different phase of the biotech venture cycle a decade ago, but the themes are still relevant (in the opposite direction) for describing the recent and challenging exit environment. With fewer startups being created, the supply/demand balance should revert to a more favorable macro bias in the coming years (once the pig has been digested). This, of course, is only a comment on ecosystem “flux” dynamics, not all of the other potential policy and pricing headwinds.

One critical caveat to these positive observations: our job is to bring medicines to patients.  A more constrained startup world means fewer bench-to-beside efforts will be embarked on by the sector as a whole, which could leave innovative new medicines stalled in laboratories around the world. We need to be mindful of this challenge, and ensure that the best ideas (rather than just the best connected ideas) are getting advanced by the sector.

It’s also important to note that my reflections above, and the data, are focused on the number of new startups being formed. Absolute funding levels are important too.  While also off from their peaks in 2021, there’s still significant aggregate venture funding flowing into the startup world by any historic metric. In the past couple months, we saw the first $1B initial financing in biotech with the launch of Xaira, as well as large first financings from Metsera ($290M) and Mirador ($400M).  Despite these mega-round financings, though, the median first financing remains in the $5-10M range, where it has been for years.

Stepping further back to the asset class, this contraction should be viewed positively by LPs, who invest into venture funds, and the VCs they back, as more discipline should translate into better returns in the long term: constrained resources should improve the average health of the venture herd.

Today IFM Therapeutics announced the acquisition of IFM Due, one of its subsidiaries, by Novartis. Back in Sept 2019, IFM granted Novartis the right to acquire IFM Due as part of an “option to buy” collaboration around cGAS-STING antagonists for autoimmune disease.

This secures for IFM what is a rarity for a single biotech company: a liquidity hat trick, as this milestone represents the third successful exit of an IFM Therapeutics subsidiary since its inception in 2015.

Back in 2017, BMS purchased IFM’s  NLRP3 and STING agonists for cancer.  In early 2019, Novartis acquired IFM Tre for NLRP3 antagonists for autoimmune disease, which are now being studied in multiple Phase 2 studies. Then, later in 2019, Novartis secured the right to acquire IFM Due after their lead program entered clinical development. Since inception, across the three exits, IFM has secured over $700M in upfront cash payments and north of $3B in biobucks.

Kudos to the team, led by CEO Martin Seidel since 2019, for their impressive and continued R&D and BD success.

Option-to-Acquire Deals

These days option-based M&A deals aren’t in vogue: in large part because capital generally remains abundant despite the contraction, and there’s still a focus on “going big” for most startup companies.  That said, lean capital efficiency around asset-centric product development with a partner can still drive great returns. In different settings or stages of the market cycle, different deal configurations can make sense.

During the pandemic boom, when the world was awash in capital chasing deals, “going long” as independent company was an easy choice for most teams. But in tighter markets, taking painful levels of equity dilution may be less compelling than securing a lucrative option-based M&A deal.

For historical context, these option-based M&A deals were largely borne out of necessity in far more challenging capital markets (2010-2012) on the venture front, when both the paucity of private financing and the tepid exit environment for early stage deals posed real risks to biotech investment theses. Pharma was willing to engage on early clinical or even preclinical assets with these risk-sharing structures as a way to secure optionality for their emerging pipelines.

As a comparison, in 2012, total venture capital funding into biotech was less than quarter of what it is now, even post bubble contraction, and back then we had witnessed only a couple dozen IPOs in the prior 3 years combined. And most of those IPOs were later stage assets in 2010-2012.  Times were tough for biotech venture capital.  Option-based deals and capital efficient business models were part of ecosystem’s need for experimentation and external R&D innovation.

Many flavors of these option-based deals continued to get done for the rest of the decade, and indeed some are still getting done, albeit at a much less frequent cadence.  Today, the availability of capital on the supply side, and the reduced appetite for preclinical or early stage acquisitions on the demand side, have limited the role of these option to buy transactions in the current ecosystem.

But if the circumstances are right, these deals can still make some sense: a constructive combination of corporate strategy, funding needs, risk mitigation, and collaborative expertise must come together. In fact, Arkuda Therapeutics, one of our neuroscience companies, just announced a new option deal with Janssen.

Stepping back, it’ s worth asking what has been the industry’s success rate with these “option to buy” deals.

Positive anecdotes of acquisition options being exercised over the past few years are easy to find. We’ve seen Takeda exercise its right to acquire Maverick for T-cell engagers and GammaDelta for its cellular immunotherapy, among other deals. AbbVie recently did the same with Mitokinin for a Parkinson’s drug. On the negative side, in a high profile story last month, Gilead bailed on purchasing Tizona after securing that expensive $300M option a few years ago.

But these are indeed just a few anecdotes; what about data since these deal structures emerged circa 2010? Unfortunately, as these are mostly private deals with undisclosed terms, often small enough to be less material to the large Pharma buyer, there’s really no great source of comprehensive data on the subject. But a reasonable guess is that the proportion of these deals where the acquisition right is exercised is likely 30%.

This estimate comes from triangulating from a few sources. A quick and dirty dataset from DealForma, courtesy of Tim Opler at Stifel, suggests 30% or so for deals 2010-2020.  Talking to lawyers from Goodwin and Cooley, they also suggest ballpark of 30-50% in their experience.  The shareholder representatives at SRS Acquiom (who manage post-M&A milestones and escrows) also shared with me that about 33%+ of the option deals they tracked had converted positively to an acquisition.  As you might expect, this number is not that different than milestone payouts after an outright acquisition, or future payments in licensing deals. R&D failure rates and aggregate PoS will frequently dictate that within a few years, only a third of programs will remain alive and well.

Atlas’ experience with Option-based M&A deals

Looking back, we’ve done nearly a dozen of these option-to-buy deals since 2010. These took many flavors, from strategic venture co-creation where the option was granted at inception (e.g., built-to-buy deals like Arteaus and Annovation) to other deals where the option was sold as part of BD transaction for a maturing company (e.g., Lysosomal Therapeutics for GBA-PD).

Our hit rate with the initial option holder has been about 40%; these are cases where the initial Pharma that bought the option moves ahead and exercises that right to purchase the company. Most of these initial deals were done around pre- or peri-clinical stage assets.  But equally interesting, if not more so, is that in situations where the option expired without being exercised, but the asset continued forward into development, all of these were subsequently acquired by other Pharma buyers – and all eight of these investments generated positive returns for Atlas funds. For example, Rodin and Ataxion had option deals with Biogen (here, here) that weren’t exercised, and went on to be acquired by Alkermes and Novartis (here, here). And Nimbus Lakshmi for TYK2 was originally an option deal with Celgene, and went on to be purchased by Takeda.

For the two that weren’t acquired via the option or later, science was the driving factor. Spero was originally an LLC holding company model, and Roche had a right to purchase a subsidiary with a quorum-sensing antibacterial program (MvfR).  And Quartet had a non-opioid pain program where Merck had acquired an option.  Both of these latter programs were terminated for failing to advance in R&D.

Option deals are often criticized for “capping the upside” or creating “captive companies” – and there’s certainly some truth to that. These deals are structured, typically with pre-specified return curves, so there is a dollar value that one is locked into and the presence of the option right typically precludes a frothy IPO scenario. But in aggregate across milestones and royalties, these deals can still secure significant “Top 1%” venture upside though if negotiated properly and when the asset reaches the market: for example, based only on public disclosures, Arteaus generated north of $300M in payments across the upfront, milestones, and royalties, after spending less than $18M in equity capital. The key is to make sure the right-side of the return tail are included in the deal configuration – so if the drug progresses to the market, everyone wins.

Importantly, once in place, these deals largely protect both the founders and early stage investors from further equity dilution. While management teams that are getting reloaded with new stock with every financing may be indifferent to dilution, existing shareholders (founders and investors alike) often aren’t – so they may find these deals, when negotiated favorably, to be attractive relative to the alternative of being washed out of the cap table. This is obviously less of a risk in a world where the cost of capital is low and funding widely available.

These deal structures also have some other meaningful benefits worth considering though: they reduce financing risk in challenging equity capital markets, as the buyer often funds the entity with an option payment through the M&A trigger event, and they reduce exit risk, as they have a pre-specified path to realizing liquidity. Further, the idea that the assets are “tainted” if the buyer walks hasn’t been borne out in our experience, where all of the entities with active assets after the original option deal expired were subsequently acquired by other players, as noted above.

In addition, an outright sale often puts our prized programs in the hands of large and plodding bureaucracies before they’ve been brought to patients or later points in development. This can obviously frustrate development progress. For many capable teams, keeping the asset in their stewardship even while being “captive”, so they can move it quickly down the R&D path themselves, is an appealing alternative to an outright sale – especially if there’s greater appreciation of value with that option point.

Option-based M&A deals aren’t right for every company or every situation, and in recent years have been used only sparingly across the sector. They obviously only work in practice for private companies, often as alternative to larger dilutive financings on the road to an IPO. But for asset-centric stories with clear development paths and known capital requirements, they can still be a useful tool in the BD toolbox – and can generate attractive venture-like returns for shareholders.

Like others in the biotech ecosystem, Atlas hasn’t done many of these deals in recent funds. And it’s unlikely these deals will come back in vogue with what appears to be 2024’s more constructive fundraising environment (one that’s willing to fund early stage stories), but if things get tighter or Pharma re-engages earlier in the asset continuum, these could return to being important BD tools. It will be interesting to see what role they may play in the broader external R&D landscape over the next few years.

Most importantly, circling back to point of the blog, kudos to the team at IFM and our partners at Novartis!