Why universities should venture invest

Until the 2008 financial crisis, the formula for commercializing university inventions had remained unchanged for a half century – intellectual property (IP) rights to develop university technologies are licensed to companies, and universities are paid royalties on the basis of the success of these technologies. Often, IP rights are transferred to new start- ups that rely on funding from venture capital groups.

In the past few years, this model has begun to change. Far fewer venture capital funds are investing in risky, early stage technologies, consolidation and outsourcing in ‘big pharma’ has resulted in more limited transactions with universities, and the dwindling number of initial public offerings (IPOs) has shifted investor exits toward acquisitions, which in turn are constrained by the capacity of large companies to engage in mergers and acquisition activity.

Funding from the US National Institutes of Health (NIH) for early development work has also declined substantially. In response, alternative commercialization mechanisms have begun to emerge, most notably in the form of investment arms of big pharma having a larger role in early stage investment. Despite this, the number of innovative, early stage start-ups that are based on university technologies has declined, threatening the viability of a key source of medical innovations. In this context, what can universities do to step up and fill this gap? One solution involves university investment funds that are designed specifically to bridge the funding gap between preclinical research and clinical proof of principle.

Universities’ contribution

University discoveries have provided a crucially important foundation for drug development in the life sciences since the first biotech products were developed in the 1970s. Of the 252 new drugs approved by the US Food and Drug Administration between 1998 and 2007, 62 (or nearly 25%) were discovered at US universities. More striking is that greater than 30% of drugs that are considered novel and medically necessary, rather than ‘me-too’ formulations for follow-on indications, were initially developed in a university setting and licensed to biotech or pharmaceutical companies1.

Universities interact with companies by entering into licensing, sponsored research and other agreements that provide funding for early stage research with the aim of moving inventions into the marketplace, where they can affect human health.

In addition to having a profound impact on patient care, these discoveries often generate revenue for the inventor and their home institution. For example, four of the five top-selling biologics marketed between 1998 and 2008 were initially discovered within universities or their affiliated hospitals. Certain university licensing groups capture this value tremendously well: Stanford realized $66.8m from its licenses in 2011 (http://otl.stanford.edu/about/resources/about_resources.html), and the Office of Technology Licensing at Massachusetts Institute of Technology (MIT) generated $85.4 in 2011. Notably, MIT inventions also formed the basis of 210 spin-out companies between 2000 and 2010 (http://web.mit.edu/tlo/www/about/office_statistics.html). Start-up companies, based predominantly or sometimes solely on university technologies, depend on third-party sources of funding, traditionally venture capitalists, corporate partners and, in some cases, the NIH Small Business Innovation Research or Small Business Technology Transfer programs to support all product development and operational activities.

A perfect storm

Since the end of 2008, a variety of factors have come together to create an extremely challenging environment in which to fund early stage discovery research and product development: first, substantially less money was raised by fewer venture firms in each year from 2008 through 2011 in a broader trend toward consolidation in the venture capital industry; second, interest among pharmaceutical and large biotech companies for early stage technology partnership deals rapidly declined; and, third, NIH funding for early stage technology in the form of grants and small business funding became increasingly competitive to secure. Together, these realities set the stage for a painful gap in funding for pre–phase 2 programs.

Simultaneously, the importance of translational approaches has been increasingly emphasized in national research agendas, and multimillion dollar translational research programs have been launched at institutions in various countries. However, fewer resources to support this increasing need for the translation of medical discoveries are available from traditional sources.

I have seen these trends evolve within the course of my own career, which began more than 15 years ago in technology transfer, continued in various business development roles in biotech companies for nearly a decade and ultimately led to the Hospital of the University of Pennsylvania, where I am an internal medicine physician.

Where did the venture capitalists go?

In 2007, before the economic crisis began, 237 venture capital firms raised $31bn. By 2010, 169 such firms raised $13.7bn, corresponding to declines of 28% and 56% in the number of firms and funds raised, respectively.

Although 2011 showed some signs of recovery (169 venture capital groups raised $18bn), the trend toward traditional venture capital fund consolidation has meant that fewer early stage deals have been funded. Indeed, the second quarter of 2012 was the fourth consecutive quarter of decreasing venture capitalist investment in the life sciences sector, and it fell 9% in dollars and 6% in deal volume (compared with the previous quarter), representing the lowest investment in life sciences since 2003 (ref. 3).

Despite top venture capital firms such as Avalon Ventures and New Enterprise Associates raising $200m and $2.6bn in mid 2012, respectively, the majority of venture capital funds have been unable to raise new capital.

The resulting void has been tempered somewhat by the creation by many large pharmaceutical companies—and a few large biotech firms, such as Amgen and Novo Nordisk —of their own internal corporate venturing groups.

These groups participated in 17% of the biotech financings in 2009 (ref. 4). But it remains to be seen whether the number of transactions in which such funds participate can compensate for the flight of traditional venture capitalists. There are no data at this stage to quantify the importance of the impact these investment groups have had.

At the same time, life sciences initial public offerings (IPOs) have clearly been underperforming. At the peak of the Nasdaq stock market in October 2007, 59% of biotech companies with IPOs between 2003 and 2007 were trading below their stock prices at the time of IPO. By June 2009, this number had increased to 79%3.

Thus, the long investment horizons, high rates of attrition and lackluster IPO performances of early stage life science ventures have dampened the enthusiasm of many venture capital funds, which have trended heavily toward shoring up existing portfolio investments and funding companies with post–phase 2 products.

Perhaps more ominous for start-ups and early stage companies is the 48% decrease from 2010 in dollars invested at the earliest stages of preclinical development (‘seed investments’) across all sectors in 2011, representing only 2% of all venture capitalist investments.

In stark contrast to this trend, the total investment in the biotech sector during this same time period increased 22% to $4.7bn for 446 deals (9% fewer than in 2010).

This is because such deals are heavily weighted toward companies with products in clinical development rather than life science ventures that are based around early stage assets. The year 2011 saw the lowest number of
deals and dollars invested in seed-stage biotech companies since 2005: $367m in 79 deals was invested in 2011 compared with $876m in 124 deals at the peak in 2009.

In contrast, the number of deals for biotech companies with products in development grew from 136 ($796 million) in 2006 to 216 ($2.06 billion) in 2011 (Fig. 1; https://www.pwcmoneytree.com/). This trend seems to be continuing in the first half of 2012.

In addition, venture capital funds are highly regionally concentrated: in the US, the leading geographic areas in terms of total venture capital dollars invested are New England and the San Francisco Bay area. For example, in 2011, $3.2bn was invested in New England, $11.6bn was invested in Silicon Valley, and, in stark contrast, only $450m was invested in start-ups in the Philadelphia metropolitan area, where I am based.

Fledgling start-up efforts in these less flush regions will probably suffer more acutely within the funding gap than start-ups in areas of the country that are rich with cash and traditionally have more entrepreneurial cultures, such as Boston and Silicon Valley. It is not coincidental that MIT and Stanford, undisputed leaders in technology transfer, thrive in these key regions in a symbiotic fashion with their venture capitalist and industrial partners.

We cannot forget, however, that less–cash-infused regions are often home to powerhouses of medicine and technology. To use Philadelphia again to illustrate this point, the city hosts three hospitals in the University of Pennsylvania Health System, the Abramson Cancer Center, Temple University Hospital, Children’s Hospital of Philadelphia and Thomas Jefferson University Hospital, to name a few, but venture capital funding in the region is drastically lower than it is in other cities with similarly excellent academic institutions.

The University of Pennsylvania is ranked second in the nation—behind Harvard —for NIH grant funding, and yet private investment in the region approximates 15% of that focused in the Boston area.

As a result, there is a vast untapped opportunity, particularly in such regions as Philadelphia, to invest in the translation of high-quality, groundbreaking science into products that make a meaningful contribution to patient care.

Industry has not stepped in to fill the gap

The traditional role of an industry partner is to enter into a corporate alliance with a young biotech company in need of expertise, infrastructure and funding to access rights to a product or technology. In the heyday of biotech deals in the late 1990s and early 2000s, it was common for pharmaceutical companies to make large deals with small biotech companies on the basis only of preclinical studies.

This started to shift toward a clearer interest in later-stage products in the mid 2000s, but once the financial crisis hit, big pharma went through a period of fundamental restructuring that led to a sharp drop in the number of deals made at any stage.

Recent deal activity has increased and is heavily focused on large, milestone-based deals—often acquisitions—with companies that have at least phase-2 assets. Examples include Gilead Sciences’ acquisition of Pharmasset for $11.2bn for their pipeline of phase-2 product candidates to treat hepatitis C and Sanofi’s $20bn takeover of Genzyme. Big pharma is particularly enamored of innovative products that alter the course of a disease but that have enough clinical data to reduce risk of failure once they start heavily investing.

This inflection point is commonly viewed to be at phase 2, leaving the pre–phase 2 companies with fewer industry partners that are willing to make a leap of faith.

In addition, as the pharmaceutical and biotech industries consolidate in an effort to augment their product pipelines, one result is that there are fewer potential partners with sufficient resources to fill this gap.
 
A larger number of underfunded early stage companies have fewer development and merger and acquisition partners with the cash and infrastructure required for success. However, because there is insufficient access to IPO markets, both traditional and corporate venture capitalists rely heavily on mergers and acquisitions to realize their return on investment.

As a result, venture capitalist investments into companies that fit the ‘pharma model’ are common; this de facto emphasis on the priorities of large corporate partners threatens the pipeline of truly innovative products that have historically been developed by start-ups.

NIH funding will not increase

The NIH has had a pivotal role historically in the development of new therapeutics by funding risky, early stage discovery research that would go largely unfunded otherwise. Universities and research institutions have come to rely heavily on this funding to offset their own investment in research, infrastructure and personnel costs.

Even so, in inflation-adjusted dollars, the 2012 budget for the NIH is $4bn lower than that for 2003. The number of research grants made by the NIH has declined every year since 2004, a trend that is projected to continue through at least 2013; indeed, 3,100 fewer research grants will be funded this year than were funded in 2004.

In 2011, there were more than 1,600 fewer competing awards than in 2003, when 10,365 projects were funded, which is a decrease of greater than 15%. Success rates for applicants have fallen by more than 14% in the last ten years, a trend that is projected to continue and, potentially, accelerate (http://www.faseb.org/Policy-and-Government-Affairs/Data-Compilations/NIH-Research-Funding-Trends.aspx).

Universities and research institutions that have historically been dependent on the NIH to provide substantial, and sometimes sole, funding for the discovery and early development of increasingly complex medical innovations must face the reality of looking to other sources or risk falling behind their peers. It is unlikely that cash-strapped state and federal governments will be in a position to fill this gap in any meaningful way.

From crisis comes opportunity

We live in a world where multiple factors are aligning to make the success of university-based, early stage technologies increasingly more challenging. It is into this void that universities must venture under an entirely new paradigm to support their unequivocal mission to advance human health by moving basic science discoveries broadly into the hands of clinicians. If done well, these same institutions will have an opportunity not only to protect their endowments and other assets but to grow them as well.

Many universities have sizeable endowments, and their affiliated health systems often carry substantial liquid assets, which they are obligated to invest on the basis of their not-for-profit status. Examples include Harvard University, with $32bn; University of Michigan, with $7.8bn; University of California, San Francisco, with $1.5bn; University of Pennsylvania, with $5.8bn; Stanford University, with $16.5bn; University of Toronto, with $1.5bn; and Oxford University, with £1.4bn ($2bn). Much of this money is reinvested into the home institutions in the form of infrastructure and research support.

A unique opportunity exists for universities with sufficient resources to become the face of ‘gap investing’ for a certain subset of their own discoveries that hold true promise to affect patient care and generate commercial success.

The goals of the universities in making these investments would be fourfold: first, and most importantly, investing in early stage, translational research in a meaningful way helps fulfill their mission to advance discoveries into the public domain for the betterment of human health.

Second, these programs would contribute t
o the ability of the institutions to recruit and retain talented physician scientists, researchers and clinicians.

Third, funding of this type has the potential to stimulate knowledge sharing, dissemination of expertise and greater interdisciplinary collaboration within the institution.

Fourth, there is the potential to generate substantial revenue with well-structured investment programs. It is worth noting that for all the pessimism around life sciences investments, the rate of return in healthcare investments from 2000 to 2010 was 15% for realized deals (7.4% for all deals), which is far greater than in any other sector and is greater still than the Standard & Poor’s 500, which returned a meager 4%.

The university venturing fund

Universities can achieve these goals by creating stand-alone venture investment groups as a substantive component of an integrated strategy to support translational research. Indeed, there are already several examples of these types of funds in the US and UK.

Massachusetts General Hospital and the Brigham and Women’s Hospital (both in Boston) created the Partners’ Innovation Fund with $35m in 2009, which has successfully built high-quality investment syndicates for 11 companies, some of which have marketed products.

Each investment by the Partners’ Innovation Fund is heavily leveraged with cash from its syndicate partners, defraying the risk to the Partners’ fund upfront.

Imperial Innovations, initially a wholly owned subsidiary of Imperial College of London, UK, and established in 1986, has raised £50m in two financing rounds (2005 and 2007) to allow the group to invest in start-ups from its IP portfolio. It is now one of the most prolific early stage investment groups in Europe, having made 24 investments totaling £13.1m in its first year of trading.

In 2011, the Institute for Applied Cancer Science was created by the University of Texas MD Anderson Cancer Center. A $75m upfront investment will be used to develop cancer drugs through the completion of preclinical studies, at which point their internal business development group will attempt to enter into industry collaborations.

The University of Michigan announced in January that it would invest $25m into a fund that would co-invest with other venture capitalists at the seed and early series A or B rounds. And in February 2012, Cleveland University Hospitals (Cleveland, Ohio) and the Harrington Family announced a $250m investment into a research institute and an affiliated, stand-alone commercialization entity with the aim of developing, partnering and potentially marketing products based on university discoveries.

Although the details of the financing arrangements in the above university venturing groups (UVGs) differ, an opportunity exists for other academic institutions to adopt a similar strategy of venture creation.

The model can be envisaged as follows: most UVGs would be financed initially with institutional funds and augmented by third-party investors that could include traditional venture capitalists, pharma venture groups, state investment groups and, potentially, alumni.

The UVGs would operate at arm’s length from the initial investors, with a professional management team and advisory board oversight from the parent institutions. The UVG would consider making small, incubator investments into discovery projects with the specific goal of enabling their development to a point of increased value for licensing or corporate formation.

Return on investment for such incubator investments would be based on a share of the royalties received by the university if the investment is licensed. A larger share of the assets from the UVG would be designated for traditional equity investments in start-up entities based on the institution’s own inventions.

The UVG would pull together groups of venture capitalists or other investors in what is known as a ‘syndicate’ at the formation of the UVG and/or around each potential investment. This would allow the UVG to stretch its dollars further by leveraging money invested by its syndicate partners.

The UVG would see a return on investment once a portfolio company generates revenue from product sales, is sold to a larger company or has an IPO (an ‘exit’), similar to a traditional venture capitalist. Importantly, potential conflicts of interest would be dealt with explicitly and transparently; founding investigators with equity in a start-up would not be principal investigators in any related clinical trials, for example.

The UVG would be operationally and legally a separate entity, minimizing the influence of the founding institutions over its investment decisions.

If established with appropriate guidelines and run by experienced, independent management, these UVGs would have tremendous competitive advantage to make such a venture successful.

First, they would be working in collaboration with faculty who have a depth and breadth of expertise and experience in relevant scientific and clinical areas to which traditional venture capitalists only have access through expert networks.

Second, they often have existing infrastructure to support discovery, development and regulatory activities that could be used more effectively.

Third, there are frequently multiple other relevant resources on campus that can be leveraged, such as top business schools, policy institutes, translational research centers, NIH-approved animal testing facilities and, often, small-scale good laboratory practice and good manufacturing practice capabilities.

Portfolios need not be limited to life sciences and therapeutics; products with much shorter investment horizons and exit points, such as healthcare information technology, diagnostics, devices, clean technology and software, could provide a counterbalance to riskier drug investments.

Structured appropriately, the UVGs could see a profitable return on investment within 5–7 years. (It is noteworthy, however, that UVGs could probably tolerate a longer investment timeline than a traditional venture capitalist, which is constrained by the financial and liquidity interests of its limited partners.) Coupled with a management team that has experience in venture investment and product development, UVGs could be positioned for unique success.

Potential pitfalls to the success of this approach do exist, however. Most notably, the inherently risky nature of investing in early stage technology companies and their high likelihood of failure places precious invested capital at risk of flat or negative return on investment.

So far, many universities have not capitalized fully on the value of their IP, and some could argue that investing more of an institution’s limited resources into such endeavors would be unwise. However, for those institutions with sufficient capital, these and other risks can be managed and are outweighed by the potential dual upsides of fulfilling the overarching mission of the institution of contributing medical advances to patient care and generating a sufficient return on investment.

Conclusions

The time has come for universities to provide direct financial support for the translation of their discoveries to products that will enhance human health.

Although NIH funding will remain the primary mechanism to support discovery research in the foreseeable future, universities are in a unique position to augment this funding and at the same time increase the value of their own technology and innovations.

They can do this by making substantive investments in pre–phase 2 programs that have high potential impact and value. It is no longer acceptable for these not-for-profit institutions with so much untapped potential to sit on the sidelines of investment in innovation; it is imperative that universities take a leaders
hip role in moving discoveries to the marketplace.

UVGs provide an opportunity to do this in a way that enables the fulfillment of their core mission and also offers substantial potential financial upside in an increasingly uncertain world.

Notes
1 Kneller, R. Nat. Rev. Drug Discov. 9, 867-82 (2010)
2 Booth, B.L. Nat. Biotechnol. 27, 705-9 (2009).
3 Booth, B. L. & Salehizadeh, B. Nat. Biotechnol. 29, 579-
83 (2011).

This is an edited version of an article that first appeared in Nature Biotechnology 30, 933-6 (2012) doi:10.1038/nbt.2390. Published online 10 October 2012:
www.nature.com/nbt/journal/v30/n10/abs/nbt.2390.html