Biotech IPOs' Iffy Prognosis

Many biotechs' initial public offerings are serving as a cash injection for drug development efforts rather than a payday for investors

by Alex Halperin

Biotech offerings are in remission. Even as small pharmaceutical developers continue to stream toward the public markets, investors are yawning. Too often, initial public offerings for small biotechs offer little short-term upside—and ask investors to take on the major risks of drug development. But recently large pharmaceutical groups have shelled out big bucks for tiny biotechs—making getting acquired more attractive than tapping the public markets for some of the most promising names.

All of which makes it a less than ideal time to come to market. Look at two small biotech outfits aiming to tackle cancer set to debut next week. Don't expect them to have a big Fortress-style (FIG) pop in their debut (see BusinessWeek.com, 2/9/07, "Investors Storm Fortress IPO"). As is typical of biotechs going public, the Canadian outfit OncoGeneX and Israeli startup Rosetta Genomics are money-losing companies without an established product. Even with a strong stock market and signs of diminishing investor aversion to risk much evident elsewhere, Wall Street is wary of small unproven biotechs that have to negotiate the difficult and risky drug approval process.

The number of biotech IPOs has climbed since the postbubble doldrums at the beginning of the decade. But increasingly, these deals serve simply as a cash injection for drug development, as opposed to a payday for investors. These days, "people like at least compelling Phase II [drug-trial] data if not Phase III data," says Matthew Geller, senior managing director at Rodman & Renshaw. In other words, the drugs should have demonstrated effectiveness. It's better still if the compounds have been shown to be more effective or safer than existing therapies.

Sarbanes-Oxley Challenges

In this tough IPO climate, big pharmaceutical companies, flush with cash and needing to fatten their product pipelines, have produced a compelling alternative to the public markets: Recently they've been buying companies for far more than the fledgling outfits could raise by going public.

"You can sell companies a lot earlier and a lot sooner," says Nicholas Galakatos, managing director of the venture capital firm Clarus Ventures. "It's a very exciting environment for M&A and a very cautious environment for IPOs." According to figures Clarus shared with BusinessWeek.com, between January, 2005, and September, 2006, 14 private biotech companies were acquired with a mean deal value of $292 million, including acquisitions for which the dollar values were not disclosed. This represents an 86% premium over the mean market valuations at pricing of biotech IPOs.

A few recent acquisitions must make that strategy look very tempting, especially when the alternative is confronting securities market challenges posed by Sarbanes-Oxley on the one hand and an uncertain drug development process on the other. Among the deals sure to get VC hearts racing, last year Merck (MRK) acquired biotech outfit GlycoFi for about $400 million. In a similar deal, GlaxoSmithKline (GSK) said it would acquire private drug discovery outfit Domantis for more than $400 million. Merck also bought the small (but public) biotech Sirna for upwards of $1 billion.

Despite the appeal of an acquisition, some IPOs are still paying off for biotechs. Affymax, where Galakatos is a director, had the strongest biotech offering of 2006. So what does it take to launch a successful offering? Compared with one of next week's hopefuls, OncoGeneX, Affymax had several advantages, even without considering their respective drug candidates. First, it is targeting the large anemia market, as opposed to the more splintered cancer segment eyed by OncoGeneX. Additionally, Affymax boasts a war chest of about $140 million, compared with about $11 million for OncoGeneX. Affymax also has a large partnership with Takeda, the Japanese pharmaceutical giant.

Outsourcing Research

While investors have grown accustomed to seeing biotech stocks languish, Affymax priced above its range in December and shares have climbed more than 50% since, to value the company at more than $550 million. As with most small drug development outfits, Affymax still has plenty of risks associated with it. It had a net loss of $44 million for the nine months ended in September. Even if its anemia drug is successful it will not be available for a few years.

For pharmaceutical outfits, buying earlier-stage companies is a relative bargain compared with those that have developed drug candidates independently. "They go through stages where they effectively outsource" their research, says Linda Killian, a principal of IPO research outfit Renaissance Capital. Their need for research dovetails nicely with biotechs, who are finding it increasingly difficult to impress investors in the public markets.

Killian says some intriguing biotech companies still choose to go public, but she doesn't anticipate any current candidates in the pipeline finding valuations anywhere near $500 million. As a result, she says most investors in these companies are knowledgeable and willing to hold on to their stake—and shoulder the risk—for years while the companies push through drug development.

The result is a mixed bag for investors. With Big Pharma willing to pick off smaller companies, investors can lose the chance to make pure-play investments in some of the best small biotechs. And with Big Pharma players so willing to buy the companies they like, the obvious question is: If they don't like a company, should you?

Halperin is a reporter for BusinessWeek.com in New York.