(Editor’s note: At VentureBeat, we’ve been pretty caught up with Web 2.0 lately — where there is acquisition fever. But take a look at biotech. Nicola Campbell has been one of the more active venture capitalists in the biotech industry over the past year, leading investments in Alvine, Marinus and Nextwave. Note her conclusion. Sound familiar?)

In the recent past, biotech was hot, IPOs were robust, and companies in their earliest trials were the hope of the future. Now there are fewer IPOs, they are more difficult to complete (i.e. the “window” is not often open) and Wall Street collusion limits the valuation of most initial public offerings.

I say collusion because biotech companies need capital from the public market to stay in business. Wall Street investors know this, and they can tighten the screws on valuation. We’re seeing $175 valuations, compared to the old days when true bidding pushed valuations to the $300M to $500 range.

If IPOs are more difficult, where do we go from here? As venture capitalists, we do the only thing we can: We adjust our investment thesis.

One way to start is by looking at the state of the multi-billion dollar drug giants • Merck, GSK, Pfizer, and BMS. They’re not doing much better. In fact, they are in the perfect storm, for two reasons: 1) The top six pharmaceutical companies have major patents expiring over the next 5 years • GSK alone is expected to see its profit drop by 25 percent in 2007 due to patent expirations. 2) There is an immense “innovation gap” where pharmaceutical companies are spending more money year-over-year to develop drugs but new Food and Drug Administration pharmaceutical approvals are declining.

However, a third trend has created a new dynamic The United States Repatriation Act is an opportunity for health care companies to bring billions of dollars back into the USA at a record-low tax rate of approximately eight percent. By going abroad, drug giants had lowered costs, and this resulted in profits. Now, they can bring those profits back to the U.S., but they need to do something with it

Where can they spend it? One way is acquire young, innovative companies. This is where the biotech start-ups help out. Most biotech companies are working to provide innovative ways to solve, or at least ameliorate, certain diseases in an efficient and safe way. To make their portfolios more attractive to the pharma giants, many VCs are building biotech start-ups in a low-infrastructure, high-value manner so that upon phase II of a drug trial (there are three phases) or early phase III , an attractive acquisition by a large pharmaceutical company is attainable.

An example is Cellective Therapeutics, a biotech start-up company created to develop new antibody for the treatment of cancer and autoimmune disease. This was a company where the plan was for it to raise enough Series A capital to allow the lead product(s) to achieve phase II data within 24 months, thereby making it a sought-after partnering or acquisition opportunity for a large company. After only one year, a major strategic investor in this company, MedImmune, decided that an acquisition was the appropriate choice • and they moved preemptively to stave off other buyers. This investment thesis and resulting strategic acquisition provided the investors with a significant return on capital for their Limited Partners.

Of all the big companies, Pfizer is on the busiest buying spree. Analysts predict it will lose about 17 percent of its earning per share this year, because of the perfect storm. So it’s leading the “acquisition pack,” paying top dollar. Pfizer acquired worldwide rights to Exubera earlier this year for the $1.3B from Sanofi-Aventis.

The lesson is simple. As venture capitalists, we need to be very observant. We need to be aware of the market environment, and have the foresight, and the courage to follow the data. Right now, the market is telling us: “Build to flip!”

VentureBeat's mission is to be a digital town square for technical decision-makers to gain knowledge about transformative enterprise technology and transact. Discover our Briefings.