Diligence Deep Dives: Demystifying the Due Diligence Process in Biotech

A few key takeaways

This article attempts to summarise many of the checklists which have been published on how VCs conduct their due diligence. The article tries to contextualise many of these pieces for biotech founders.

• Why VCs conduct due diligence
• What VCs are looking at while evaluating the market, IP, clinical development plans, and valuations

Demystifying the Due Diligence Process in Biotech

Many different checklists and thought pieces have been published over the years to help founders prepare for this part of the fundraise; but these are typically catered towards tech start-ups and therefore do not reflect the nuance of building in biotech. We’ve therefore tried to summarise the myriad of work published in this area and additionally focus it on the biotech journey. What follows is a very high-level summary of what VCs are thinking about as they go evaluate your company. By understanding the questions VCs are thinking about, you can better tailor your pitch, data room, and conversations to the investors you are speaking with.

The Importance of Due Diligence.

The due diligence process is a key part of a VC’s decision-making process, as it helps mitigate investment risks via a comprehensive understanding of a company’s technology, market potential, and growth prospects. Given the scientific complexity, regulatory hurdles, capital needs, and risk profiles common in biotech, VCs cannot afford to cut corners on comprehensive diligence while making their investment decisions. Therefore, VCs will often bring in subject matter experts and KOLs to help them with their diligence, particularly to help evaluate and explain the science behind the technology. However, technical diligence of the science does not complete the picture, and understanding of the team, financing plan, pipeline, and regulatory roadmaps are equally as important.

Founder and Team

Particularly within the context of early-stage companies, team is crucial: successful founders require both technical expertise and visionary leadership, supported by experienced teams and advisors. Within their due diligence, VCs are evaluating whether the company has the right team at the helm; the technical expertise, industry experience, and leadership capabilities of the team is critical for determining their ability to navigate the challenges of the industry and drive the company's growth. VCs will also focus on clinical development expertise, commercial and manufacturing experience, as well as intangibles such as team dynamics under pressure, coachability, adaptability, and support from trusted references and the Board. Therefore, it is important to frame your team’s expertise to help VCs understand Why You? and Why Now?.

Science

This diligence focuses on evaluating the scientific validity, novelty, and feasibility of the company’s technology or product. In the case of early-stage companies, it involves assessing the underlying scientific research, experimental data, and any proof-of-concept, PK/PD, or toxicology studies to determine the strength of the scientific basis. If the company is at a later stage, the clinical trial design, including regulatory feedback, target patient population, and dosing will also be evaluated. We will go in depth into how one VC thinks about evaluating new scientific products or platforms in Part 2.

Manufacturing and Supply Chain

A company’s manufacturing plans and practices are crucial because they directly impact a biotech’s viability and potential for success. Diligence will focus on the company’s ability to scale production, ensure product quality and consistency, identify potential constraints and elements that can be externalised within the supply chain, and address manufacturing challenges and risks are extremely important pain points. Manufacturing a drug has significant cost implications and concerns which are absent in most non-biotech cases; it is therefore critical to describe the key steps and challenges in the production process and the cost mitigation strategies which are planned or already in place. From a narrative perspective, it can be particularly helpful to estimate and break down the COGS for a single dose, including major cost drivers and scalability factors, and provide data to back up your estimates. In doing so you can showcase your grasp of the product's financial feasibility and its potential to compete effectively in the market.

Intellectual Property

Conducting a comprehensive analysis of the intellectual property landscape, including patent landscape analysis, freedom to operate assessments, patent infringement risks, and opportunities for IP portfolio optimisation and expansion is a key portion of the due diligence process. This involves assessing the scope, strength, and enforceability of the IP assets to protect the company’s technology and market position. Investors may also want to see the university spin-out terms, where relevant, including licensing agreements.

Partnerships and Collaborations

This will include assessment of the company’s partnerships, collaborations, and strategic alliances with other industry players, academic institutions, research organisations, and potential collaborators to leverage expertise, resources, and opportunities for growth. Partnerships can provide crucial validation of your technology or approach, often bringing in additional resources, expertise, and funding to accelerate development and reduce risk. Collaborations can also offer access to complementary technologies, expand intellectual property rights, or enhance manufacturing capabilities. Furthermore, strong partnerships can pave the way for future licensing deals or acquisitions. VCs will assess the terms of these partnerships, including revenue sharing, milestone payments, and decision-making rights, to understand their impact on the company's potential returns and autonomy. They will also evaluate the strength and reputation of the partners, the strategic fit of the collaborations, and how well these relationships align with your company’s overall objectives.

Market and Competition

VCs will conduct thorough due diligence into the market size and competition of a biotech for several critical reasons. The process helps validate the commercial potential of the company, assess the likelihood of long-term success and informs valuation and generate returns profiles.

This analysis may include epidemiological assessment of the markets you are focusing on, as well as standard of care and treatment paradigms within those markets, and patient outcomes.

Competitive analysis reveals how crowded the space is, whether your approach offers genuine advantages, and if there are significant barriers to entry. This investigation also helps identify potential challenges in market adoption, pricing strategies, and regulatory pathways. Overall, by understanding the competitive landscape, a VC can evaluate your company’s differentiation and value proposition. When some competitors are at later development stages this may include assessment of their clinical trial design, publicly available data, including primary and secondary endpoints, adverse events, affected patient cohorts, dosing, and administration. Additionally, investors will utilise their network to stress test your claims of differentiation, anticipate challenges, and assess larger industry trends.

This due diligence is not done in a vacuum. Frame your narrative by outlining the broader market landscape, then clearly define your niche and how you are addressing these unmet needs. Use data-driven comparisons when discussing competitors, acknowledging their strengths while emphasising your unique value proposition and competitive advantages. Focus on differentiation, highlighting your team's expertise, proprietary technology, or IP position. Address potential future competition and frame market challenges as opportunities your company is uniquely positioned to tackle. By backing your claims with validated data and explainable assumptions, you not only create credibility, you also demonstrate deep understanding of the market and position yourself as a trusted partner.

Clinical, Regulatory, and Commercial Development

In many ways, biotechs’ have relatively straight forward routes to market. In comparison to a software company, where Go-To-Market strategy is a pain point (which can lead to significant value inflection, if you get it right), it is easy to see the journey your drug or diagnostic must go on to get to regulatory approval. However, it is universally true that risk is relative, and investors know that as clear cut as this journey may seem on paper, nothing is guaranteed. Therefore, it is important to showcase your plans for the clinical development of your pipeline.

From a diligence perspective, work will focus on evaluating the regulatory development strategy. This includes assessing plans for obtaining regulatory approvals, navigating complex pathways, and ensuring compliance with applicable regulations and standards specific to the product type (e.g., FDA regulations for drug development, CLIA regulations for diagnostics).

For early-stage companies, this diligence overlaps with diligence into the team as the VC will be evaluating the team's expertise in planning and conducting clinical trials, their track record in obtaining regulatory approvals, and their overall understanding of the drug development process. These factors are essential for assessing the company's readiness to advance its products through the development pipeline efficiently and effectively.

In the context of a clinical-stage company, the diligence process delves deeper into the specifics of the clinical development plan. This involves scrutinising the design and execution of ongoing or planned clinical trials, including:

1. Patient recruitment strategies and feasibility
2. Endpoint selection and their relevance to regulatory and commercial success
3. Plans for data collection, management, and analysis
4. Trial logistics and operational considerations
5. Strategies for engaging with regulatory bodies throughout the clinical process

Additionally, the diligence will examine how the clinical plan aligns with the overall regulatory strategy, commercial objectives, and potential market positioning of the product. This comprehensive evaluation helps investors gauge the likelihood of clinical and regulatory success, as well as the potential for market adoption post-approval.

Even though most spin outs will be quite early in the development of their pipeline, VCs will often analyse the start-up's plans for market access and reimbursement, including understanding payer dynamics, reimbursement pathways, and strategies for securing favourable reimbursement coverage for its products. This is particularly true in the current competitive market; we are now seeing that FDA approval isn’t enough to drive market adoption. In addition, when many pharma companies are preferring to focus on Phase 3 M&A over early collaborations and development partnerships, so it is understood that a young biotech will need to plan for longer runways and more rounds of private funding.

Financing, Corporate Structure, and Valuation

As part of the due diligence process, investors will conduct comprehensive examination of your finances, including scrutinising the company’s financial history, past funding rounds, burn rate, and cash runway. This will also include upcoming milestones, identifying value inflection points, key de-risking readouts, timelines, as well as the resources and mitigation strategies required to get there. This also involves review the start-up's cap table, allocation availability, and alignment with other investors, including identifying entities or individuals with significant equity stakes (over 5%) as well as any pending equity grants. Particularly in the context of university spin-outs, this can be a key area a VC needs to diligence. This is done to set investment expectations, including trying to determine expected ownership percentage, share price, and board seat requirements. By assessing the equity distribution, investors can also evaluate team dynamics, roles, and contribution.

Additionally, investors may diligence the corporate structure of the company. Does the VC have specific geographic remit? If the company currently falls out of scope there may be some flexibility here, in which case open and honest discussions with the investors can be very productive. Are there any beneficial tax structures in place which your company can take advantage of? What is the litigation strategy? Even at the pre-seed stage, litigation can arise, often from former employees or founders. Assessing these risks early is crucial for informed decision-making. Additionally, while governance issues are minimal, particularly at pre-seed, knowing if non-founders are on the board and their reasons for being there is important for understanding company oversight.

Assessing the valuation of an asset or the company is by far the most nuanced element of the diligence process. Investors will consider many things, including:

• What percentage ownership does the investor want/need in order to drive the necessary returns for the fund? At what share price?
• Does the valuation seem fair for where the company is going? Is it a bit frothy for where the company currently is?
• When are the next value inflection points? Is the team well equipped to hit these milestones?
• What does the cap table already look like? Are there portions of this round already allocated?
• What do we as investors bring to the table? What does the rest of the syndicate bring? Can we be complementary?

Many people will say that setting the valuation is as much an art as a science, and this definitely rings true, even in the biotech world.

Concluding Thoughts

While the investment decision process may be a long one, thorough due diligence is essential for VCs to make informed decisions and mitigate risks. By meticulously examining all aspects of a company, from its science and market potential to its financials and partnerships, VCs can better assess the probability of success and potential returns, ultimately aiming to identify those rare opportunities that could yield significant breakthroughs in medicine and substantial financial rewards. Hopefully this primer has helped demystify the due diligence process and provide a framework through which to read the subsequent articles.

Sources

While many pieces have been written about the due diligence process, this article pulls significantly from these authors:

Due Diligence Strategy for Biotech VCs (Longe VC)

What is a biotech diligence? (Shubham Chatterjee)

Due Diligence Checklist for Pre-Seed Companies (Charles Hudson)

Diligence Deep Dives

• Part 1: Demystifying the Due Diligence Process in Biotech
• Part 2: Vetting New Biotech Products
• Part 3: How To Avoid Pitfalls During Investor Diligence
• Part 4: Essential Questions to Vet Your Investors