Introduction
An avid follower of emerging trends in the venture markets is likely to have heard of psychedelics. After all, psychedelics companies like Atai Life Sciences AG are now worth $2 billion without even earning any revenue. In fact, most companies in the psychedelics space make no money, yet are worth hundreds of millions, sometimes more.
However—what really are psychedelics? In short, they are currently illegal drugs that seem to be on the verge of decriminalization in the United States. During the height of the Cold War, the Central Intelligence Agency (CIA) launched the secretive MKUltra project, where it experimented on subjects with psychoactive hallucinogens such as lysergic acid diethylamide—better known as LSD or acid. This project, which gained notoriety as the “mind control experiments” of the CIA, partnered with several well-known institutes of higher education, and oftentimes conducted illegal experiments to determine if there was a way to control the minds of captured Soviet spies. From a chemical perspective, the substance in the psychedelics would bind with serotonin receptors in the brain, triggering abnormal states of consciousness—hallucinations, or “trips”. This was a very useful property for CIA agents, but also for the hippies of the 1960s, who experimented heavily with the use of psychedelics during the counterculture movement of the 1960s, such as at the famous Woodstock festival in 1969. Now, states like Oregon have already decriminalized psychedelics, signaling the increased likelihood of legalization. In fact, a new psychedelics ETF, composed of companies like MedMind, has also been launched. This shows that psychedelics have already entered the financial mainstream. To many, this is simply a continuation of the trend of drug legalization that started a few years ago with the push to legalize cannabis.
This trend of normalization within the psychedelics sphere is not surprising at all. Research shows that psychedelics such as psilocybin, ketamine, and ibogaine have immense applications in the pharmaceuticals sector, offering potential solutions for problems ranging from addiction to mental health issues. While psychedelics are still in their nascent phase, they are very likely to become a major driving force within the pharmaceuticals industry due to their wide range of applications. Psychedelics also have potential to revolutionize how we tackle neurological disorders such as addiction, pain, and depression. This will consequently result in great growth in the psychedelics industry over the next few years, as well as consolidation in the currently fragmented sector.
However, while there is potential for huge opportunities within this industry, it would likely be difficult for most investors to effectively capitalize on them due to the difficulties associated with conducting due diligence into psychedelics in the absence of strong scientific and legal knowledge.
Demand and Market Size
While many of the pharmaceutical applications of different psychedelic substances seem very niche, there is a very large market for their applications. The psychedelics market as a whole is expected to grow at a cumulative annual growth rate of 15.8% from 2020 to 2027, reaching a market size of $7 billion.
Some of the major uses of psychedelic substances are to treat addiction and psychiatric issues. Ibogaine is one such psychedelic compound which significantly decreases addiction problems associated with opioid use. By putting users in a “dreamlike state”, Ibogaine likely increases neuroplasticity in the brain, leading to the formation of new neural pathways. In effect, studies have shown that ibogaine is highly effective in reducing opioid dependency in subjects. One study found that administering ibogaine significantly decreased negative moods, craving intensity, craving frequency, and craving duration; it also retained a lasting effect. Other studies suggested that ibogaine could also be used to treat alcohol and nicotine dependence. This represents a massive untapped market for psychedelics companies that conduct research into anti-addiction medication.
There are an estimated 10.1 million Americans who abused an opioid in 2019, and over 15 million with diagnosed Alcohol Use Disorder. Out of the people suffering from Alcohol Use Disorder, only 7% received treatment and a mere 4% received approved medication. As such, not only is there a huge market for drugs like ibogaine to treat opioid addicts, but it also bridges the gap between the large number of alcoholics in the US and the available treatment options.
In addition, substances like ketamine have applications in combating psychiatric illnesses, such as depression and PTSD. Much like ibogaine, ketamine is also theorized to target the brain’s neuroplasticity. Furthermore, observational studies demonstrate reduced suicidal tendencies in depressive patients.
As the spotlight shines on issues surrounding mental health, there is a huge potential for psychedelics to help these individuals, with an estimated 7.7 million Americans suffering from PTSD and 15.1 million suffering from major depressive disorder. In particular, there is a significant opportunity in the depression treatment market, because there are increasing concerns that the most commonly used antidepressants, such as selective serotonin reuptake inhibitors (SSRIs), may not be as effective as other medications.
Another key demand segment for psychedelics is pain relief. There are two main types of pain: nociceptive pain and neuropathic pain. Nociceptive pain usually occurs in reaction to bodily harm, such as bruises, burns, and fractures. Neuropathic pain is completely different, and it includes issues like nerve pain, which there are not very effective remedies against. As such, the problem of neurological pain represents a largely untapped blue ocean market, ripe for the novel application of psychedelics. An example of a related area is migraines, for which there are several reported psychedelic cures. The market for migraine cures is predicted to reach $3.5 billion by 2026 due to an expected cumulative annual growth rate of 13.3%.
Company Adaptation
Where there is opportunity, there will inevitably be a large number of companies looking to make the most out of it. Although not yet legalized, there are numerous companies already involved in psychedelics, such as MindMed, Compass Pathways, Mind Cure, and Cybin.
However, since none of the companies are generating revenue, they must bleed cash to fund their research and development (R&D) costs, and they regularly raise shares to meet funding needs. For example, in February, Cybin issued $34.2M in shares, with corporate management saying that they intend to use these funds to accelerate two drug development candidates, development of new tech platforms, and expansion for a major research program. It is worth noting that these companies do not issue debt because they do not have the income to service the interest payments. Some of the biggest spenders on R&D are Compass Pathways and MindMed, spending $19 million and $13.5 million, respectively.
In addition, another major expenditure of psychedelics companies tends to be on acquiring intellectual property (IP) from other companies. Cybin spent over $18 million to acquire several patents relating to pharmaceutical applications of psychedelics from Adelia, greatly increasing the total IP that the company owns. Similarly, MindMed purchased the 18-mexthoxycoronaridine (18-MC) program from Savant Addiction Medicine in the summer of 2019 for $5.5 million worth of shares. This gives MindMed the rights to one of the most innovative opioid addiction treatment programs in the world, with the 18-MC molecule being a synthetic substance based on ibogaine. In general, since psychedelics are still in a very nascent phase, these companies want to ensure they have access to patents for revolutionary substances. This will likely lead to significant acquisitive action in the markets as larger companies seek to expand their IP portfolios. The nascent nature of this sector means that there is enough space for giants and small players alike.
For example, “Big Pharma” companies like Johnson and Johnson have rolled out products such as a ketamine nasal spray meant to reduce suicidal tendencies in depressive patients. As established pharmaceutical giants add psychedelics based medicine to their arsenal, this helps further legitimize the industry. Smaller companies like Mind Cure are planning on investing heavily into digital therapeutics, which would pair up psychedelics-based therapy with smart watches and machine learning. By leveraging the use of technology at an early stage, these companies can achieve general synergies to use psychedelics in a more effective fashion for greater results.
There are also significant opportunities for companies to vertically enter into various segments of the psychedelics supply chain. While the companies that research and manufacture medicines themselves tend to get the most attention, other functions like equipment manufacturing are also highly lucrative and currently unsaturated. For example, while the R&D focussed pharmaceutical giant Eli Lilly has seen relatively volatile profitability over the past five years, the medical equipment manufacturer Medtronic sees similar profitability, but with far more stability and predictability. As such, there is still space for companies to enter into supporting functions within the psychedelics sector, thus helping it flourish and expand its reach across the pharmaceuticals industry.
Consumer Sentiment
Based on a survey conducted by Prohibition Partners in the US and UK, there is minimal negative sentiment towards psychedelics. 51% of adults are in favour of legalization and 36% are unsure, with the remaining 13% disagreeing with psychedelics legalization.
Additionally, 45% of those surveyed said that they know someone who could benefit from psychedelics based mental health therapy. 70% of these people are also calling it a breakthrough for the mental health treatment world. While there is still some resistance to psychedelics legalization as a vestige of the “War on Drugs” era, the people who support it tend to be very outspoken in their belief that psychedelics have immense applications in treating mental health issues.
Valuing Opportunities
While it is relatively easy to see why the entire psychedelics sector is well poised for strong growth, it is more difficult to value individual psychedelics firms, which could present challenges in actually capitalizing upon the opportunities available in the industry. A major problem facing investors trying to value psychedelics companies is that the majority lack revenue, and are currently just burning cash raised through equity offerings; as such, the traditional methods of valuation, such as discounted cash flow analysis or comparing EV/EBITDA ratios do not easily work. To gain first hand insight on how interested investors evaluate opportunities in this sector, the Waterloo Business Review reached out to an associate at a psychedelics focused venture capital firm, as well as a former investment banker focused on healthcare coverage.
One of the main issues with psychedelics companies is that they are generally pre-revenue, making it very hard to value them. This usually means that they suffer from binary risk, wherein if their “lead drug” is not approved, they could likely fail in entirety. As such, it becomes very important to attach a probability to different line items and projections. For example, while mature companies can be valued through regular discounted cash flow analysis, it is quite common to use probability weighted cash flow modelling with early stage biopharma startups due to the aforementioned binary risk. For even earlier stage biopharma companies, such as psychedelics in this case, investors will often look at Peak Revenue figures, where maximum attainable revenue figures in the future are multiplied by the probability of the lead drugs being cleared in trials, and discounted to the present. Then, this peak revenue figure could ostensibly be used instead of regular revenue in EV/Revenue valuation multiples. Apart from just income projections, valuing assets is also quite difficult with companies in the psychedelics sector. With an increased emphasis on their intellectual property (IP), which these companies aggressively try to acquire from one another, there are lots of legal aspects to valuing the companies based on the strength of the IP.
In general, it becomes very difficult for new investors to size up individual companies in the absence of prior knowledge. Without being able to conduct proper scientific due diligence, most investors would not be able to accurately ascertain important probabilities and peak revenue figures. Psychedelics focused venture capital firms usually have teams of scientists and lawyers to help them evaluate the odds that certain drugs will make it past trials, which is a type of expertise an average retail investor would not have. As such, despite the prospect of huge growth within the industry, it may be difficult for average retail investors to be able to get in on the opportunity.
Despite the risks, institutional investors often still pile into psychedelics companies; however, this should not be seen as a sign of encouragement by retail investors.
Venture capital firms tend to invest in convertible preferred equity, which oftentimes provides these investors a liquidation preference of 1x their initial investment, which significantly reduces their downside risk. On the other hand, retail investors would be buying common shares, which have practically no protection against downside risk, which is a significant concern for a whole host of reasons. With psychedelics companies involved in an industry which is still illegal, they will have to wait years for their drugs to pass clinical trials, while burning cash at the same time. In case of distress, the main types of assets that investors would have claim to are the intellectual property, which itself is subject to binary risk. As such, without having downside risk protection like venture capitalists, retail investors have the cards stacked against them in many ways.
Conclusion
Overall, with Oregon already having decriminalized psilocybin and there being a push for legalization from prominent investors like Peter Thiel, it is likely that America is on the eve of medical psychedelics legalization, alongside other periphery markets such as Canada. The applications of psychedelics are immense, with the potential to tackle the addiction crisis, ameliorate our treatments for mental health problems such as depression, and revolutionize how we treat neurological pain. Currently, the business landscape for psychedelics companies is very exciting: research and development expenses are increasing, and mergers and acquisitions (M&A) activity is on the rise as well. Psychedelics companies are aggressively raising cash by issuing shares through the equity capital markets. This cash is then being funneled into R&D programs and purchasing other firms for their intellectual property—thus consolidating the industry. Overall, psychedelics seem to be well-positioned to achieve tremendous growth and disrupt the pharmaceuticals industry, and it is up to ambitious leaders and entrepreneurs to make the most of this exciting time in the healthcare sector.
Nevertheless, the true difficulty is how to capitalize upon these opportunities—how can the barriers of entry for laymen investors be reduced in a field dominated by accomplished scientists?