Don't be blinded by science: The venture capitalist Dr John Walker is worried about the euphoria surrounding biotechnology flotations

Click to follow
Iam concerned about some of the medical, and especially the biotechnology, companies now coming to the stock market.

My worry is that investors are being badly served, and that the failure of any of these companies will affect all young, innovative businesses in this sector seeking investment.

It is difficult enough for young technology businesses to find investment as it is, but a few highly publicised failures will make it even more so.

Yet as a venture capitalist, I want to see a continuation of the promising new source of later-stage finance for technology companies that was created by the Stock Exchange's decision to relax its entry rules. This should encourage early-stage investment in these companies.

The new entry rules, which have in effect created a new class of immature company, will encourage the development of new technology-based companies. Fifteen biotechnology companies are now listed and several more are expected to float in the next year or two. But there are problems.

We must have more effective monitoring of the claims made for some of these companies, or many investors will be disappointed.

The quality of information available on many of the companies coming to market is poor, especially when compared with biotechnology prospectuses in the US.

UK prospectuses, in many cases, fail adequately to draw potential investors' attention to the risks of investing in these companies; the information tends to be cursory, and the comments frequently come from academic scientists rather than from those better able to analyse the commercial potential and risk.

One could say that sophisticated institutional investors should take all this in their stride. I don't agree. Many investors in these biotechnology companies are individuals whose imaginations have been captured by a 'rainbow's end' dream of scientific breakthroughs and life-essential products making huge profits.

All of us investing in the sector have an element of this optimism, but the only thing that matters ultimately is the reality of the proposed investment opportunity.

The valuations for these businesses are only justified if the companies concerned can exploit successfully a unique product or know-how.

Two criteria should be applied in assessing the investment opportunity of the companies coming to market. First, the quality of the strategic alliances in place at the time of flotation. By this I mean the contracts signed between the young company and at least one big company in the sector.

Frequently, the big company will invest directly in the young company, providing finance as well as distribution channels in return for continued innovation.

Large companies need new products but cannot match smaller companies' speed of response to that need.

Second, there must be truly proprietary technology which, if successful, can create a sizeable market opportunity and ultimately provide the earnings stream.

This is the hope that underlies the valuations of these companies, since the technologies generally address markets with big problems, such as serious disease categories: Alzheimers, cancer or cardiovascular disease.

I group medical companies into four catagories, only one of which in my view is an obvious group for flotation - companies producing new chemical or biological entities.

Here you have proprietary products, publicly available information on tests and licences, the ability at least to estimate the market potential, and products which, if they have any significance, will already have attracted big companies to market and distribute. Companies such as British Biotechnology, Celltech, Xenova and Cantab would fall into this group.

The second group is the diagnostic companies producing a range of services and products from tests for disease to environmental pollution services.

Unless the technology involved is really proprietary and offers significant advantages over the competition, it is difficult to see long-term growth potential in the diagnostics sector because the barriers to entry are usually so low.

Diagnostic markets tend to be dominated by big international companies such as Abbott or Beckton Dickinson, which can exploit economies of scale in marketing and distribution, plus a large number of tiny companies focused on very small niches. This is not an easy market in which to make substantial profits.

Third, there are the service companies - companies that make products for other companies to use in their own processes. Again, I find it difficult to see real growth potential. How do you generate value when the real value lies with the customer company that owns the proprietary compound and you are totally dependent on such customers for growth?

Finally, there are the medical device companies. Here products demonstrating significant technical advance have shown considerable commercial success: artificial kidneys, blood dialysis machinery, keyhole surgery equipment, imaging technology, and many more.

But I believe that the long-term commercial potential for businesses in this area is limited both by the sheer technical specialism of each company, and by the relatively small demand for each single device.

The fact is that successful small companies in the device business are acquired by larger companies long before flotation, because the large companies can manufacture a wide range of devices and so achieve economy of scale.

So, amid the recent euphoria I would cast a warning about biotechnology companies: some look good, but investors need to be far better informed before rushing in to buy shares.

For the UK market, this is a new sector and none of us involved in that sector wishes to see it damaged by spectacular failures that could be avoided through more diligent analysis.

The author is senior partner of Trinity Capital Partners, a venture capital company that invests in technology-related companies in the biotechnology, healthcare, environmental and information technology areas. A chemist by training, he spent 16 years with ICI before joining the venture capitalists 3i. He set up Trinity in 1984.

(Photographs omitted)

Comments