Nature Biotechnology 25, 859 - 866 (2007)

A better prescription for drug-development financing

Mark Kessel1 & Frederick Frank2

As the cost of drug development continues to rise and public markets shift their attention to companies with late-stage products, an increasing diversity of financing options are becoming available to biotech companies with early-stage clinical programs.

Securing adequate funding for drug discovery and development programs continues to be challenging for the biotech industry. Historically, such funding has been raised through dilutive equity in often unpredictable public capital markets and/or by out-licensing key programs to big pharma, leaving biotech shareholders with only a fraction of the full value of their companies' innovations. Both of these capital sources have serious drawbacks, and biotech companies are seeking alternative financing sources that mitigate the value leakage inherent in issuing undervalued stock or licensing away their pipelines' most promising assets to big pharma at values that do not capture the significant upside potential for their shareholders.

In response to these trends, a range of alternative financing sources have become available, including royalty monetizations, committed equity financing facilities (CEFFs), contract research organization (CRO)-linked financings and collaborative development financings, all of which have increased the capital channeled into the industry in recent years. However, this capital inflow still pales in comparison to the industry's reliance on equity financings and deals with big pharma. Big pharma, for its part, has also been exploring additional ways of deploying its capital, forming closer relationships with venture capital firms and establishing incubator organizations—for example, the Pfizer Incubator (La Jolla, CA, USA), which Pfizer (New York) launched in March 2007—providing some capital to emerging biotech companies, while at the same time expanding its access to attractive early-stage drugs for in-licensing. In addition to these alternatives, not-for-profit foundations have increasingly dedicated funds to directly support drug development projects, though this approach has channeled only moderate amounts of capital into the industry and has been focused on just a handful of high-priority disease areas.

This article frames the present challenges in drug development and financing, describes alternative sources of capital to traditional financing and presents our view of financial and strategic pros and cons of these funding sources for companies with compounds in early clinical studies.

The drug development environment today

Although R&D spending by the pharmaceutical industry has increased steadily over the past decade, the industry's productivity has fallen (Fig. 1). According to trade association Pharmaceutical Research and Manufacturers of America (Washington, DC), from 1995 to 2005, the pharmaceutical industry reported that R&D expenses increased from $15 billion to $39 billion in real terms—a 160% increase. Over the same period, the Biotechnology Industry Organization (BIO, Washington, DC, USA) reported that R&D spending by members of the biotech industry mirrored this increase, growing from <$8 billion in 1995 to >$20 billion in 2005.

Figure 1: A comparison of biotech and pharmaceutical R&D productivity.

Figure 1 : A comparison of biotech and pharmaceutical R&D productivity.

Source: Parexel's Pharmaceutical R&D Statistical Sourcebook 2005/2006; Defined Health Analysis. NME, new molecular entity.

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At the same time, the productivity of R&D investments has been declining. This is particularly true for the submission for regulatory approval of novel drug candidates—the US Food and Drug Administration (FDA) reported that the number of new drugs submitted to FDA declined from 88 in 1995 to just 49 in 2004. Although the number of clinical-stage products continues to grow as new biotech tools increase productivity (Fig. 2), the time required for clinical testing and the likelihood that a new drug will successfully progress through the stages of development and receive regulatory approval has not changed meaningfully over the years. For every 10,000 compounds initially identified, only one on average will ultimately be approved, and the extremely expensive clinical and preclinical studies required to demonstrate safety and efficacy take an average of about 15 years. Even among the most promising group of drug candidates that show sufficient potential to warrant human clinical trials, only one in five will ever be approved.

According to an analysis conducted by the Tufts University Center for the Study of Drug Development in 2006 (ref. 1), the average cost involved in the development of a single successful biotech drug is estimated at $1.2 billion, representing a stiff hurdle to traditional models of financing in the biotech sector. Today, these factors are creating both challenges and opportunities for the biotech industry and big pharma.

Problems with traditional fundraising vehicles

Accessing sufficient capital to fund development activities by biotech companies continues to be a central challenge. The US public markets for biotech equity securities have a long history of volatility, rendering biotech issuers prone to Wall Street's random walks. Whereas the ebullient equity markets of the late 1990s offered biotech companies access to large amounts of equity capital at exhorbitant, unsustainable valuations, today's public equity and venture capital markets are starkly different. Although the capital market for emerging biotech company initial public offerings (IPOs) has been moderately, although inconsistently, accommodating since 2003, with few exceptions, public investors have demonstrated an appetite for only those companies with drug candidates in later-stage clinical trials. Furthermore, it has proven extremely challenging for biotech companies to secure public equity capital on attractive terms—of the 19 biotech IPOs completed in 2006, 17 fell short of their targeted valuations by an average of more than 30%. Furthermore, at least 7 companies that filed registration statements to go public during 2006 had to withdraw or delay substantially their proposed offerings.

Similarly, the cost to biotech companies that are already public of raising additional equity has increased greatly in recent years. This trend is reflected in the dramatic increase during 2006 of private investments in public equity (PIPE) transactions, a high-cost form of equity financing where a company typically issues stock to investors at a price well below market prices (Fig. 3).

The biotech industry's need for clinical development expertise, in addition to its substantial capital requirements, is surprisingly underestimated. This need has continued to drive biotech interest in corporate partnering, principally with big pharma.

Corporate partnering and premature licensing

The pharmaceutical industry offers a combination of capital and clinical development capabilities, especially for large phase 3 trials. For big pharma, partnering with biotech constitutes a key means of meeting the unprecedented challenge of replenishing its anemic pipelines at a time when numerous blockbuster products are coming off patent and generic competition is on the rise. During 2006, branded drugs with total sales exceeding $18 billion have lost patent protection, and an additional $21 billion of branded drugs are expected to lose patent protection during 2007. It is no coincidence that big pharma's partnering appetite is voracious and undoubtedly will remain so.

In turn, in seeking to avoid excessively dilutive equity financing the biotech industry is looking to corporate partnerships as a funding source, licensing away its promising drug candidates to fill the voids in big pharma's pipeline. Traditionally, large pharmaceutical companies' in-licensing efforts have been focused on late-stage compounds where they were willing to pay up for what they considered less risky investments. However, together with the declining availability today of attractive unlicensed phase 3 candidates and increased bidding competition for compelling candidates, big pharma collaborators have begun to focus on compounds earlier in the pipeline, offering biotech companies more attractive terms for phase 1 and even preclinical candidates than has historically been the case. Driven by these trends, the aggregate annual volume of big pharma licensing transactions has increased dramatically over the past decade (Fig. 4).

Figure 4: Value of biotech out-licensing deals.

Figure 4 : Value of biotech out-licensing deals.

'Announced value' represents the overall biodollars announced publicly and the 'total value' represents the estimated overall value of all deals, including those for which there was no announced value. Source: Recombinant Capital.

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Many biotech companies in the current environment are entering into corporate collaborations with big pharma for their early-stage clinical programs in the expectation that they are capturing more value for their shareholders from the large firms. Although this might seem like a sound economic decision, a compelling argument can be made that even on the more attractive financial terms available today, biotech companies are in fact making short-sighted strategic decisions in prematurely giving up control over their most valuable pipeline opportunities.

Based on data from Recombinant Capital, an industry consulting firm focused on biotech licensing transactions, midpoint 'biodollar' values for individual phase 3 deals (approx$220 million) are more than triple those for phase 1 deals (approx$65 million)—phase 2 deals fall in the middle, with a typical biodollar value of approx$130 million (Fig. 5). Although the average biodollar figure for deals in all phases has increased dramatically in recent years, this wide disparity between early- and late-stage deals underscores the core value proposition of partnering later.

A further dissection of typical deal terms reveals that late-stage deals are far richer in several key ways beyond the headline biodollar amounts. Firstly, the upfront component of phase 2 and 3 deals average $18 million and $70 million, respectively, versus $7 million for preclinical and $10 million for phase 1 deals. Secondly, late-stage deals typically include much higher royalty rates on product sales, enabling biotech innovators to retain a far greater proportion of upside than would be possible through a preclinical or phase 1 licensing transaction. The difference between a 12–15% royalty typical of a phase 1 deal and the 18–26% typical of a phase 3 deal can translate into a dramatic loss of shareholder value and less available cash to build the company without additional dilutive equity financing.

Smaller upfront and total deal considerations are not the only pitfalls for biotechs that elect to license early- and mid-stage programs to big pharma; perhaps just as important is the near-total loss of control over key strategic assets. Unlike late-stage deals that frequently offer additional strategic benefits to biotechs, such as comarketing rights, early- and mid-stage alliances sacrifice shareholder value as the opportunity to commercialize a high-potential product is often sold, irreversibly, for a royalty stream representing a small fraction of future sales. The example of Amgen's (Thousand Oaks, CA, USA) 1985 outlicensing of Epogen (epoetin-alpha) rights to Johnson & Johnson (New Brunswick, NJ, USA) serves as a tangible illustration of the relinquishment of significant value by premature licensing. In this case, Amgen received $34 million from Johnson & Johnson to fund clinical development of Epogen in return for US marketing rights for all uses except treating kidney dialysis patients. As a result, Amgen has foregone tens of billions in sales whereas Johnson & Johnson has profited handsomely; in 2006 alone, the latter reported approx$3.2 billion for epoetin-alpha sales, which translates to approx$15 billion in foregone enterprise value for Amgen's shareholders, based on the company's current market valuation.

Alternative financing sources

The vagaries of the public equity markets, negative experiences with the loss of shareholder value and control posed by premature licensing transactions with big pharma and biotech's growing need for capital and strategic resources have driven the emergence of a range of alternative financing sources that address, to varying degrees, these shortcomings and needs2 (Table 1 and Fig. 6).

Royalty streams. One such alternative is the sale of royalty streams on future product sales of commercial or very late-stage clinical candidates to institutional investors to fund the advancement of promising earlier-stage drug candidates. Under this model, which has brought several billion dollars of capital into the biotech industry in recent years, a defined portion of future product sales is provided to investors in exchange for upfront capital.

Committed equity financing facilities. More recently, the biotech industry has turned to a second alternative source of financing: committed equity financing facilities or 'CEFFs'. Under the CEFF model, an investor agrees to purchase a defined amount of equity from a biotech issuer at prices slightly below market over a fixed period of time, but at the demand of the issuer. Because the biotech can issue the new shares at a time of its choosing within the deal window, the guessing game of organizing a single large public offering of stock or PIPE is largely eliminated—the biotech can predictably issue shares over time at prices it deems fair.

CRO-linked financing. In this third model, a CRO partners with a biotech company to provide both capital and value-added development resources. NovaQuest, the partnering arm of Quintiles Transnational (Research Triangle Park, NC, USA) has invested over $1.6 billion in 60 partnerships since its founding in 2000—approximately three-quarters of these deals have been with biotech partners. CROs typically receive royalties on future product sales, an ownership position in the biotech company it is partnering with or both in return for its capital contributions and development services and expertise provided. Similarly, Pharmaceutical Product Development (Wilmington, NC, USA) has been active in such arrangements.

Collaborative development financing. Collaborative development financing provides a source of capital that uniquely addresses the financing and development resources needs of biotech companies with products in early-stage clinical development. This financing model emerged in the early 1980s and has been instrumental in the development of several commercially successful biotech products to market (Box 1). Collaborative development financings allow biotech companies to broaden and accelerate their clinical development programs through the application of dedicated capital and clinical expertise, to preserve control of key strategic programs through key value inflection points and to off-load the risks of program failure, all in a manner that is minimally dilutive to its shareholders and neutral or accretive to its earnings. Under this model, a biotech company licenses a portfolio of drug candidates to a company funded by external investors with the exclusive purpose of advancing the development of those drugs. In return for the technology licenses, the biotech company receives the exclusive right to reacquire the drugs at a later date at prenegotiated prices (if, in its view, the drugs have shown sufficient safety and efficacy to warrant the buyout price), thereby allowing the innovator to retain the lion's share of future upside. Should the trials fail, the investors bear 100% of the risk of loss of their invested capital that funded the development effort. In addition, the collaboration enables the biotech company to access clinical development expertise.

One of us (M.K.) is managing director of Symphony Capital (New York, NY, USA), which since mid-2004 has completed six collaborative development financings (Box 2 and Table 2), the general structure of which is illustrated in Figure 7.

Figure 7: Example of a collaborative development financing structure.

Figure 7 : Example of a collaborative development financing structure.

(a) Development company (DC) is capitalized by investors. (b) Development company licenses programs from a biotech company for clinical development. (c) Biotech receives an option to purchase the development company at any time during a specified term (two to five years), and investors receive shares or warrants to purchase biotech stock. (d) Development company administers contracts with biotech and clinical services providers. Biotech is paid market rate for its services. (e) If trials are successful, biotech acquires development programs by exercising its option to purchase development company. Reproduced from Nature Reviews Drug Discovery.

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Development financing does not preclude a contemporaneous transaction with big pharma. With the completion of a development financing in parallel with a big pharma partnership, a biotech company could cofund a larger portion of the partnership's development activities, thereby significantly improving on the terms that might be offered absent such funding. Similarly, a preexisting collaboration with big pharma is not an impediment to a development financing (Exelixis financing in Box 3). In today's environment, such cofunding by biotech companies has proven an important tool in the enhancement of downstream financial and strategic terms of big pharma partnerships.

With the promulgation by the US Financial Accounting Standards Board of accounting rules (FIN 46R) relevant to collaborative development financing, the accounting treatment is straightforward and transparent. The entity that is investing in the drug development programs is consolidated into the collaborating biotech company's financial statements. Although the R&D expenses are recorded on the biotech's profits and loss, the losses are 'owned' by the company capitalized by the investors with the net effect generally being neutral or accretive to the bottom line, depending on whether the R&D dollars being spent are in addition to or in lieu of the expenditures that the biotech would have funded on its own.

Pros and cons

Although all the alternative financing models described above are useful sources of capital, we consider the strategic, financial and clinical benefits derived from today's model of collaborative development financing to be particularly compelling (Table 3).

Although royalty monetizations provide a nondilutive source of capital, substantial upside can be leaked to investors in cases where products feeding the royalty exceed expectations. Similarly, although CEFFs provide biotech companies with more control over the issuance of new shares at fair prices, CEFFs still require issuing equity at prices that may not fully reflect the potential of a company's pipeline, causing considerable dilution. In the case of CRO-linked financings, a nondilutive, two-pronged solution is provided that addresses biotech's dual need for capital and development expertise. However, like royalty monetizations, CRO-linked financings also have the potential to leak significant future value from biotech shareholders to the investing organization.

Collaborative development financing represents an attractive alternative for companies to retain an option on the future value of their products that can be exercised within a defined period of time and at a defined cost (Box 3). In addition, when coupled with access to premier clinical trial design and management expertise, it can further increase the likelihood of clinical success.

Taken together, these advantages differentiate collaborative development financing from dilutive equity issuances, costly premature deals with big pharma and other alternative sources of funding available to the biotech industry.

There are several key strategic benefits to this financing model. First, it provides the ability to accelerate early- and mid-stage clinical programs. Given the vicissitudes of the public equity markets, biotech companies manage the clinical programs to a large extent based on a budgeted cash burn rate that is not necessarily tied to the most advantageous development plan, that is, one that is conducted better and faster to maximize the value of the drugs, even if the plan requires more capital than the biotech company would have been able to finance on its own.

Second, unlike a deal with big pharma, there is a complete alignment of interests between the collaborating development company and the biotech company. The investors have no other competing drugs that are being developed and no long-term interest in retaining the drugs. The complete focus of the collaboration is to maximize the value of the development programs: as the difference between the value created by the collaboration and the price to be paid by the biotech company to buy back the drugs increases, the incentive for it to exercise its buy-out option also increases.

Third, the financing results in off-loading all or part of the risk of development failure. Should the trials fail for whatever reason, the investors lose their invested capital that funded the programs. In effect, this results in the biotech company funding its development programs after key data are known and key milestones are met.

And fourth, the biotech company has the opportunity to exercise the buy-out option. This enables it to preserve downstream control of key development programs and commercialization opportunities.

The financial benefits are also considerable. First, a dedicated pool of capital is provided that is designed to take the programs through predetermined phases of clinical development. There are no milestones or contingencies established for funding the programs. Second, as compared to other forms of capital, dilution of shareholders' equity is minimized. And third, unlike the typical corporate deal, future economics are preserved for the biotech company's shareholders (Fig. 8). Given the rich valuations afforded to late-stage programs by the public markets, the net effect is a notable increase in shareholder value driven by the retention of economic upside by existing shareholders, as well as risk mitigation.

Figure 8: Illustrative value creation through collaborative development financing.

Figure 8 : Illustrative value creation through collaborative development financing.

Increasing the value of a product in development gives a biotech company a greater incentive to exercise a buy-out option. (a) Candidate has low product value before demonstrating clinical proof of concept. (b) Clinical proof of concept drives major inflection point in product value. Reproduced from Nature Reviews Drug Discovery.

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The biotech industry's need for clinical development expertise is also addressed through collaborative development financing. If aligned with the right collaborative team, a biotech company can access incremental clinical and regulatory expertise that does not reside within the company. Also, if handled effectively, the biotech partner, which is paid for its services at a market rate, can use the reimbursement of its services to build out its internal resources (Fig. 7).

In addition to the core benefits offered to unprofitable biotech companies that are in the early stages of their corporate life cycle, collaborative development financing also presents more mature members of the biopharmaceutical industry with a compelling value proposition—the opportunity to significantly expand their R&D budgets in a manner neutral to profits and loss, one that off-loads development risk to outside investors. These benefits could enable more aggressive acquisition strategies, funding for broader sets of pipeline candidates and maximization of long-term shareholder value without sacrificing near-term, earnings-per-share discipline. Accessing the clinical development expertise may also be a benefit if such acquisitions result in ownership of programs not within the therapeutic competency of the acquiring biopharmaceutical company.


As the biotech industry continues to grow, the challenge of securing adequate funding for the expanding pipeline of clinical candidates will not dissipate. In addressing its funding needs, the industry has a growing array of financing opportunities. The issue for the biotech industry to address is whether it will continue to use suboptimal solutions like the issuance of highly dilutive equity and prematurely licensing key programs to big pharma, or will pursue alternative financing sources that mitigate the drawbacks of issuing undervalued stock or licensing away core assets before their value is appreciated. Despite its compelling strategic and financial benefits and a series of recently completed deals, collaborative development financing has yet to be widely embraced.

Various factors have accounted for the relatively slow adoption of collaborative financing since its reemergence in 2004. In some cases, biotech managers or boards of directors have favored a deal with big pharma for the perceived validation of the compound in question, as well as the potential access to development expertise. The latter point is more likely to be a factor when phase 3 trials are to be conducted, which is big pharma's pronounced advantage. As development financing investors are primarily focused on strategically important compounds, those that the biotech companies are most likely to want to reacquire, there can be concern on the part of the development team at the biotech company that they are relinquishing control over their compounds to investors. A great deal of trust is required to part with 'the crown jewels'.

Some firms also perceive, wrongly, that entering into a collaborative financing would preclude their entering into a deal with big pharma. They also regard collaborative financing as expensive because they inadequately assess the risk associated with the development of their own compounds and erroneously consider their own programs a lot less risky than industry-wide statistics and experience suggest is the case.

The structure of collaborative development financing is more complicated than an equity type of financing and it has taken time for institutional investors and sell-side security analysts to understand the model and gain comfort with the appropriate accounting treatment. Companies that do not recognize or need the additional clinical development expertise, in certain cases, have perceived other forms of capital to be less costly.

But the above view ignores the very substantial benefits of off-loading risk to outside investors. Indeed, analyst coverage of the collaborative development financings completed to date has generally concluded that this funding model brings many benefits to biotech companies, notwithstanding the perceived cost of capital if the compounds are successful and are repurchased—a 'high class problem' in the minds of some analysts.

At present, only Symphony Capital is engaged in this type of financing, limiting the number of deals that can be completed. From the investor's point of view, selection of compounds with the appropriate risk profile is not without its challenges. It requires assessing several factors, including the scientific, medical and commercial pathways for the compounds. For investors to have multiple 'shots on goal', the value inflection points (Fig. 8) of each compound included in a development financing must exceed, as a general matter, the buyout price. In addition, these compounds typically must be good 'traveling companions', with each reaching key value inflection points in a similar timeframe. Thus, to mitigate some of the risk, investors are seeking compounds that are in the clinic, thereby lessening the safety risk. If the compounds to be financed are preclinical, there is a greater risk that needs to be factored into the decision whether to make the investment. In a world where most biotech firms have never taken a compound successfully through approval, investors must have confidence that the biotech development and management team has the expertise to create the appropriate development plan and implement it. Investors also need to assess whether the biotech company will have the capital to buy back the portfolio should the compounds warrant further development. For these reasons, in the deals completed to date, the returns to investors (comprising the buyout price and the equity, generally in the form of warrants, received by the investors) have varied. Each investment presents its own set of risks, and calibrating these risks is more art than science.

Historically, development financings have played an important role in the growth and success of many of the biotech industry's brightest stars. The strategic, clinical and financial benefits are compelling. As these financings and their benefits are increasingly understood and focused on by biotech companies, their investors and analysts, it is likely that demand for these financings will increase as an antidote to both dilutive equity financings and premature or suboptimal deals with big pharma. To date, although other investor groups have focused on several of the alternative financing models outlined above, to date only Symphony Capital has provided both capital and development expertise in a structure that allows the biotech company to reacquire its compounds. For collaborative development financing to become ubiquitous, more groups with the requisite combination of expertise (e.g., CROs) and capital will need to enter the marketplace. As with most financing opportunities, if the demand on the part of biotech companies for these financings increases, new investors will step in to fill this demand. This was the case historically when a number of investment banking firms sought to do the precursors to the financings recently completed.

The collaborative development financings of the 1980s and 1990s accelerated the development of several of the industry's most successful drugs and were instrumental in helping to build those companies that availed themselves of this form of financing. As this next wave of collaborative development financings begins to generate its own crop of success stories, biotech firms, investors and the industry as a whole will increasingly look to this model as an important complement to more traditional sources of capital.



The authors would like to thank Sam Hall of Symphony Capital LLC, who assisted in the preparation of this article.

Competing interests statement:

The authors declare no competing financial interests.



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  1. Mark Kessel is at Symphony Capital, 875 Third Avenue, 18th floor, New York, New York 10022, USA. e-mail: mark@symphonycapital.com
  2. Frederick Frank is at Lehman Brothers, Inc., 745 Seventh Avenue, New York, New York 10019-6801, USA.