A Biotech Start Up Forgoes VC money

Venture capitalists should pay attention to a development brewing in the medical world.

The Children’s Hospital of Philadelphia last week funded a new gene therapy business called Spark Therapeutics. The move was notable because it’s unusual for a research institution to launch a promising biotech company and to cut venture capital firms out of the process.

While the hospital’s $50 million investment is a one-off deal, it could herald a world where well-funded institutions find creative ways to grow without VC money. It comes as other research centers, like Stanford University, also have been getting into the for-profit game.

The Children’s Hospital is investing in gene research just as the overall biotech investment landscape is shifting. Venture funding in that sector peaked near $6 billion in 2007, bottomed out in 2009 and 2010, and then began a slow march upward, hitting about $5 billion in 2011, according to data from BIO, the Biotechnology Industry Organization. After sliding a bit, investment is on track to hover between $4 billion and $5 billion this year.

The Children’s Hospital isn’t just another institution allocating endowment money to a VC firm’s biotech vehicle. The hospital didn’t even co-invest alongside an investment fund, a practice that has become increasingly common as limited partners, particularly private equity LPs, seek bigger returns and more favorable fee structures. Rather, it bootstrapped a for-profit company, a move that Travis Blaschek-Miller, a spokesman with the life science association Bay Bio, says is highly unusual.

The story of Spark, in a nutshell, goes like this: About a decade ago, Katherine High, a doctor, clinician, scientist, and adviser to many gene therapy start-ups, convinced the Children’s Hospital of Philadelphia to help fill a research void. Her field had been promising. Throughout the 1990s, scientists had explored the idea of treating damaged genes, which often cause diseases, rather than treating the illnesses caused by flawed genes. The new approach was often referred to as “gene therapy.” But when a teenage boy died in 1999 due to complications related to an experimental treatment, VC money dried up and companies closed down.

The hospital supported a cellular and molecular therapeutic research unit with research funds. The work yielded a potential cure for a rare form of inherited blindness. To get the treatment through clinical trials and, hopefully, to obtain Food and Drug Administration approval, Ms. High’s team would need a serious capital injection. It seemed likely that they would travel a well-worn path—seek early stage funding, spin out from the hospital, and effectively give up the biggest piece of the equity and the potential upside.

But in a move announced last Tuesday, the hospital used money that would normally have gone toward research to form Spark around the work done by Ms. High’s team.

“Now the hospital and the researchers are in a position to retain the biggest slice of the enterprise value pie,” says Spark chief executive Jeffrey Marrazzo. He adds that academic organizations and research hospitals usually license their work to other companies and get low-single-digit royalty rates. The gene therapy for blindness is in Phase 3, the final phase of trials before FDA approval. It’s vying to be the first-ever FDA-approved gene treatment. The enterprise value could be big.

Not every research center will be able to follow Spark’s lead, since many hospitals and foundations don’t have the same money and flexibility as the Children’s Hospital. But Spark is a notable case study for well-capitalized institutions. Venture firms are patient money to a point, but they made their priorities clear in the late 1990s and early 2000s by leaving the gene therapy sector. For Spark, the hospital is a financial partner with a shared mission that will hopefully be around longer than early-stage investors. “The Children’s Hospital, which has existed for hundreds of years, is not going anywhere,” Mr. Marrazzo says.

Inasmuch as the Children’s Hospital seeks to reap financial benefits from homegrown talent, the Spark investment resembles Stanford University’s decision to invest in tech companies developed by the school’s students.

But there are two important differences. Stanford uses endowment funds, whereas the Children’s Hospital essentially owns a for-profit company. And Stanford, which says it has deployed millions of dollars over the past couple of months via the Stanford-StartX Fund, is always a follow-on investor in companies that have already raised financing rounds. The hospital, by contrast, has bypassed venture capitalists entirely for now.

It appears to be a good time for the Children’s Hospital to make this bet. The public markets are embracing biotechnology. The NASDAQ biotech index has nearly tripled since 2009. There have been 35 initial public offerings in the sector this year, including gene therapy company BlueBird Bio. BIO reports that those stocks have posted a median gain of 56%. Of the companies that held IPOs, five were working on drugs that were in pre-clinical or Phase 1 testing, showing investors’ willingness to take more risks. “VCs are getting a liquidity event even if their companies haven’t sold a product,” says Mr. Marrazzo. “The public markets have helped get venture capital money back into gene therapy and other biotech companies,” he says.

As investors look for opportunities in sectors like medicine, it’s good to see a hospital have the confidence and resources to bet big on its own product. If the Children’s Hospital’s investment pays off, it will be a lesson to other players in the field that they don’t have to cede all the upside to the financial professionals.