If Hamlet Were a VC

To tranche or not to tranche, that is the paraphrasing of a tired cliché.

Cliché or not, it’s an important question venture capitalists often ask themselves when financing a start-up that potentially could require significant capital. (We ask it here.) The obvious benefits are clear. Venture investors can commit large bits of capital to these companies—enough perhaps to carry a company to commercialization—without actually having to hand all the money over at once. (As an added benefit, they boost their IRR by shortening the time between their distribution of capital and their realized--they hope--returns.)

This morning’s panel at our In3 East conference in Boston examined two specific cases of companies running on tranched financings: atrial fibrillation company Endosense SA and spinal implant maker Innovative Spinal Technologies Inc. (IST) In the spirit of obtaining both sides of the argument, the panel included an investor perspective—delivered by Thomas Pollare investment director at 3i and lead investor in Endosense—and management—represented by Scott Schorer, president and CEO of IST.

The discussion—led by colleagues David Cassak and Stephen Levin—didn’t come to any definitive conclusion, pro or con. Pollare and Schorer obviously endorse the concept since each agreed to tranched financings in 2005. Pollare negotiated a $20 million Series A financing with Endosense, which is developing a catheter capable of delivering radiofrequency energy that scars heart tissue and disrupts the irregular electrical flow that leads to atrial fibrillation.

Schorer, meanwhile, signed a $39 million Series B with Orbimed, MPM and JPMorgan Partners taking equal parts. The company is currently selling and developing several new spinal implants.

Both suggested the tranched financing structure gives companies the capital necessary to make serious headway on a business plan. Pollare suggested the inclusion of milestones aligns the interests of management and investors as both will be rewarded by the execution of the business plan. “As an investor it’s important to have the capital working for you so it can be used efficiently,” Pollare said. “Obviously, it’s important for a second reason because if they don’t hit milestones something is wrong. You have to rethink the plan and the valuations.”

Schorer agreed but warned that the milestones could easily become a problem if management and investors don’t share the same interpretation of milestones and results. “I generally don’t like milestones and, as I was telling myself that, I looked back at the last few deals I’ve done and I realized that they all have contained milestones,” Schorer said.

IST, according to Schorer, drew down $20 million in July 2005 when it first closed on the $39 million Series B. The second $19 million came later, after the company and investors renegotiated the terms of the second tranche when the company missed some of its milestones. “We did that in reasonable terms,” Schorer says, concluding that the key to the success of tranched financings is high level of trust and respect between investors and management. The biggest risk is that investors and executives don’t share similar interpretation of results, so disagreements can arise over whether or not milestones have been met.

“There is nothing you can build into the deal structure to make it smoother,” he added. “You have to trust the people you’re working with to be fair.” IST is raising a $30 million to $35 million Series C round. It hopes to close on the financing early next year.

An audience member challenged the structure, saying it was unhealthy because it automatically put management and investors at odds. Experienced investors should be capable of judging management, evaluating performance and rewarding results without dangling the carrot and stick of a tranche investment.

Pollare, however, defended tranching, saying it gave investors an additional level of control over how their capital is used. “You can’t just give the check and say, `Call me in three years,'” he said.

“That, would be ideal,” Schorer joked.

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How Much Does Pfizer Want to Succeed?

Yesterday, Pfizer’s Jeff Kindler ended the speculation around what we think is his most important appointment, elevating development chief Martin Mackay to the top R&D job (an appointment, by the way, which we predicted--here).

As the WSJ’s health blog pointed out, Kindler has chosen managerial continuity. If Mackay does some of the requisite R&D reforming, it will at least come from within the Pfizer context – and theoretically won’t generate the antibody response an outsider’s initiative would (like Peter Corr’s attempts when the former Warner-Lambert chief was briefly R&D boss).

Second, Mackay is not John LaMattina. He clearly recognizes the need to change Pfizer—as he’s noted to IN VIVO and as he’ll explain at Windhover’s FDA/CMS Summit on December 6.

But two big issues will determine how successful Mackay can be—one more or less in his control; the other out of it.

The first: just how far is he willing to go in reforming Pfizer R&D? A $7.5 billion annual cost, it is vastly too expensive for what it produces. And it’s got too many people working on too many projects to manage effectively.

To succeed—our view, of course--Mackay will have to reduce headcount; start and objectively judge experiments in development (like its Project Fisher, a parallel to Lilly’s Chorus division); figure a way to push biologics into the mainstream of Pfizer’s discovery and development and create systems for monitoring the likely but as yet unknown safety challenges they’ll present; push for independent (and probably independently traded) R&D organizations, on the models of Genentech or Theravance, to whose output Pfizer will have post-Phase II options; and figure out ways of partnering Pfizer’s own de-prioritized drug candidates.

Among other things. But that’s enough for right now.

Problem is: Pfizer’s commercial and financial sides (including its CEO) will have to accept and adapt to the kind of output a revitalized Pfizer R&D must generate—high-value specialty drugs, including biologics. That will mean a smaller, more focused commercial Pfizer--or even Pfizers (we’re all for disaggregation and spinouts—therapeutically focused mini-Pfizers, for example). When Pfizer has followed its instincts, taking a mass-market approach to specialty drugs, it’s failed: witness the disappointing performance of Rebif in multiple sclerosis or the disaster of its inhaled insulin, Exubera.

We know and respect Martin Mackay. And we know he has his work cut out for him. But if he does his bit, Pfizer then needs to let him succeed.

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On the Beach at St. Tropez

Oh please, please Brer VC, please don’t make me go to St. Tropez.

But he did, and your blogger has endured the vins de Provence, smoked salmon and paté, chevre and Roquefort, moules mariniere, and breast of duck of Atlas Venture’s Riviera hospitality to provide you some personal takeaways from its Life Sciences retreat.

We’re not quoting attendees or speeches thanks to our journalistically questionable promise to ascribe none of the chit-chat to particular attendees—a promise we assume doesn’t apply to IN VIVO Blog's own presentation, which is available here for free downloading (thanks to Atlas’ Kevin Clancy for preparing the slides).

And oh yeah, it also doesn’t apply to the other day’s Myogen vs. the VCs post.

So what did we learn midst gawking at boats the size of our house?

The increasing leverage of biotech. Everyone agrees that the pivot point of deal values is proof-of-concept (for more on why, see here and here).

But will the prices continue to increase? Yup. Despite Big Pharma’s relatively rich early-stage pipelines, thanks in part to a better understanding of chemical challenges, the biological risk has soared—and with it the attrition rates. While we at least believe in the possibility that collaborations are now inching toward the asymptotic endgame of full value, one top Big Pharma executive argued--with the authority to do so--just the opposite: given the appetite from his and other companies for post-proof-of-concept candidates, deal prices will continue to rise on just about the same steep slope they’re on now.

No end in sight to the Big Pharma biologics appetite, whetted by lower perceived risk, higher pricing, and—thanks to the regulatory Berlin Wall against biosimilars—longer product lives. (For an in-depth analysis of pharma strategies here, see the upcoming October issue of IN VIVO). Particularly mouthwatering: technologies—like Adnexus’s Adnectins—which open up the IP spaces around validated mechanisms targeted by antibodies to improved fast-followers.

But not so fast. Let’s at least admit we really don’t know the risk of biologics, at least not in quantity. Think first about manufacturing, cautioned one former research chief. Are companies whose QA/QC processes were built around the relatively straightforward chemical characterization of small molecules really prepared for the kind of QC necessary for parallel bioprocessing of perhaps a dozen biologics (a slide on Pfizer’s pipeline, chock full of biologics, showed just how possible a flood of biologics might be)?

Then think about their commercialization. Given that more and more of these biologics will end up being used chronically (after all, Big Pharma wants to replace post-expiration chronic-care small-molecule drugs and most acute-care biologics won’t fill their revenue shoes).

Suddenly, said the ex-research boss, the number of patients on large molecules will dramatically increase the likelihood that unforeseeable signals will show up – like the two PML cases which yanked Tysabri off the market for a time and which would have been impossible for any approval statistics to uncover. At least with small molecules, we’ve got the tests for the likely toxicities, allowing us to shoot compounds in the head before they ever get developed. So with biologics: what signals are companies setting themselves up to look for?

Now let’s talk pricing and patents. Our reading of the meeting’s consensus opinion: BIO made a colossal mistake in stalling a pathway to approval for follow-on biologics, pulled by the nose—accused a variety of meeting attendees--by its richest members (Amgen, Genentech, Biogen Idec, J&J) while ignoring its smaller members. A panel on Washington matters was utterly dominated by the subject, with most of the audience (or at least the many in the audience who voiced their displeasure) apparently convinced that the biotech industry had thrown away its political white hat in favor of the guise of intransigent profiteers.

The political chance lost: a Republican majority which could have at least passed a bill reasonably attractive to biologics innovators while allowing in lower-priced competition. Now it’s payback time: a Democratic majority, more closely tied to a few large-ish generics players, heel-dragging for a bill with relatively minimal exclusivity provisions, speculated attendees.

We'll have more to say about the retreat once we’ve been to the gym to repent our hedonism.

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Dollens: Reimbursement Uncertainty May Slow Innovation

Ron Dollens knows a little bit about innovation, and he’s worried.

In a keynote address that opened our In3 East Conference, the former president and CEO of Guidant Corp. warned that the instability of the current reimbursement system is threatening innovation in the life sciences sector.

“Health care policy is the strategic issue,” warns Dollens before a packed room at the Westin hotel in Boston. “If health care policy is not right, this sector will not be able to attract the financing capital required for early-stage companies, and those are the companies where breakthrough things happen. And if the financial capital is not available then the intellectual and human capital won’t follow, and it’s the human capital that is the source of all the creativity.”

Dollens says the Centers for Medicare and Medicaid Services (CMS) needs to work more closely and cooperatively with industry as well as with the Food and Drug Administration. A green light from the FDA means considerably less without a reimbursement code with which a company—and ultimately its investors—get paid.

In his address, Dollens says “risk capital” aka venture capitalists pay for 20% of all innovation in life sciences and medical devices. The figure goes up if you factor in private equity firms, he says. If private equity and venture capital investors don’t see the potential for “above average return” on their investment, they’ll walk.

“Do VCs have to invest in life sciences? Are there any barriers to where the money flows? The answer is obvious. They are not,” says Dollens. “They’re not tied to health care. They are not tied to life sciences.”

Dollen holds Guidant up as a prime example of the power of innovation. The company was built around its ability to discover and develop new products. At any point in time, two-thirds of Guidant’s sales came from products that were less than 12 months old, and Dollens says that ability to innovate was an asset its suitors sought to acquire (along with its existing businesses, of course).

The Eli Lilly spin-off grew from a $1 billion company in 1994 to a $27 billion company in 2006 when Boston Scientific outbid Johnson & Johnson to buy the company. (For BSC CEO James Tobin's take on the integration of Guidant, go here.)

In a question and answer session with colleague David Cassak and the audience following the address, Dollens questioned whether Guidant’s rapid rise could be recreated today. “I think you could,” he says. “But I don’t think you’ll have the market capitalization because of the health care policy concerns.”

Patients and physicians have an appetite for new technologies, but Dollens wonders where there's an equal desire to pay for them. He suggests the primary purpose of Health Care Technology Assessments—the extensive study of a device's technology and impacts on health care—is to keep a lid on costs.

More ominously, Dollens recalled a meeting Guidant officials had with CMS “a couple of secretaries ago” seeking reimbursement for a new device that already had received FDA approval. The Guidant officials presented the data showing that the company's device improved mortality rates in a certain patient profile.

He said the secretary’s first question was, “`Well how many patients are we talking about?’”

“He can ask that question for one of two reasons: one because he could be concerned about how many lives we were potentially going to save…”

“Or,” Cassak offered, implying CMS was concerned more about how much the new device would cost.

“And I think it’s the 'or’,” Dollens concluded.

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High Noon at Myogen

Most VC meetings provide a feel-good story for the portfolio CEOs—usually a variation on the business resurrection theme. The Atlas Venture retreat, which just finished up in St. Tropez, is no exception.

But it’s rare to hear one as compelling, or as compellingly told, as the story Bill Freytag related at the Atlas meeting of the showdown between Myogen’s management and its venture board.

Freytag, then Myogen’s CEO, told the story of a board meeting in the middle of the deadly 2003 IPO drought. To get its pulmonary arterial hypertension drug ambrisentan developed, Myogen needed the kind of money only an IPO could deliver – and for which Freytag and his team had found, despite the extraordinarily dry weather, some investor interest.

But at the board meeting, the VCs said no. IPOs were impossible, several maintained. It was “slash and burn time”--cut research radically, pare back the company, and prepare to unload the business. One apparently stood up, pointed a finger at Freytag, and said: through the whole history of the company “you haven’t created any shareholder value!”

Which was in fact literally correct. For the last several rounds, the company had raised money at the same $7 a share price—though since the VCs controlled the financings, the blame could hardly be laid at Freytag’s feet.

Freytag is a mild-mannered man—you certainly wouldn’t expect him, or frankly the kind of managers you’d assume would gather around him, to play the Gary Cooper role in some business version of High Noon. But according to Freytag, “I said, ‘Time out,’ that the management needed to caucus. And we left the room.” In the hallway, Freytag says he told his managers that it was “D Day.” Did they really believe that, given the resources of an IPO, they could develop ambrisentan and its follow-on, darusentan—and build the company around it? Their unanimous answer was “yes.”

The group went back to the board room—“I was shaking in my shoes,” said Freytag, who realized that contradicting the venture board could mean his job. “We’ve heard your advice,” he recalls saying, “but we’re going to go forward with the IPO.”

In fact, Freytag probably had little real reason to be nervous: the board faced a management team united in its opposition to them and would hardly want to inherit the responsibility for running the company. And indeed the board backed down; the IPO went ahead, raising $81 million at $14 a share, and opened the window for a host of other IPO candidates. Myogen went on to sign a $100 million ex-US deal on ambrisentan with GlaxoSmithKline and finally to sell to Gilead for $2.2 billion--the ultimate happy ending for investors.

Freytag says he’d thought he’d end up in venture capital and talked to a number of VCs about joining a firm. But when Aspreva CEO Richard Glickman surprised the board by resigning this past summer, Interwest partner Arnie Aronsky asked Freytag to run the company.

It’s a very different kind of challenge for Freytag: with $325 million in cash and marketable securities at the end of the second quarter, annual cash flow of about $150 million a year, and a drug whose clinical value outside of transplant has so far been surprisingly difficult to prove while its patent-clock races toward expiration, Freytag is hardly likely to try to face down the board in favor of product development. (For an analysis of Aspreva’s original strategy in in-licensing Roche’s CellCept, click here.) There are probably better uses of Aspreva’s cash—and plenty of unloved biotech R&D programs around to soak it up.

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Don't Miss Dollens

Regular readers of IN VIVO the magazine may recall a particularly insightful question-and-answer piece with Ron Dollens, the retired president and CEO of Guidant Corp., in our January issue.

Colleague David Cassak led Dollens a bit down memory lane and drew very telling details of the start—and the end—of Guidant. Well, don’t take our word for it. You can get a free copy of the article here.

Now you’ve got an opportunity to hear Dollens in person this week at our upcoming In3 East conference in Boston. He’ll be the keynote speaker on Thursday morning leading off two days of genuine information and insights on the medical device industry. Check out the second day panel.

Just prior to the publishing of the article, Dollens was the recipient of the Lifetime Achievement Award at last year’s Phoenix Medical Device CEO meeting, which is sponsored by PriceWaterhouseCoopers, Wilson Sonsini Goodrich & Rosati, Versant Ventures and IN VIVO. For more information on the upcoming Phoenix meeting click here.

And if you do make it to the In3 conference this week please say hello. Baseball fans seeking spirited discussion in between presentations will find healthy representation of the four American League playoff teams. We shipped the Phillies fan to London.

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While You Were Winning the NL East!

M-V-P

How 'bout them Phillies! Could we be heading for an intrablog standoff between IN VIVO's Philly and Boston contingents? Only time will tell...

Sorry for the late and skinny weekend roundup; our flight was delayed several hours returning to the UK after the PSA conference and we were too excited about the Phillies victory (and frankly, without an easy internet connection) to post yesterday.

So we'll keep it short:

• Vernalis' and Endo's Frova hits the wall. The migraine drug's second time around at FDA--its supplemental NDA for expansion of its label into menstrually associated migraine--turned ugly over the weekend when the agency sent the companies a surprise "Not Approvable" letter. As one analyst told IN VIVO Blog today, "there's a lot of egg on a lot of faces" at Vernalis and Endo. The companies had been extremely optimistic about the drug's label expansion prospects.

(AP Photo/Tom Mihalek)

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