Biotech and Pharma

Biotech investing trends may be hurting innovation

Anita Balakrishnan

Jonathan Fleming, a medical researcher and investor, worries about how the Great Recession set back American health. He's concerned that five years from now, we will be no closer to treating and curing diseases like Alzheimer's.

"The thing that will bury us more than anything—more than climate change, more than Iran as a nuclear power—will be millions of demented baby boomers," said Fleming, president and treasurer of the Network for Excellence in Health Innovation in Cambridge, Massachusetts.

Jian Wan | Vetta | Getty Images

The problem with Alzheimer's, diabetes, mental health and other common diseases is a lack of private-sector funding for innovative start-ups, said Fleming. Investors have been overlooking cutting-edge medicine in favor of less risky consumer apps—forcing researchers to use venture money carefully and creatively as they work to create a pipeline of future medicines.

Read MoreBetting big on a biotech giant

In a paper in February's issue of Health Affairs, Fleming argued the complexity of developing life science products, combined with uncertainty about Food and Drug Administration policies, drained venture capital from early stage life science start-ups that make medical software and devices and biotech firms.

A trend reversal

Data from industry consultants and experiences Fleming has had with his own investments back this theory, he said. Over the past five years, investor money is increasingly moving toward consumer software and later-stage life science ventures.

Venture capital investments hit a decade peak in 2014, and life science investments, which include biotechnology and medical device companies, were at their highest levels since 2008, according to PricewaterhouseCoopers' MoneyTree report for the fourth quarter of last year, which measures quarterly venture capital investments in the United States.

But there is an important nuance—the companies who are attracting fresh capital have been established bioscience players, which leaves the new guys to fend for themselves.

In 2009, the majority of venture capital for life science start-ups was in early stage ventures, according to Fleming's research. By the end of 2014, the opposite was true: venture capital in early stage life science companies had decreased, and shifted to companies in the later stages of product development, he said.

A later-stage product starts making money sooner, and is more certain to do so—especially if it has already gained FDA approval for clinical trials, said Fleming.

Read MoreRecord rise for specialty drugs

Further, the life science sector, especially medical devices, is growing slower than other venture-backed sectors. In the fourth quarter of 2014, software investment was up 53 percent and biotechnology was up 85 percent quarter over quarter, but medical devices were up only 21 percent for the same period, according to the MoneyTree report.

'Like gambling'

Investor Milena Adamian has lived and breathed this issue since she founded Life Science Angel Network, which focuses on early stage medical software and device companies, in 2010. Back then, in the wake of the recession, she was investing in life sciences when everyone else was running the other way.

"By that time, the early stage capital was virtually absent—it was very difficult," Adamian said.

Biotechnology is especially "like gambling," wrote Jason Kolbert, head of health-care research and a senior biotechnology analyst at Maxim Group, in a February industry update.

Put simply, creating something like a new medical device requires more research and development than designing an app—and that means it has a higher price tag and more risk early on compared to other start-ups.

"So as an early stage biotech investor, you have to feel comfortable in a business' ability to make money, the regulatory environment, and the science. Those are three knowledge barriers, compared to the world of software. There are fewer investors there [life science] because it's harder to invest in," said Tyler Willis.

Willis is an entrepreneur who founded Involver, software that helps corporations manage social media. Today, he is an angel investor who advises and mentors start-ups and writes advice for them on the blog Venture Hacks.

Willis and Adamian are angel investors—wealthy or well-funded individuals that step up to fund and mentor emerging companies. Angels step in when no one else will—when a venture is so risky that it requires specialized sector knowledge to determine if it can succeed. Life science angels know the industry and are able to better foresee "unknowns" like FDA approval.

Read MoreFighting mosquitoes with more mosquitoes

But because there have been fewer dollars flowing in from other sources, start-ups are having to look for other sources of funding. One solution has been to team up with big pharmaceutical companies much earlier in a start-up's development, a trend that is helped by corporate programs designed to foster the next generation of businesses, said Adamian. She cited her investment in ZappRx, an online prescription platform, that received funding in December from SR One, the corporate venture capital arm of GlaxoSmithKline.

Johnson & Johnson, Eli Lilly, AstraZeneca, Roche and Merck are also among the big pharma companies that have established corporate venture capital arms, and their role is increasingly important, according to a report in Nature Biotechnology.

Bubble trouble in biotech?

And if the start-up shows more promise, sometimes these investments turn into mergers.

"M&A [mergers and acquisitions] has continued to be a fundamental part of this sector," Edward Tenthoff, managing director and senior biotechnology research analyst at Piper Jaffray. "Big pharmaceutical and biotechnology companies need to continue to buy new products every year to grow."

Despite the risk, Willis sees a future for creative investors who are willing to take a life science company from its launch through to its later stages.

"If you look at things like biotech, or other areas that are not as competitive, historically, investor returns usually come to the really smart investor working in the sector that everyone else is ignoring and that is about to become really important," Willis said. "And there are hundreds of proof points that bio is really a critical growth area for the next 100 years of human civilization."

Analyst Kolbert, too, has a positive outlook. He wrote that a growing portion of treatments are fitting into FDA fast tracks where they receive an expedited review, and that will drive drive performance, specifically in the biotechnology sector.

"Today, better clinical science is translating into earlier 'proof of concept,' making approvals more predictable," Kolbert wrote. "The fact that the number of FDA approvals has been trending positively each year is a great sign."