The pulse of the biotechnology industry feels somewhat weaker since its lifeblood, venture capital funding, proved disappointing during the last half of 2010. Gains made during the second quarter of last year faded quickly during the third quarter and dropped off steeply during the fourth quarter, placing biotechnology second for the year behind software in venture capital funding.

For the full year, dollars raised by the industry rose a modest 3% over 2009 to $3.7 billion, according to the MoneyTree Report by PwC and the National Venture Capital Association, based on data from Thomson Reuters. Deal volume declined 8% to 460 deals in the same period.

The decline in venture capital funding for the biotechnology industry undoubtedly reflects an increasingly difficult US regulatory environment. Biotech companies and investors perceive a lack of transparency in the approval pathway.

Regulatory uncertainty has a huge impact on the cash–burn rate of start–ups and on venture capital firms' willingness to invest. No one can predict how much capital a company will require just to see a drug through the approval process. During the past three years, many start–ups have exhausted their research and development funds, even after cutting staff and costs to the bone, and many have gone under. The possibility of high returns may no longer be enough to entice reluctant investors to take a chance on fledgling biotechs when the chances of failure appear to be increasing.

A glimmer of hope lies in a recent pickup in the exit market. The biotechnology space has seen some liquidity during the past six months, following a dearth of exit activity during 2008 and 2009. Biotechnology captured three of the 32 US venture–backed initial public offerings (IPOs) in the fourth quarter of 2010.

Pacific Biosciences at $200 million, the largest biotech IPO of the year, and Complete Genomics at $54 million, generated excitement for the industry. These companies are working to reduce the cost of genomic sequencing, a highly promising tool in terms of advancing the field of personalized medicine. The positive IPO trend has continued into the beginning of 2011.

An uptick in mergers and acquisitions toward the end of 2010 and continuing into 2011 also has helped to free up capital and time for venture funds, allowing them to seek out and nurture new enterprises. Big Pharma continues to buy large and small biotechs with products in late–stage clinical trials to replenish diminishing product pipelines as blockbuster patents expire. Big Biotech is also pursuing a similar course, buying smaller biotechs with promising products in late–stage development.

In part because of stepped–up exit activity, early-stage funding rose 6% for biotechnology last year—not a big jump but enough to reflect renewed interest on the part of venture capitalists. Exits by late–stage companies put more money on the table for early–stage ventures.

In contrast to the overall investment picture for the sector, the outlook for companies receiving funding for the first time improved during 2010. Biotechnology was second to software in the value and volume of first–time funding. This ranking bodes well for start–ups with voracious appetites for research and development funds but little or no revenue.

The San Francisco Bay area, which includes San Francisco–Berkeley and San Jose, continues to attract the highest level of venture funding for the US biotechnology industry. California serves as a nurturing ground for the industry:

• More than half of US venture funds are based in the state
• The San Diego and San Francisco Bay regions are home to several high–quality research institutions, which serve as biotechnology incubators
• A skilled workforce and entrepreneurial culture helps foster and staff biotech start–ups.