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When Funds Flow

Venture capital investment in the biotechnology sector of San Diego continues to climb despite the industry’s reputation of being volatile and risky.

In San Diego, venture capitalists invested $222.4 million in 26 deals in the second quarter of 2014. Of that total, 66 percent, or $146 million was directly invested in local biotechnology firms, according to a report by PricewaterhouseCoopers LLC.

The biotechnology industry had the strongest second quarter nationally since at least 1995, with $1.8 billion flowing into 122 deals, capturing the second largest investment total just behind the software industry. Even after excluding two large biotechnology deals, the sector saw a nearly 40 percent jump in investment dollars over the previous quarter.

Prior to 2011, the biotech industry experienced nearly a decade of disappointing stock market performance. Shortly after initial profit offering, companies in the industry watched their stock rise and then sharply fall.

“The IPO window had been shut pretty hard for years, and people who tested the water found that their stock would drop right after IPO,” said Partner Jim Blair of Domain Associates LLC, one of the few San Diego-based venture capital firms that invests exclusively in the life sciences sector.

Trends began to shift around 2011 to 2013, Blair said, when mutual fund investors began to see double digit returns on biotechnology and life science investments.

“They sort of whetted the appetite of people with their excellent returns,” Blair said.

According to a report by Renaissance Capital LLC, there have been 51 biotech IPOs year to date, up 113 percent over the same period in 2013.The elevated number of biotech offerings is likely to continue in the fourth quarter due to positive clinical trial results and recent merger and acquisition activity in the biotech sector.

Despite the current positive performance, the IPO window remains temperamental as biotech startups line up to go public in the fall. In fact, the sheer size of the contenders may be the reason for the investors’ fatigue. As more companies go public that have underdeveloped business plans, leadership or scientific research, their impending failures reflect negatively on the industry’s market.

“There’s more selectivity now, but there are still companies going public who have no business going public,” said Jay Lichter, seasoned biotech entrepreneur and managing director of Avalon Ventures LLC.

“What you tended to see in 2013 was not only did the super good companies find a way to get into the marketplace, but the medium and less-than-medium grade companies got out into the market too,” said Blair. “In a strong wind, even turkeys can fly — and we’ve had a very strong wind.”

The large anticipated pipeline will allow investors to be increasingly picky. Several biotech companies lined up for the fall IPO offering boast collaborative funding agreements, well-known backers and multiple drug candidates with addressable markets.

Worth the investment

As tumultuous as the field might be, the biotech sector is high-risk and high-reward. San Diego-based Otonomy Inc., a biotech company developing treatments for the inner and middle ear, was founded by Lichter in 2008. Avalon Ventures invested $28 million, along with a slew of venture capitalists including Domain Associates bringing the total venture investment to $143.4 million.

Otonomy raised more than $100 million in an upsized initial public offering in August of this year. The company priced 6.25 million shares at $16 each, which was the high end of Otonomy’s estimate, and sold 1 million more shares than expected. Shares are currently selling at $19.50 on the Nasdaq under the ticker symbol OTIC.

Otonomy’s IPO success is leading the charts for local biotech offerings this year. While there is no hard and fast rule for an investor’s expected return, Entrepreneur magazine estimates that first-round investors usually take between 25 and 45 percent of the equity.

“If you take a million dollars from me, you need to give me back three million.” Lichter said.

Domain Associates has 30 companies in its portfolio of which the venture firm invests $15 million to $30 million each. Blair said that generally three to five companies of the 30 will fail.

“So the company’s idea didn’t work or we shut the company down having lost everything we put into it,” Blair said. “But the other 25 carry the weight of our portfolio.”

Lichter at Avalon has a much higher estimate of failure in the biotech industry.

“It is the only industry that takes a long time, a tremendous amount of money and most of the time you fail,” Lichter said. “People keep putting money into it because for every 30 or 40 that fail, one wins and your $50 million investment turns into a billion dollars.”

Lichter said that investing carefully primarily consists of evaluating companies based on their management team, their technology and the novelty of their product or drug.

“It has to address a market that is new,” Lichter said. “Kind of a white space disease where no medicine exists.”

Lichter also attributes wise investing to instincts and gut reactions to business plans.

“If I’m going to be doing everything like big pharma, I better have a billion dollars or I’m going to fail,” Lichter said. “So I have to do it differently. I have to be more clever, I have to more nimble, and I have to take risks that big pharma would not take.”

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