Incentives For Drug R&D: A Survey Of Biotech Venture Capitalists’ Perspectives

Editor’s Note

This article is part of a Health Affairs Forefront short series, “Prescription Drugs: Promoting Affordability And Innovation.” The posts in the series are written by participants in a recent invitation-only conference on drug pricing and innovation incentives hosted by Rena Conti and sponsored by Arnold Ventures and Questrom School of Business, Boston University. The conference focused on a research and policy agenda to support both drug affordability and innovation and included discussion of several topics regarding drug development, access, and efficacy. The series is produced with the support of funds from the conference budget; articles are independently reviewed and edited by Health Affairs Forefront.


Following on the Lower Drug Costs Now Act (H.R.3) and the Reduced Costs and Continued Cures Act (H.R.5260), Senate Democrats have now agreed on new language seeking to rein in the prices of prescription drugs to improve access and affordability; if approved by the Senate parliamentarian, the new language would be part of a scaled-down reconciliation package dealing with health care, climate change, and other issues.

All these proposals would provide for the Secretary of Health and Human Services (HHS) to negotiate prices for select drugs on behalf of patients. The new language and H.R.3 would allow HHS to penalize companies for price increases in excess of the rate of inflation; H.R. 3 was projected by the Congressional Budget Office to save taxpayers approximately $500 billion and result in two fewer drugs over the next 10 years. An added focus of H.R.5260 was improving competition by ending pay-for-delay agreements and product-hopping practices.

Many proposals considered by policymakers attempt to pair broad restraint of drug prices with targeted non-price incentives to improve innovation incentives. For example, H.R.3 proposed a $7 billion increase in National Institutes of Health (NIH) funding targeted at cancer, antimicrobial resistance (AMR), and rare diseases as opportunities for increased innovation. Other government support for basic research and development (R&D) efforts have been proposed, including enhanced priority review and market exclusivities; R&D tax credits; schemes to “delink” product revenue from sales volume, including market entry rewards (under which the government rewards companies for bringing products to market with payments generally based on public health value rather than volume and often tied to conditions such as affordable pricing and—particularly for antimicrobials—good stewardship programs); and additional financial support for early-stage companies.

Nevertheless, critics of current reform efforts worry that lower drug prices through the mechanisms proposed in these policies, particularly combined with additional potential corporate tax increases, could discourage companies from investing in new drugs.

Largely missing from these discussions are the perspectives of venture capitalists (VCs), the most prominent funders of new drug development by early-stage biotech companies. It is the early stage biotech companies that contribute to innovation by generating novel targets and techniques for treating diseases.

VC Interviews

In Fall 2019, we interviewed five leading VCs (see exhibit 1) about how financial incentives impact their investment decisions in early-stage biotech companies, and ultimately innovation. The VCs were a convenience sample drawn from ‘top’ VCs that raised capital in 2019 to invest in biotechnology, according to industry reports. The interviews took place after the February 2018 Council of Economic Advisors white paper on reforming prescription drug prices was released and the original text of H.R. 3 was introduced in the U.S. Congress (September 2019), but before H.R 3 passed the House in December 2019.

Exhibit 1: Overview of VC interview participants (as of time of interviews).

Source: Authors

In this article, we summarize major findings from these interviews and discuss how current reform efforts address the VCs’ priorities and concerns.

Finding #1: Biotech VCs view their investments as central to bringing new drugs to market and are aware of the significant benefits and risks associated with their investments.

The VCs we spoke to repeatedly articulated the idea that “venture financing is making innovation happen” in drug development, particularly in comparison to commercial-stage drug companies. They took great pride in doing work they viewed as benefiting society. They also stressed that early-stage biotech investing is fundamentally a high-risk business, like “wildcatting” or “playing roulette.” They consistently made the case that for the system to work, these risks need to be offset by high rewards.

Finding #2: Biotech VCs largely invest with the aim of being acquired by a large pharma company.

“Success” was repeatedly defined by the VCs we interviewed as a venture-backed biotech being acquired by a large pharma or biotech firm. This is consistent with industry reports. As one VC articulated: “My big fear is the downside scenario that I don’t get bought.” When biotechs exit via mergers and acquisitions (M&A) to pharma firms, investors are rewarded far earlier.

But VCs told us that M&A isn’t just good for investors—it’s also often the best way to get drugs to the market. After an acquisition, a small company’s pipeline agents benefit from the larger company’s resources and infrastructure for late-stage development, pharmacovigilance, post-approval commitment trials, and marketing. The VCs we interviewed stressed that many of these capabilities are impractical for most venture-backed firms to build on their own.

Finding #3: Many biotech VCs evaluate potential investments through the lens of expected returns to potential acquirers.

All of the VCs we interviewed referred to net present value (NPV) calculations they construct to aid in their investment decision making. VCs told us that they make investments using a portfolio approach, and that their decisions to pursue one investment over another are motivated by maximizing returns given the costs of investment. A big driver of those returns is the expected revenue that specific investments will provide to the VCs; in turn, the expected value of their product will generate returns for the acquiring company.

From the acquirer’s perspective, the value of the product has two components: the price that may be charged for the product at launch and the number of addressable patients. Several VCs explained that maximizing revenue could be derived from different combinations of price and quantity, yielding the same results: low price times large volume, or high price times small volume. They also suggested that some products have more value than others because of the nature of transformative science that may provide large clinical benefits in underserved areas and have many different uses. Under current policies, products exhibiting these characteristics are acquired at greater valuations by larger pharma companies. In turn, the acquirers can price these products at a premium.

Finding #4: Unmet medical needs and associated premium pricing drive many biotech VCs’ investment decisions, with antibiotics as a major outlier.   

VCs expressed pride in helping bring to market drugs that address unmet needs and suggested that this is their primary concern when making investment decisions. As one VC commented: “We figure that if we can transform the life of a patient, we’ll figure out the right price.” However, VCs articulated that the possibility of premium valuations of their investments, in part related to the premium pricing the acquirers can charge, drives them to invest in areas that they may not have otherwise invested in, such as gene therapy programs and early-stage oncology drugs.

On the other end of the investment spectrum, antibiotics were consistently seen by the VCs as a true ‘market failure,’ where low revenue potential has dampened big pharma’s interest,  and therefore VCs’ interest, in the space. Several VCs noted that, from a public health perspective, there is enormous pressure to severely limit the usage of new antibiotics. “Antibiotic stewardship means you’re putting something out with the goal of it not being used, so you don’t get resistance over time,” one VC explained.

The VCs we interviewed also stressed that investment in antibiotics is dampened by pessimism that novel R&D can yield antibiotics with transformational benefits. As a result of both factors, VCs see few M&A opportunities for early-stage innovators in the antibiotics space and are generally (though not entirely, as elaborated on below) prioritizing other investments.

Finding #5: Biotech VCs were open to drug price reforms that would preserve “value-based pricing” for clinically transformative therapies.

VCs were open to the general idea of constraining drug prices, provided that there was still room for pricing commensurate with value. As long as clinically transformative medicines can command value-driven prices, they said, they will likely remain attractive to large pharma acquirers, and in turn to VC investors.

Several VCs articulated that even if significant value-based pricing is maintained, substantive reforms that reduce large pharma revenues might negatively impact early-stage biotech investment by reducing pharma firms’ available resources for M&A. One investor predicted that drug pricing reforms that substantially reduce pharma’s income might indirectly force VCs to focus on a smaller subset of clinically transformative investment opportunities, possibly deprioritizing treatments that would only benefit handfuls of patients worldwide: “I don’t think we would continue to do investments in ultra-orphan indications, because the math wouldn’t work.”

Finding #6: For non-price innovation incentives to meaningfully encourage R&D, they need to increase the likelihood of M&A exits.

A major finding of these interviews is that VCs view incentives that would make biotechs significantly more attractive for future pharma M&A as having the most impact on early-stage VC investment and hence innovation. One VC strongly argued in favor of a focused extension of market exclusivity because longer protection from generic competition is a major driver of pharma companies’ NPV calculations on potential acquisitions. Several other VCs cited the extended market exclusivities offered to orphan drugs, as well as the relatively protected status of most biologic agents from competition after loss of exclusivity, as powerful incentives for them to invest in those areas.

In contrast, market entry rewards were seen as unlikely to have a major effect on VC investment because they would likely not benefit small biotechs directly. To affect early-stage investments, market entry prizes would need to be large enough to substantially reduce the cost of manufacturing and commercialization and sizably impact the investment’s likely exit valuation.

Although programs that hasten approval timelines, such as priority review vouchers (PRVs), might seem like valuable incentives for biotech investment because of their impact on NPV, VCs reported that these instruments have no impact on their investment decisions. Similarly, the biotech VCs we surveyed said that R&D tax credits do not affect the value of expected M&A-financed exits and consequently have virtually no effect on their investment decisions. Direct subsidization of the costs of product development through government-funded clinical trials and additional financing were not seen by the VCs we interviewed as having a large impact on their investment decisions because they do not affect the value of expected M&A-financed exits—although they may be valuable to emerging biotech and large pharma companies engaged in later stages of drug development, including more expensive clinical trials.

Finding #7: Antibiotics represent a unique case of market failure where additional price and non-price incentives are needed.

Several VCs we interviewed have continued to invest in early-stage antibiotic companies despite market failures. They stressed their investments are essentially a bet that policy fixes will be enacted to improve the NPV of antibiotics and rekindle development in this product market.

One major suggestion to invigorate the innovative antibiotic market was to enable value-based pricing by removing antibiotics from inpatient ‘bundled’ reimbursement based on a diagnosis-related group (DRG). Another VC suggested that enhanced market exclusivity protections like those available to orphan drugs would catalyze pharma activity in the sector.

VCs also supported market entry awards and delinked ‘revenue guarantees’ for antibiotics through subscription models and other mechanisms. One VC pointed to the National Institute for Health Care and Excellence’s (NICE) subscription approach as a model for the U.S. The VCs stressed that to sustainably support early-stage investment in antibiotics, a revenue-based incentive would need to appropriately reward clinical value and also yield a meaningful NPV for potential investors and acquirers.

VCs also raised several other reform proposals to encourage investment in antibiotics, several of which have been described in the literature. A VC who remains highly active in antibacterial development called for additional funding for potentially transformative pre-clinical research. According to this VC, because of the long-standing lack of pharma investment, “good researchers and money have left the space, and this treasure trove of preclinical work is going to just die on the vine, with nobody to take it forward.”

Currently Discussed Reforms And VC Priorities Align In Important Ways

VCs asserted that high rewards are needed to offset risk and improve the chances for M&As. However, they were receptive to policy reforms aimed at reining in drug prices provided “value-based pricing” was retained for clearly clinically transformative therapies, and additional incentives were created in areas of high unmet need with poor incentives to innovate.

Both H.R.3 and H.R.5260 followed through on these promises in slightly different ways. Both proposals limited the number of drugs to be subject to negotiation in a given year—though notably the new Senate Democratic language limits the annual increase in the number of drugs per year but not the ultimate number—and expressly aimed to preserve value-based pricing for products that provide significant clinical benefits.  Policymakers may wish to go further and consider exceptions from negotiation for drugs that target orphan diseases or drugs deemed ‘breakthrough’ by the US Food and Drug Administration.

Proposals to invest an additional $7 billion over 10 years in NIH Innovation projects targeting AMR, rare diseases, and other “high need cures”—supporting both research and development activities of emerging biotech companies—may also present a unique opportunity to sustain investments from early-stage companies and the VCs we interviewed. Policymakers may wish to consider other ways to support innovation by early-stage biotech companies through targeted incentives for selected ‘valuable’ disease areas, including AMR.

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