Funding From an Unlikely Place

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The credit crunch and bear market have made it tough on drug developers. Gone is the easy money of secondary offerings and loans using the company's intellectual property as collateral. But the sources of cash aren't completely dried up; nonprofits still have some, and they're willing to fork it over to for-profit drug companies.

Earlier this month, the Global Alliance for TB Drug Development agreed to share development costs of Johnson & Johnson's (NYSE: JNJ) multidrug-resistant tuberculosis drug, TMC207. Early indications from a phase 2 trial suggest that the drug is working well, and it could become the first drug in 40 years to be developed for TB using a new method of action.

In exchange for its investment, the TB Alliance gets a royalty-free license to TMC207 to treat drug-susceptible TB. Johnson & Johnson retains the rights to sell the drug for TB that's resistant to other drugs, but will be required to set up an access program to ensure the compound reaches patients in developing countries that need it. Considering that Johnson & Johnson probably won't be able to make much money selling the drug in developing countries where the incidence of TB is the highest, the financial help in development is worth giving up the drug-susceptible indication.

Vertex Pharmaceuticals (Nasdaq: VRTX) took a slightly different approach with its partnerships with the Cystic Fibrosis Foundation. In exchange for $79 million, the company gave the nonprofit royalties on VX-770, should it make it to market. Vertex is almost certainly spending a lot more of its own money on the development of the drug, but I imagine the royalties are in the low single digits for that kind of cash.

Generally speaking, the funding comes for disease, where nonprofit money is needed to help make the drug research a financial success. There is, however, some money available for drugs that could become blockbusters, but that need a helping hand because they might be scientific long shots. For example, the Juvenile Diabetes Research Foundation has funded programs at Biogen Idec (Nasdaq: BIIB) and others that seek to reverse the effects of diabetes by regenerating insulin-producing cells.

Seal of approval?
If a nonprofit is willing to throw its hard-earned donations to fund a drug's development, it's easy to think that the potential for success is higher, but investors need to be careful not to read too much into these partnerships.

Sure, the nonprofits have likely had experts look at the data before committing money to the drug development, but that doesn't ensure that the drug will succeed. The partnership is an endorsement of the potential for the drug, not much different than GlaxoSmithKline (NYSE: GSK), sanofi-aventis (NYSE: SNY), or Bristol-Myers Squibb (NYSE: BMY) licensing a drug from Exelixis (Nasdaq: EXEL); the company or nonprofit is saying that the drug is worth some amount of money at this point in development, but sharing development risk doesn't make it more likely that the drug will get through the clinical-trial marathon.

Foolish takeaway
There are two investment takeaways from nonprofits funding drug development. The first is that big pharma may have lots of cash, but they don't have all of it. While the credit crunch over the past year has taken its toll on development-stage drugmakers, there's an alternative source of funds available. For fledgling companies that might be lucky enough to be developing a drug for a disease with an associated nonprofit to support it, those funds could help the company fight off a takeover by a bigger company at fire-sale prices.

The second related takeaway is that investors shouldn't take the funding too seriously. It's a nice input of funds that takes some of the development risk away from the for-profit company, but investors should treat these cash infusions the same way they would a drug development deal with another for-profit company.

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