Investing Before the IPO

Let's face it, IPOs are exciting. Whether you buy in and cheer them on, or sit on the sidelines and hope for an entertaining stock-price roller-coaster ride, getting in on the ground floor provides a certain thrill.

But it's not really the ground floor, of course. Companies that make initial public offerings existed well before their IPOs. Occasionally they're started with just the founders' money, but more often than not, venture capital funds are involved in getting the next Google or Genentech (NYSE: DNA  ) off the ground. Investing in one of the many funds out there is possible, but I hear the venture capital funds usually want a large sum invested -- not something that this Fool has lying around.

If the idea of investing pre-IPO excites you, but you don't want to invest directly in a venture capital fund, it turns out there's a way to get in on a piece of the new company action by buying publicly traded companies: Many drug companies have venture capital arms.

Old school
This isn't really a new phenomenon; Johnson & Johnson (NYSE: JNJ  ) has had a venture capital arm since 1973. In the world of "what goes around, comes around," Amgen (Nasdaq: AMGN  ) was started with venture capital funding and now has its own fund to invest in start-up companies.

In perusing the pharmaceutical companies' websites, it's interesting to note that the venture capital arms appear to be purely in the business of making money, and often make investments without worrying whether their parent company will get an eventual licensing agreement. On the other hand, I'm sure that having a connection to the up-and-coming company doesn't hurt when it's looking for a marketing partner down the line.

While buying stock in these drugmakers does allow you to get a piece of the action, in reality it's a very small piece of most of the pharmaceutical companies' businesses. In scouring Merck's (NYSE: MRK  ) most recent 10-K, I couldn't find any references to how much money its capital venture subsidiary makes. Presumably, any income it makes is rolled into the "other" category on the income statement.

New age
While the venture capital business can certainly make money, a couple of drug companies have started programs --called incubators -- to take a more hands-on approach to developing new companies. Most likely, they are more interested in the prospects of filling their pipeline down the line than they are in getting equity in the pre-IPO company.

Just like the incubators that are used to grow cells in a laboratory, these incubators house up-and-coming businesses in their infancy. The pharmaceutical companies nurture with money, equipment, and experts.

In many ways, I like this system much better. It gives the start-up a fighting chance in the complex world of drug development, and potentially benefits the big guy as well.

Pfizer (NYSE: PFE  ) seems to like its program. It's expanding it from one site to three. In exchange for the rights to acquire drugs or technologies at fair market value down the line, Pfizer invests about $2 million a year in each company. That's pocket change compared to recent deals for more advanced drugs.

Pfizer isn't alone in this incubator model. Biogen Idec (Nasdaq: BIIB  ) also has an incubator, dubbed bi3, with the same sort of in-house focus on helping start-ups with pre-clinical drugs develop them quickly.

Desperate times call for sane measures
I don't think these investments are a sign of desperation by the drug companies, but they certainly point to the patent cliff that many drugmakers face. Drugmakers need to restock their pipelines, and if they're unable to do it in-house, acquisitions and licensing are the only option. Personally, I'd rather see pharmaceutical companies spending a little money on unproven pre-clinical drug candidates than a lot of money on phase 2 (but still unproven) drugs.

More Foolishness on not-so-public investments:


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