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The Classic Biotech Startup Model
Biotech companies live and die by innovating and creating new treatments. The basic model follows the regular steps:
- Start with an idea or a scientific discovery
- Develop the idea into a potential drug or treatment for a disease
- Raise capital to prove the efficiency and safety of the treatment in-vitro and on animal
- Raise more money to do a phase I clinical trial, proving the safety of humans.
- Either raise more money or partner with a big pharmaceutical company to manage the very expensive phases II and III of the clinical trials.
- Get approved and sell the treatment either directly (rarely) or through the sale network of one of the top 20 big pharma companies.
An alternative path is licensing the potential drug early to big pharma, which reduces risk and gives up all potential upside to the larger partner.
Because of the ubiquity of this model, investors are limited in their options. Either invest in risky, early-stage startups and hedge their bet with a lot of diversification, as most clinical trials produce unviable products. This also involves a lot of risk of dilution, as each new step requires a lot more capital than the previous one. Or invest in large big pharma companies that are much safer but also lack growth.
The New Royalty Model for Biotech Companies
This limited choice between small upstart companies and a few massive giants with slow or no growth is not unique to biotech. The same problem exists in the mining sector. Striking gold is as uncertain a venture as finding a blockbuster drug. And investors in the sector would experience similar frustration, having to choose between high-risk growth and no growth safety.
This is why a new model emerged: the royalty company. The royalty model differs from the old textbook in a few key points.
It provides capital, but not in exchange for shares or partial ownership of the drugs. Instead, it will make money from a percentage of future sales linked to the drug.
For the startup, it avoids dilution of shareholders, including the founders, so it is very attractive. It also keeps fully in the company all future drugs not developed yet: the royalty concerns only one project, not the whole company's future income.
For investors in the royalty company, it allows for diversified risk without turning to VC funds, usually accepting only accredited investors with millions to invest. Because this is a better deal for the founders than emitting shares or licensing agreements, the royalty company can also negotiate more favorable and profitable terms.
The second aspect is that the royalty company can show an explosive growth profile. By sharing the fortune or misfortune of the startup it invests in, it also shares its growth profile. While still offering diversification by signing royalty deals with multiple startups.
This also means that royalty companies are remarkably lean organizations, often having less than 100 people on their payroll. In that respect, they are more like investment firms or hedge funds than biotech companies. The consequence is that once royalty money comes in, they can reinvest or distribute in dividends 80-90% of the income stream.
So, for investors, royalty companies can be the best of both worlds. Strong growth profile, but with diversification between drugs, medical fields, and technology of a big pharma company.
This model was pioneered in mining by Wheaton Precious Metal, which specializes in gold miners and whose stock has gone up 17x since its IPO in 2005. Many other royalty companies have appeared in the mining industry, and many have performed well.
This model is now starting in biotech, led in parts by the company Innoviva.
Innoviva: The Biotech Royalty Company
Innoviva brought to biotech the royalty model, with several products now commercialized. It started as a “normal” biotech startup, which would go on and sign a royalty stream for its product with the pharma giant GSK.
From then on, Innoviva would use its money not to develop new drugs but to acquire more royalty streams.
For a long time, Innoviva was entangled in a complex relationship with GSK and Innoviva's spin-out R&D department, Theravance. It is now out of the way and has a much simpler corporate structure, as Innoviva bought back from GSK the 32% of Innoviva it owned (for $392M) and sold its royalties for the Trelegi drug for $282M.
The most important royalty is Relvar/Breo, bringing $234M in royalty to Innoviva in 2021 and an expected royalty stream in the next 5 years of $1B.
To give some perspective, the company's current market cap is $863M, trading at a P/E of 3.71. As the company has roughly the same amount in current assets ($313M) as in long-term debt ($394M), its current valuation depends entirely on its investment in the current and future royalty streams.
The company does not distribute a dividend, as it preferred to repurchase shares worth $100M in November 2022.
The Future of Innoviva
Relvar/Breo asthma drug is what’s driving the current revenues of Innoviva and is justifying the current market cap.
However, growth and capital gain for investors will need to come from the future royalty from some of Innoviva's investments. So, potential investors need to understand this portfolio.
It contains several acquisitions, usually after an initial royalty stream or small investment was signed and when Innoviva felt more value would be created by acquiring shares in the target companies.
Entasis / La Jolla
The 2 companies were acquired by Innoviva in the summer of 2022 and are now merged together.
La Jolla was the owner of treatments for patients suffering from septic shock or complex infections.
Entasis is developing new antibiotics for life-threatening antibiotic-resistant infections and saw its main drug, SUL-DUR, accepted for review by the FDA, with a decision expected on May 29th, 2023.
The combination of the 2 companies allows for the sharing of the hospital sales network, as both are related to complex infections involving resistance to antibiotics. This should significantly reduce the marketing costs for the SUL-DUR launch.
Innoviva judges the fair value of this investment at $330M.
Armata Pharmaceuticals (ARMP)
Armata is working on treating antibiotic-resistant infections with bacteriophages. Bacteriophages are viruses that target only bacteria, allowing them to be used on patients similarly to chemical antibiotics. The company is focused on respiratory infections and infections caused by antibiotic-resistant Staphylococcus aureus, with a bacteriophage in phase I clinical trial for both.
Innoviva owns 60% of Armata, as well as an additional $45M and $30M investments. Thanks to this additional investment, Innoviva will own more than the current 60% by the time Armata’s product reaches commercialization.
Innoviva judges the fair value of this investment at $156M.
Diversified Small Stakes
Innoviva has also invested in early-stage biotech startups not publicly listed. The small stakes, estimated to be worth together a total value of $43M by Innoviva, include:
- 13% in InCarda, a cardiac disease treatment.
- 5% in ImaginAb, an imaging system to reduce the need for biopsies.
- 1% in NanoLive, an imagery system for drug discovery.
- GateNeuro, is developing drugs to treat depression, schizophrenia, and sleep disorders. (ownership percentage is not disclosed, but the investment round was with 2 other firms and of $25M)
ISP Fund (Innoviva Strategic Partners LLC)
Innoviva has invested $300M in the fund formed in 2020, which is advised by Sarissa Capital Management LP, an activist hedge fund based in Greenwich, Connecticut. It is investing in a diversified array of publicly traded healthcare equity. You can see more here about the type of investment Sarissa Capital has been doing from their holdings (follow the link).
To date, the fund seems to be valued at $290M, so even if it did not lose money, it did not provide much returns either.
Royalty can be an interesting way to get exposure to biotech, different from directly investing in startups or through big pharmaceutical companies. The most important criterion will be the past track record of its management, as the quality of its assessment of future investments will determine the company's future a little bit more, like picking a fund manager more than picking a biotech company.
Innoviva has adopted a flexible approach, mixing royalties and partial and complete acquisitions as investments in publicly traded larger companies. Its current valuation seems to mostly reflect the value of currently ongoing royalty income, putting at a steep discount the acquisitions of Armata, Entasis, and La Jolla, as well as the ISP Fund and the other smaller investments.
So, the current income and low valuation provide some margin of safety, and the upside is expected to come from the existing and future portfolio of acquisitions and royalties.
Innoviva management seems to see a strong opportunity in the field of infection management and in solving antibiotic resistance, either through new drugs or with bacteriophages. This makes it an attractive company for investors interested in acquiring exposure in that sector. The share repurchase also indicates that the company considers its own stock undervalued and that repurchase is a good way to create value for the shareholders.