Investors are tripping on psychedelics startups despite a murky path to commercial success

This story is part one in a two-part series looking at the psychedelics drug development landscape. Part two, which examines the regulatory issues and clinical applications, is available here.

When attorney Dustin Robinson decided to parlay his expertise in psychedelics law into a venture capital firm that would invest exclusively in that growing field, he knew he would compete with several other VCs looking to invest in biopharma companies that are turning ketamine, magic mushrooms and other illicit drugs into therapies.

But he wasn’t worried. In fact, he picked up the phone and started talking to those VCs about sharing the deal flow.

“If you think about psychedelics, they’re all about unity. They bring a lot of oneness with the universe and with nature,” said Robinson, managing partner of Iter Investments, in an interview. “The VC world kind of reflects that.”

Robinson’s Fort Lauderdale firm launched in May with $15 million to fund psychedelics startups. And Iter was far from alone. There are now 18 venture capital firms—most of them founded in the last three years—that have poured more than $79 million into the psychedelics field so far, according to a recent analysis by Business Insider. Their investment picks span not just psychedelics developers but also companies that will support them, including ingredients manufacturers and chains of clinics where the drugs may have to be administered under strict supervision.

That VC interest is no doubt being fueled by the prospect of rich exit strategies. Compass Pathways, which is developing the magic mushroom compound psilocybin to treat depression, raised $146 million in its September initial public offering, and $144 million in a secondary offering seven months later. And in June, Atai Life Sciences—backed by PayPal co-founder Peter Thiel and advancing a broad pipeline of psychedelics—raked in $258 million from its IPO.

But all that cash is flowing into an industry that’s facing its fair share of risks. The illicit nature of the compounds raises questions about just how receptive regulators, physicians and patients will be to this new class of medicines.

“A good portion of clinicians view this as a cutting-edge field worth exploring,” said Brian Abrahams, M.D., an analyst for RBC Capital Markets who covers Atai, in an interview. “We have seen signals that derivatives of these drugs could have effects in treating high unmet needs, like treatment-resistant depression, post-traumatic stress disorder and opioid addiction.”

That said, “the data are mostly still too early, and given the challenges of administering these drugs consistently and safely, other clinicians see this as too challenging,” Abrahams added.

RELATED: Compass plans IPO to take 'magic mushroom' drug to phase 3

Johnson & Johnson has made the murkiness of that commercial path all too clear. After winning FDA approval in 2019 for Spravato, an antidepressant derived from ketamine, J&J’s product was rebuffed by cost watchdogs and some insurers for its list price of $6,785 for the first month and $3,450 per month thereafter. It didn’t help that the FDA required the drug to be administered under strict supervision at healthcare facilities.

Spravato brought in a modest $100 million in sales in 2020 and is estimated to peak at $450 million, Abrahams said in a recent note. The disappointing returns “may be attributed to its in-clinic administration profile,” he wrote.

To mitigate the risks inherent in psychedelics drug development, VC upstart Iter intends to spread its capital among biotechs, raw materials producers and clinics, Robinson said. Its portfolio includes Psygen, a maker of active pharmaceutical ingredients for psychedelic drug developers, and Wesana, which is developing psilocybin as a treatment for traumatic brain injury.

Palo Santo, a Chicago-based psychedelics VC firm that launched in July with $35 million under management, is backing drug developers working on diseases ranging from chronic pain to obsessive-compulsive disorder. One of its big bets is Beckley Psytech, a U.K. company with a portfolio that includes 5-MeO-DMT, a drug derived from the venom of the Sonoran Desert toad. The substance has been shown to have long-term antidepressant effects similar to those of psilocybin and MDMA, but with an initial psychedelic trip that lasts for an hour or so rather than a day or more.

“I don’t know who thought to smoke this thing, but they found out that within 20 minutes it offered tremendous therapeutic benefit,” said Tim Schlidt, co-founder and partner of Palo Santo, in an interview.

Beckley Psytech is advancing a chemically synthesized version of 5-MeO-DMT that may be delivered in a nasal spray, Schlidt added, though, admittedly, it’s still early days. “Is there any toxicity? Does it interact with other medications? How durable is it in addressing depression? We’re still trying to figure that out,” he said. Beckley Psytech recently raised $80 million to advance 5-MeO-DMT in depression and low-dose psilocybin in short-lasting unilateral neuralgiform headache attacks (SUNHA).

Palo Santo is spreading the risk of its exposure to psychedelics by investing in companies that are making non-psychoactive analogs of the drugs, including Gilgamesh Pharmaceuticals, which is working on a ketamine derivative for depression. “There could be a lot of value in a take-home medication that activates the key receptors but that is minimally or not at all psychoactive,” Schlidt says.

One of the challenges for investors, both Schlidt and Robinson said, is making sure psychedelics developers have sound strategies around intellectual property. The compounds in their natural form would be generic plays at this point, and not so interesting for investors. But derivatives of psychedelics could be patented, as could novel delivery methods.

That will be important for piquing the interest of Big Pharma, which could be a critical player in scoring rich exit strategies for investors in the form of M&A, Schlidt said.

“I do think pharma will start swirling around this space, as they look for the next big breakthrough in central nervous system disorders,” he said. “But intellectual property can be weak, and I think they’re trying to wrap their heads around that part of the equation.”

RELATED: Psychedelics-focused investment firm Palo Santo launches with $35M to tackle mental health crisis

Safety, effectiveness, IP—they’re all risks for public investors in the psychedelics space, too. A shrewd ability to manage those risks is what drew RBC analyst Abrahams to Atai. The newly public company has built its portfolio by partnering with psychedelics startups that are in various phases of development. For example, in January 2019, it acquired a majority stake in Perception Neuroscience, which is now in phase 2 trials with PCN-101, a ketamine derivative for treatment-resistant depression.

Early data suggest the positive effects of PCN-101 last longer than those of Spravato, with less likelihood of adverse cardiovascular events, Abrahams said. And if Atai can follow through on plans to develop a version that patients can inject under the skin, it could reach a market that J&J has so far failed to attract.

“If Atai is able to dial down the side effects and formulate this into a version that can be self-administered at home, that could open up a broader market opportunity,” Abrahams said. The drug could ultimately generate $750 million in annual revenues, he estimated.

Atai, through subsidiary Recognify, is also advancing RL-007, a novel GABA/nicotinic modulator to treat cognitive impairment associated with schizophrenia (CIAS). Abrahams estimates it could pull in more than $1 billion in annual sales—but he also thinks it only has a 15% chance of succeeding. “It’s never been studied in a specific trial for CIAS,” he said. “There have been some scattered signals across earlier studies in other indications, like pain, that suggested it should be tested in CIAS.”

The pro-cognitive benefits were inconsistent and only evident at the lowest dose, he added. “That makes us conservative as to whether [the effects] will indeed be replicated in a CIAS-defined trial.”

On Aug. 12, Atai unveiled its newest subsidiary: Revixia Life Sciences, which plans to develop the plant-derived drug Salvinorin A into a treatment for pain, depression and substance use disorder.

When Abrahams initiated coverage of Atai in mid-July, the company’s stock had already hit his price target of $19 a share. It has since fallen to $13.55. The share price could reach as high as $50, he wrote, or as low as $7.

That’s just the nature of an emerging industry that’s dabbling in risky drug derived from illicit substances, he warned. “A lot in the end is going to depend on the magnitude of efficacy, how safe these drugs are and how easy they are for providers to give,” Abrahams said. As for the rush of companies now vying for market leadership in psychedelics, he added, “it’s certainly an important risk to consider.”