TheCostofCapitalforEarly StageBiotechnologyVentures

IainCockburnandJoshLerner
BostonUniversityandHarvardUniversity

ExecutiveSummary
EvidenceshowsthattheCostofCapitalfor venturebackedearlystagecompaniesinlife sciencesishigh:
Manyestimatessuggest20%orhigher

Thisreflectsinvestors expectationofareturn sufficienttocompensatethemfortakingon extraordinaryrisk Permanentlyloweringrealizedreturnswilllead tolowerinvestmentinacriticalcomponentof thelifesciencesindustry

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PurposeofStudy
Understandingcostofcapitaliscriticalin economicmodelingoftheimpactof regulatoryandpolicychangesoninvestment andindustryeconomics:
Forallpubliclytradedcompanies,allsectors, averageisaboutaround10% Projectseekstounderstandwhetherthisis appropriateforprivatebiopharma companies

TheCostofCapital
CostofCapitalisacriticalbenchmarkforassessing commercialviabilityofaproject
Measuresopportunitycostofresourcesemployed Oftenusedasahurdlerateofreturn todecidewhether toinvestinacompany Alsousedasadiscountrate toevaluatefuturecash flows

Outsideinvestorswillputmoneyintoventurefunds onlyiftheyexpectreturns(IRR)>CostofCapital Veryimportanttogetthisrightinevaluatingthe economicsoflongterm,riskyprojects

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TheCostofCapital(2)
Combines(1)timevalueofmoney,(2)riskof notgettingyourmoneyback
Forlarge,diversifiedcompanieswithpredictable cashflows,typicalCostofCapitalisabout10% Forsmallercompaniesfacingsignificant(andnon diversifiable)businessandtechnologyrisk,Costof Capitalismuchhigher:hereinvestorsdemand additionalcompensationfortakingonhigherrisk (e.g.,biotechstartups)

Simpleeconomicsofbiotechventures
Biotechhasseveralchallengingfeaturesforventure investors
(1)Verylongtimetomarket(typically10yearsormore) (2)Veryhighlevelsofrisk(fewerthan1%ofdrug candidateswillmakeittomarket) (3)Largeamountsofcapitalcontinuallyneededtomove mosttechnologiesforward (4) Thefewsuccessfulcompaniesusuallyhaveabig developmentpartnerand/oranacquirer

Comparedtomanyotherassets,ventureinvestors needtotakeonmorerisk,holdilliquidinvestments, andwaitlongerforareturn andthereforerequirea higherrateofreturn =ahighCostofCapital 6

Thebiopharmaceuticalecosystem
Drugdevelopmenttakesplacewithinacomplexweb ofinterdependentorganizations
universities/NIH,R&Dboutiques,established biopharmaceuticalcompanies,healthcareproviders

Venturebackedcompaniesplayacriticalrolein fillingthefrontendofthedrugdevelopment pipeline(andincreatingtoolsandplatformstomake drugdevelopmentfaster/better/cheaper)

Morethan50%ofmoleculesthatgointohumansoriginate andareacquiredfromentrepreneurialcompanies
Seee.g.CockburnHealthAffairs (2004)
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Thebiopharmaceuticalecosystem
Universities, NIH, foundations etc.

New biotech companies

Physicians and providers

Acquisitions, partnering, and licensing from biotech accounts for 67% of new drugs
Nature Rev. Drug Discovery, 2008

Established pharma and bio firms

New Drugs

Successfulproductsneedtogeneratereturns toencourageinvestmentininnovation
Mostbiotechstartupsrelyonpartnershipswithlarger companiesforlateclinicaldevelopment,regulatoryaffairs, manufacturingandmarketing Ifthesepartnersexpectpotentialnewproductstohavelower salesorshorterexclusivityperiods,theywillplacelower valuesontheproductstheylicenseoracquire Inturn,thismeanslowerexpectedreturnstoinvestorsinthe smallcompanies,leadingtohigherinvestmenthurdle Impactofthiswillripplethroughtheecosystem fewer projectsbeingfundedmeansaweakerindustrypipeline,and fewernewdrugs Venturebackedfirmsareakeystonespecies inthe ecosystem Thissectorisalreadyunderseverestress current perceptionsaremakingithardtoraisemoney
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NewVentureFundraisingHasDeclined
Source:ThomsonReutersVentureXpert database

NewCapitalRaisedbyVentureFunds

40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0

$B 2004 19.2 2005 28.7 2006 31.9 2007 35.6 2008 28.3 Q109x4 17.2

VentureInvestmentisDown; BiotechInvestmentMuchMoreSo
Source:ThomsonReuters/NVCAMoneyTree Report.DataSource:ThomsonReuters

VentureCapitalInvestmentinCompanies($B)

35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0

AllVC Biotech 2004 22.2 4.2 2005 23.0 3.9 2006 26.5 4.6 2007 30.7 5.3 2008 28.2 4.5 Q109x4 12.0 1.1

WhatistheCostofCapitalfor biotechnologyventures?
EvidenceonCostofCapitalcomesfromtwo principalsources
Actualreturnsrealizedonventureinvestmentsin biotech
Weassumethatcompetitivesupplyofinvestmentwill driverealizedaveragereturnsclosetotheCostof Capital
Unlessinvestorsgetgoodreturns,theywontputmore moneyinventurefunds!

Expected returnssuggestedbyfinancetheory
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Whatistherateofreturnto investmentsinventurecapital?
Verydifficulttomeasure
Highlyvariableovertime Manyfailures+afewbigwins Privatelyheldcompanies,proprietarydata Fundsversusindividualinvestments

PooledaverageIRR,allventurecapital:
January1989December2008:17.0%. Largecapreturnsoversameintervalwere8.4%.
Source:ThomsonReutersVentureXpert;IbbotsonAssociates

Exceptionalreturnsreflectexceptionalrisk!
Longrunaverageconcealsplentyofbadyears
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10yearrollingreturnsto investorsinVCfundsintheU.S.
NetIRR
30% 25% 20% 15% 10% 5% 0% 1980 Source: Authors' analysis of Thomson VentureXpert data

1983

1986

1989

1992

1995

1998

2001

2004

2007

Cumulativeventurereturns overvarioustimeperiods
20% 15% 10% 5% 0% 5% 10% 15% 20% 20Years 10Years
Verylowreturnsin recentyears likelyto discourageinvestorsif continuetobelow

5Years

3Years

1Year

Source:ThomsonVentureXpert.AllreturnsfortheperiodendingDecember31,2008. NetreturntoinvestorsinVCfunds.

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Decliningreturnsinrecentperiods
Dramaticdropinreturnssinceburstingof bubble in2000:
IPOexitshavedriedup

Manyobservershaveexpressedconcernsthat ventureecosystemisunderstress:
Institutionsandindividualsunlikelytoinvestat samerateunlesscanbeassuredofsatisfactory returns Fallenpublicmarketvaluationsmeanlower valuationsofprivatecompanies Investorconcernsaboutfutureoutcomes
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Whataboutbiotech?
CambridgeAssociatesInc.isanindustrystandarddatasource, andmaintainsunusuallycomprehensivedata,tracking80%+ ofindividualventureinvestmentssincethelate1970s Canidentifybiopharma ventureswithsomespecificityinthese data,notjusthealthcare ingeneral Rateofreturn(IRR)on1606biopharma companiesnow acquired,gonepublic,orfailedwas25.7%grossfrom1986 2008;correspondsto20.7% netreturntoinvestors
Aboveaveragereturnscomparedtoallventurecapitalreflectabove averageriskofbiotech
Assumes500basispointgrosstonetdifferential

Usefulguidetohistoricalrealizedreturns,butdoesntaccount foroverhang ofunrealizedinvestments:

OverallIRR,includinganother1223unrealizedinvestmentscurrently heldinportfolios,is~15.7%nettoinvestors
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Cashmultiplesrealizedfrombiotechinvestments
44%ofdealswereafullorpartialloss

Source:CambridgeAssociates.Includesallexitedbiotechdealsasof12/31/08.1606totaldeals.
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Historicalreturndata
CambridgeAssociates 1606biotechcompanies19862008:
20.7%averagegrossIRR onrealized biopharma investments,afterfeesandothercosts(5%) Buthugerisks:
44%ofinvestmentswereafullorpartialloss 2/3ofprofitableinvestmentstook5yearsormoretoberealized Another1223investmentsinthisdatasethaveyettopayout:even ripe investmentsareverydifficulttorealizeincurrentmarket conditions

SoVCsevaluatinganinvestmentwouldneedtoanticipate 40%todeliver20%IRRoverall
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Wheredothesereturnscomefrom?
Willingnessofinvestorsto
1. Takeonhugerisks:44%ofinvestmentswereafull orpartialloss! 2. Holdilliquidinvestmentsforalongtime:2/3of profitableinvestmentstook5yearsormoretobe realized

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Howdoesthisrelateto CostofCapital?
Realizedratesofreturnindicatehowmuch venturebackedcompaniesneedtopay for outsidecapital Theoryofcorporatefinancetellsushowto measureCostofCapitalmorerigorouslyin termsoftherateofreturninvestorsexpected atthetimeoftheinvestment,usingthe CAPM model
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Costofcapitalandthecapitalasset pricingmodel(CAPM)
ProvideswaytocomputeCostofCapital,basedon ratesofreturnondebtandequity) IntheCAPM,returnonequityisgivenby:
RateofReturn=riskfreerate+ xriskpremium Riskfreerate=Tnotes(e.g.4%) Riskpremium=paymenttoequityinvestorstotakeon generalundiversifiable risk(5% 7%) isacompanyspecificmeasureofrisk
Fortheaveragematurecompany, =1 Forriskiercompanies, >1 Forveryriskycompanies, >2
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IllustrativeCostsofCapital
Riskfree rate Riskfree(e.g.,Treasury bonds) Mature,diversifiedfirm Midcapbiotechcompany Smallcap,earlystage biotechcompany Ventureinvestmentin biotech
Note:Assumesnodebt

+ + + + + 0.0 1.0 1.5 2.0 2.5 x x x x

Equityrisk premium

WACC/ Costof Capital = 4%

4% 4% 4% 4% 4%

7% 7% 7% 7%

= 11% = 14.5% = 18% = 21.5%

Notemuchhigherthan recentreturns!
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Publishedstudiesshow forpubliclytradedsmallcapbiotechs isaround1.52.0(Barra Betas, IbbotsonBetaBook,Golec &Vernon.2007,DiMasi &Grabowski,2007). Forallventure is around2(DriessenLinPhalippou,2007;Woodward,2005),likelyhigherforbiotechinvestments

CostofCapitalRiseswithRisk
25.0 20.0 15.0 10.0 5.0 0.0
RiskFree CoC 4.0

CostofCapital(%)

MatureFirm (Fortune500) 11.0

Midcapbiotech 14.5

Smallcap biotech 18.0

Privatebiotech startup 21.5

Note:Illustrativedata.Assumesnodebt. Publishedstudiesandstandardreferencesourcesshow forpubliclytradedsmallcapbiotechs isaround1.52.0(Barra Betas,IbbotsonBetaBook,Golec &Vernon,2007,DiMasi &Grabowski,2007).Forallventure isaround2(DriessenLin Phalippou,2007;Woodward,2005),likelyhigherforbiotechinvestments

Evidenceonriskandreturns forbiotechnology
WACCforpubliclytradedbiotechstocks
Golec &Vernon(2007):16.25% DiMasi &Grabowski(2007):1317%

Estimatesof forsmallcapbiotechstocks
Forasampleof90lifesciencescompanieswithmarketcapbelow $250MM,srangeashighas3.0[Bloomberg]

AICPAguidanceforvaluingearlystagecompanies:19.2%Costof Capital GolecVernonmodelsuggests2/3rdsofhigherCostofCapitalfor biotech(versuspharmaceuticalfirms)isduetosmallsizefactor:

Impliesthatcostsofcapitalwillbeevenhigherforsmallestbiotechfirms

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Whyis andthereforeCostofCapital sohighforbiotechcompanies?

Immaturityandresultingfragility Size
Microcap riskpremiumis9%

Limitedliquidity
OTCtraded,smallvolumes

Considerableexposuretoeconomicfluctuations, whichcanleadto:
Inabilitytoaccesscapitalmarkets Cutbackoncorporatealliancespending Reducedwillingnesstoholdyoung,riskystocks
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OtherevidenceonCostofCapital
Almostnoabilityofthesecompaniestoborrow mediumorlongtermevenatcreditcard interest rates riskissohighthatlendersrequiresubstantial upsidethroughwarrantsetc.tocompensatethem forhighprobabilityofdefault Veryhighhurdleratesusedbyventureinvestorsto beabletomeettheirCostofCapital:
Oftenashighas50%oreven75%forearlystage companies.
ReflectsbothhighCostofCapitalandcorrectionforfactthat entrepreneurs projectionsareoftenoptimistic.
Plummer(1987);Lerner,Leamon,andHardymon (2007).
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Finalthoughts
Canidentifyreturnstoinvestinginearlystageinvestments (andthusCostofCapital)from:
Actualreturns Expectedreturns

BothmethodologiessuggestCostofCapitalisquitehigh Recentreturns(IRR)haventkeptup Reflectsharsheconomicsofbiopharma investorsrequire sufficientreturnstoovercomeilliquidity,longtimehorizons, andtechnologyrisk Regulatory/policychangesthatreducereturnsinbiopharma willdriveventureinvestmentintoothersectorsorasset classes Lessventureinvestmentwillmeanfewernewdrug candidatesatatimewhentheindustryisstrugglingto maintainproductivity
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TechnicalAppendix
MeasuringtheCostofCapital

1.Measuringventurereturns
Venturereturnsarehighlyvariable:
Insomeperiods,hugelypositive:e.g.,19962000. Insome,verylow:e.g.,198389,200103. Togetaveragereturnsthatinvestorsanticipate,mustlookoveralongtime periodandaverageoutgoodandbadperiods.

Keyquestionisadditionalrateofreturn(spread)overotherassets classes Noteasytocalculatethisforventurecapital:needtoidentify specific investments,thenfollowthemoverlongperiodsuntil(if)apayoffis realized

Truncationbias ifpotentiallargepayoffsarestillinplay Needtotrack2nd,3rd,4th subsequentroundsofinvestmentinthesame company,adjustfordilutionofshareholdingsetc.

Datahighlyproprietary:usuallyonlyreportedinaggregate
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Totalventurecapitalreturns
ThomsonVentureXpert compilesreturnsovermanyfundsoverlongtime periods:
Looksatactualreturnsrealizedaswellasinterimvaluations.

PooledaverageIRR,allventurecapital:
1970s December2008:15.3%. January1989December2008:17.0%. January1999December2008:15.4%.

ProblemisthatsourceslikeVentureXpert compilereturnsonafundby fundbasis. Mostfundsinvestinamixtureofinformationtechnologyandlife sciences. Thus,whilewecanmeasurereturnstoventureinvestorsinaggregate,we cannotsaybasedonthesedatawhatreturnsareforbiotechspecifically

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CambridgeAssociatesdata
C.A.maintainsunusuallycomprehensivedata,trackingindividual investmentssincethelate1970s Canidentifybio/pharma ventureswithsomespecificity,notjusthealth care ingeneral Forinvestmentsin1606biotechcompanies19862008: 25.7%averagegrossIRRforfullyrealizedinvestments,upto500basis pointslesstotheinvestors Forall2829companies,including1223unrealizedinvestments,IRRto datehasbeen20.7%gross/15.7%net Notehugerisks:
44%ofinvestmentswereafullorpartialloss 2/3ofprofitableinvestmentstook5yearsormoretoberealized

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2.Lookingatexpectedreturns
Theright approachtoestimatingtheCostofCapitalistolookatwhat theexpectationsofinvestorswereatthetimeoftheinvestment. Financetheorygivesusindicationsofwhatthisexpectationwouldbe. Evaluationofpublicmarketshasadvancedconsiderablyrecently, based ontherecognitionthatinvestorsmusttakeportfolioviewofinvestments.
InsightoftheCAPMmodel. Riskisameasureofthecorrelationofoneassetsreturnwiththeoverall market. Newinnovationsinmultifactormodels. Correlationwiththemarketisnottheonlysourceofrisk. Multifactormodelsincreasinglyusedtomeasurereturnsofanassetclassand returnsofindividualinvestors.

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Riskadjustingreturns:CAPMmodel
Allmodelsofreturnsshowthatrisk isdeterminedbythecorrelationof onereturnwiththereturnonasetoffactors
CapitalAssetPricingModel(CAPM)
Riskismeasuredbythedegreeofcorrelationwiththemarket. Investorswealthisdependentuponwherethemarketis. Woulddemandlowerreturnsonaninvestmentthattendstobeahedgeon market.

Greatercomovementwiththemarketimplieshigherrequiredreturns. Regressionanalysisusedtoestimateparameters
Betaiscommonlyusedmeasureofrisk.
Betaofthemarketis1. Higherbetameanshigherrisk.

Interceptintheregression(alpha)measuresriskadjustedreturns.
Whatsleftoverafteradjustingforcomovement withthemarket.
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Riskadjustingreturns:AlternativetotheCAPM
Alternative3factormodel(FamaFrench).
Marketrisk. Sizerisk.
Smallcompaniesareriskierthanbigcompanies.

Booktomarketfactor.
Highbooktomarketcompanies(valuestocks)areriskierthangrowthcompanies (distress).

Bothmodelsusedtopricevariousstockandbondportfoliosquite successfully. WillfocushereonCAPM,thoughbothapproachesgivesimilarresults.

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Returnsandriskpremia forsmallfirms
Riskpremiumismuchlargerforsmallcapstocks:pointstomuch higher riskformicro ventures
Ibbotsonanalysisofallstocksgivessizepremium forsmallestcategory(mkt cap<$136MM)at9.5%

10yearTreasuryyield:3.84%. Overpasteightdecades,riskpremiumof~7%.
IbbotsonAssociates,2009Stock,Bonds,BillsandInflationYearbook,2009.
Usinglongtimeperiodmakessense.

Recentacademicresearchfindsriskpremiumas>5%(JohnCampbell, Estimatingtheequitypremium, Harvardworkingpaper,2008.)

Impliesexpectedreturnof2021%.

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Difficultieswithapplyingframeworkto analyzingventurecapitalreturns
Allexpectedreturnmodelsaredrivenoffofreturncorrelations. Privateequityreturncorrelationwithotherassetclasseshavelittle meaning.
Privateequityportfoliosoftenkeptatbook. Hesitancytowritedownandup:
Certainlyhistorically,andeveninpostFAS157world.

Leadstolargedownwardbiasinestimatedcorrelations. Cannotusemostcommonmodelstoriskadjustreturns.

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Acriticalproblem:staleprices
Whateffectdoestheaccountingconventionofkeepinginvestmentsat bookvaluedotopotentialcalculations? Significantdownwardbiasincalculatedcorrelationswithotherasset returns:Investmentsseemlessriskythantheyactuallyare. Needperiodicportfoliovaluesthataretrue values. Thesolution:markingtomarket:
Differentpapersusesdifferentapproaches. Revalueattimesofwritedownsorwriteups. Lookatchangesinoperatingperformance. Lookatchangingpriceearningsratioinpublicmarket. Usetheinformationonmovementinsimilarprivateequityprices toadjust. Getperiodicseriesofreturns,whichthencomparetopublicmarketdata.

Illustration:
Correlation with the S&P 500 GE GE with One Stale Month GE with Two Stale Months 0.743 0.372 0.334 IBM IBM with One Stale Month IBM with Two Stale Months Correlation with the S&P 500 0.582 0.307 0.249 S&P 500 S&P 500 with One Stale Month S&P 500 with Two Stale Months Correlation with the S&P 500 1.000 0.490 0.407
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Noteonexpectedreturnsforventurecapital
Thetrueexpectedreturnsinventurecapitalarelikelytobehigherthan thecalculatedonesdueto:

Theneedtocompensateinvestorsforilliquidity(these calculationsassumenoliquiditypremium).
Thegreaterriskofbiotechinvestments(asseenabove,actualreturns arehigherforbiotech).

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References
Cockburn,I.(2004)TheChangingStructureofthePharmaceuticalIndustry Health Affairs, 23(1),pp.1022. DiMasi,J.andGrabowski,H.(2007)TheCostofBiopharmaceuticalR&D:IsBiotech Different? ManagerialandDecisionEconomics, 28,pp.469479. Driessen,J.,Phalippou,L.andLin,T.(2007)ANewMethodtoEstimateRiskand ReturnofNonTradedAssetsfromCashFlows:TheCaseofPrivateEquityFunds, Unpublishedworkingpaper,availableatSSRN:http://ssrn.com/abstract=965917. Golec,J.andVernon,J.(2007)FinancialRiskInTheBiotechnologyIndustry NBER WorkingPaperNo.13604. Lerner,J.,Leamon,A.andHardymon F.(2007)VentureCapitalandPrivateEquity:A Casebook.NewYork,JohnWiley&Sons. Plummer,J.(1987),QEDReportonVentureCapitalFinancialAnalysis,PaloAlto,CA, QEDResearch. Woodward,S.(2005),MeasuringRiskandPerformanceforPrivateEquity, Unpublishedworkingpaper,availableat http://www.sandhillecon.com/pdf/MeasuringRiskPerformance.pdf.