Although the first thing that may come to mind when someone says "biotechnology" is a speculative small-cap drug stocks, the industry today is where a lot of cutting edge drug development takes place. And given the enormous number of diseases needing treatment, there are plenty of opportunities for biotechnology companies (known as 'biotechs' for short) and investors to succeed..

Before you throw your hard-earned money into the diverse and confusing biotech industry let's dig deep and fully understand what makes it tick.

Source: Sergei Golyshev, Flickr.

What is the biotech industry?
Biotechs harness proprietary and existing technologies to develop drugs that will alter biologic pathways and help treat various types of diseases and disorders.

Historically biotechs dealt exclusively with biologics -- drugs extracted from, or created in, living organisms. By contrast, the pharmaceutical industry traditionally produced synthetically derived chemical compounds. However, those distinctions have blurred thanks in part to collaborations, mergers, and acquisitions. 

The goal of the industry is simple: to help people live longer and healthier lives. This means reducing the rate of infectious diseases, creating personalized treatments designed to treat chronic and rare diseases, and improving patient quality of life. It sounds straightforward, but there are a number of arduous steps to make this happen.

DNA double helix. Source: Mehmet Pinarci, Flickr.

How does the biotech industry work?
The first key component for any biotech to succeed is capital. Whether a biotech is just getting started or has a handful of products approved by the U.S. Food and Drug Administration or foreign regulatory agencies, it needs capital to fund the research of new drugs and the eventual preclinical and clinical studies that would hopefully follow a successful compound discovery.

Some smaller companies borrow in order to acquire appropriate research capital, while others turn to venture capital firms, investors, or collaborations for their seed money. More established biotechs can raise capital by going public through an initial public offering. Larger companies rely on positive cash flow from approved drugs to pay for their research costs, or they may turn to share offerings to raise capital.

Once ample capital has been secured, the next step is for the biotech to analyze its drug in a preclinical setting. This involves testing the investigational drug in animals and assessing how well the drug is absorbed, metabolized, and removed from their system. This is also the initial stage in which biotechs will begin to gauge a drug's toxicity.

If all goes well, the next step is filing an investigational new drug application, or IND, with the FDA in order for the company to study its experimental drug on human patients. The standard drug development process involves three phases:

  • Phase 1: Also known as the early stage studies, in phase 1 a biotech doses a small group of patients with its investigational drug and examines them for adverse side effects. While early evidence of drug effectiveness is occasionally observed in phase 1, early stage studies are primarily all about safety, tolerability, and finding appropriate dosing.
  • Phase 2: Known as midstage studies, phase 2 trials usually give investors their first glimpse of drug efficacy. They involve a greater number of patients, and usually there is at least some focus on efficacy, although the primary endpoint (i.e., the effective goal of the study) often remains safety and tolerability.
  • Phase 3: If a phase 2 study meets its primary end point and shows some likelihood of efficacy, the company moves to phase 3 trials, which are also known as late-stage studies. Phase 3 trials involve a much larger patient pool and will include a predetermined primary end point as outlined by the biotech and approved by the FDA. While safety always remains crucial, the predominant focus of this phase is drug efficacy.

Should an investigational drug succeed in all of these steps a biotech can file a new drug application with the FDA; it will then wait up to 10 months from acceptance of the application for a standard review decision. Approval allows a biotech to market its product, while a rejection, which is known as a complete response letter, will spell out the drug's shortcomings -- be it efficacy, safety, or even drug manufacturing aspects -- that led to the denial. However, biotechs that receive a CRL have the opportunity to address these concerns and eventually resubmit their drug at a later date. In other words, a rejection isn't necessarily a death knell for any investigational compound. It should be noted that CRLs are not publicly available documents, so investors rely on a biotech's management to accurately relay what caused the FDA rejection.

How do biotechs make money?
There are two primary ways that biotechs make money.

Source: PublicDomainPictures, Pixabay.

The first and most obvious is directly from sales. If the FDA approves a drug, the biotech then hires a sales force and attempts to sell the product.

The second way is through collaboration. If a biotechnology company feels it needs extra capital to assist with clinical studies, or simply wants a more experienced sales force to help market its drug (which can be particularly helpful when a drug has significant competition), it can license its drug to a larger biotechnology company or big pharmaceutical company.

Drug licensing can occur at any time -- during preclinical research, clinical trials, and even after regulatory approval. Often the company licensing the drug will make an up-front cash payment to the developing biotech -- cash that can be vital to sustaining ongoing research and development. The licensing agreement will likely also include development, regulatory, and sales milestone payments for the developing biotech, as well as royalties on a percentage of the drug's total sales. Every licensing deal is different, and there are no set ground rules, but it can sometimes work out as a big win-win for both parties.

Other factors to consider
A drug approval is no guarantee of a biotech's success. A company needs to successfully launch its drug in order to generate significant cash flow and impress investors. This means properly targeting the patient pool, actively marketing to physicians, and pricing the drug high enough that the company quickly recoups its development costs, but not so high that it discourages insurers, physicians, and patients from using the drug.

Competition can be another source of promise or frustration for biotech investors. Biotechs that focus on orphan diseases (those that affect 200,000 people or less in the U.S.), or that develop drugs that have no competitors, often have an easier time commercializing -- if patients want treatment, there's really only one option. Conversely, diseases and disorders with a lot of competition can make it difficult for one drug to stand out from the pack, which can hurt a drug's total sales potential.

Capital raises are a big concern within the biotechnology industry. Because a number of publicly traded companies may have wholly clinical pipelines or a small number of approved drugs on the market, it's not uncommon to see companies turn to share offerings to raise money. While this is an easy way for biotechnology companies to fund their research and development, it can have the negative effect of diluting the value of shares currently held by investors.

Finally, it pays to keep a close eye on venture capital investments into the sector. Since seed money drives start-ups, the flow of cash into or out of the industry can give investors valuable clues as to how larger biotechnology backers view the sector.