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STEVEN DICKMAN

Biotech's $$$ problem

REACH FOR a sleeping pill, a multiple sclerosis drug, or a drug to treat a rare metabolic disease, and the chances are you will be consuming a drug discovered at a biotechnology company.

Biotech has become the source of much of the pharmaceutical industry's innovation. Now, a looming threat to the financing of early stage biotechnology companies is making it harder for the industry to keep the supply of new medicines flowing.

No Boston-area biotech company could have survived its infancy if it had required financing from today's venture capitalists. Biogen (now Biogen Idec), Genetics Institute (now part of Wyeth), and Genzyme were all started on the premise that owning one or several technologies useful in drug discovery would be sufficient to achieve profitability for the companies and their investors. Each of these companies was created in large part to sell picks and shovels to the miners searching for gold in new drugs. These companies managed to keep raising money long enough to invent either a technology or a drug that led to commercial success.

Now, startup companies must own their own drugs before venture capitalists will finance them. The so-called ''early stage" of biotech development, a period of uncertainty and innovation, has largely been eliminated.

How did it come to this? Let's follow the money. It typically takes a biotech company six to 10 years and $100 million in capital to develop a new drug. Traditionally, the bulk of this money has come from venture capital firms. Venture capitalists raise their money from pension funds, university endowments, and private investors with a high tolerance for risky investments.

But the profits for venture capitalists have been reduced lately. Instead of making their money just after the initial public offerings of their best companies, venture capitalists have been forced to wait until the drugs in these companies show benefit in clinical trials. This shrinking of the risk premium has persuaded most of them to change their investment strategy.

Venture capitalists are no longer able to sell speculative investments to public-market investors in part because of the fallout from the genomics bubble. After being told that the target-finding technology of genomics would bring faster, cheaper drug discovery, and then seeing the bottom drop out of genomics companies, retail investors, from mutual funds to day traders, now want to see actual drugs, not picks and shovels, before putting in their money.

Venture investors are also under pressure from hedge funds, a risky but sexy asset class. Hedge funds do two things that make them irresistible to deep-pocketed investors: They invest in the stocks of public companies, making the assets much more liquid, and they invest in both downturns as well as upturns in the prices of these stocks. Returns have been fantastic in the early years of the hedge fund boom. The amount of money hedge funds manage has doubled from an estimated $500 billion in 2000 to $1 trillion in 2005, according to Business Week.

The impact of hedge funds on life sciences venture capital can be compared to the dual impacts of Wal-Mart on consumers and suppliers: The buyers of biotech stocks, especially at the initial public offering stage, get lower prices, but the suppliers -- the venture capitalists -- get paid less for developing the companies.

In response, venture capitalists have become more like eBay merchants. As if attending garage sales, they are picking up drugs that have been abandoned by the pharmaceutical industry, retesting or reformulating them (the industry term is ''reprofiling"), and then reselling those that work back to pharmaceutical companies.

While there are strong arguments for laissez-faire, there are also three downsides to the trend.

First, there is little incentive for highly trained scientists to found or join companies that do not already possess drugs far along on their way to market. If they follow the value by joining later-stage companies, these individuals are no longer devoting their efforts to innovation. The ''not-invented-here" syndrome lamented at many big companies is backing up into startups.

Second, it is hard to see where more innovation-friendly capital will come from now that everyone has become a public market investor. Again, follow the money: Investors in both venture capitalists funds and hedge funds won't wait years for the venture capitalist funds to pay off if they can have quarter-by-quarter gains provided by the hedge funds.

Finally, the impact of the public's already sizable investment in biomedical research will be diluted. Until recently, budgets for basic biology research were only rising. The National Institutes of Health budget alone, which is invested in Boston, Cambridge, and other university towns, as well as at the headquarters in Bethesda, Md., has quintupled since 1985. But the government wants to leave drug discovery to the private sector.

The industry may get along fine for a while. Just as the resellers on eBay keep finding more gold at garage sales to repackage, new drugs continue to emerge from the discovery pipeline based on research commercialized by venture capitalists in the 1990s. But if the current trend continues, just a few years down the road venture capitalists may find an empty garage. Worse, a gap may loom that could threaten not only the biotech industry, but our health as well.

Steven Dickman, a former venture capitalist, is CEO of CBT Advisors, a consulting firm in Cambridge.

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