10/05/2010 10:00 am ET | Updated May 25, 2011

How to Invest in Life Sciences

No area of investing has greater potential risks -- or greater pay-offs -- than companies in the life sciences sector, especially if you consider their potential benefits to society. Who doesn't want to contribute to a cure for Parkinson's or Alzheimer's disease or even to the development of a "marker" to help in the diagnosis of a disease? It's often a hugely personal decision for investors whose interest may be peaked because a family member or friend has a particular disease. But investors have to be prepared to understand what makes life sciences companies different from other investments. And they need to know what questions to ask.

In a recent presentation for angel investors at a Golden Seeds forum, Anne Shehab, who holds a PhD in Chemical Engineering as well an MBA, and has filled strategic leadership posts at DuPont, Biogen, Arthur Little, and Valeritas suggests three distinguishing industry features: it's a highly regulated industry worldwide; the value chain has an imbalanced power structure, which gives more control to the payers (insurance companies, for example) than to the ultimate beneficiary, the patient. It's also an industry in transition in terms of delivery systems, technology, diseases in the spotlight and regulations, especially since the recent health reform act passed.

So what's an investor to do? First, understand that regulation and pathways differ substantially for drugs, devices and diagnostics. What Anne Shehab suggests is to review the impact of the company on each link in the value chain. Here are some considerations:

• Hospitals are continuously challenged to allocate their scarce resources between patient care and technology. They need a good reason to switch from existing practices: new technology must not only improve patient care, but also be cost-effective.
• Doctors are reimbursed based on set codes set by insurance companies or Medicare. So, as well as improving patient care, new technology or drugs have to help them make money by saving time, moving reimbursement to higher paying codes, increasing patient recruitment, or providing access to new group of patients.
• Payers are also increasingly demanding cost effectiveness data before new products are reimbursed. Start-ups must collect this data during clinical trials if possible. For devices, getting reimbursement codes takes a long time, though sometimes it's possible to make use of existing codes. This issue applies to international health care systems too. Start-ups should develop not just a US-based strategy, but also European and Asian strategies too.
• A good sales rep or distributor wants to maintain and grow the use of leading brands and technology and will try to ward off low-cost competitors. To do this, they often become partners with MD's and even assist in surgeries which use the devices they sell. Thus, a start- up is fighting a Goliath!

Good investors always focus on exit strategies. Assuming the company has a quality team, a strong competitive position, patent-protected technology and demonstrated development experience, investors must also look for potential pre-launch milestones that demonstrate the company's potential for an early exit. For example, for new drugs in pre-clinical development, investors should look for strong, tightly-linked animal data in models that can reliably predict human outcomes. Manufacturing processes should fit with existing commercial systems. For new medical devices, look for clinical studies demonstrating efficacy and proof of market acceptance with early revenue streams, and, ideally, profits! Diagnostic products require early revenues too, along with clinical studies demonstrating efficacy and cost-effectiveness, and compatibility with current lab systems.

Finally investors should never hesitate to ask hard questions of life science entrepreneurs:

• How will you demonstrate efficacy claims to FDA?
• What type of clinical data will convince end users (including practicing physicians) to adopt the product?.
• How do you plan to set pricing? Have you developed pricing scenarios based on different levels of product performance expectations?
• Can you launch your product under current reimbursement codes? What data will payers want to see before developing a new code?
• What's the launch strategy for outside the US?
• How will MD's incorporate your drug or product into their current treatment modes? How will this product expand their business?
• What is the distribution plan? What type of marketing partnerships might help accelerate your growth?
• What milestones will offer proof of viability? What's the likely timeline to exit?
• Who are the potential exit partners, and why is your business compelling to them?

One longtime diagnostics veteran, Marie Wesselhoft, who recently launched a company, MSDx Inc., which commercializes biomarkers for monitoring therapeutic effectiveness in patients with multiple sclerosis, is experiencing the challenges of a life science start-up. Her first step was to secure patents to protect her technology; the next hurdle is to address the regulatory process, both of which require hiring external expertise. But in the end, Wesselhoft observes,

"life science investors are not like other investors. You have to be o.k. with a long term exits because the process takes time. But when you see a company that is going to produce a product that makes a difference at an attractive profit, you don't look back. You know it's worth all the trials. For me, it's a mission and a passion with a hugely significant social goal -- the health of the society."

And investors have to share that same drive, passion and patience!