In general, 2003 was a good year for biotechnology as sobered-up private equity investors recognized the industry's merits following the dot-com correction in 2000.

Maria Walker

While overall numbers are still down from 2000, the life sciences accounted for the largest part of the venture capital funding pie in the third quarter of this year -- both nationally and in San Diego -- over the last year deal flow was up. The number of venture funds focusing on the life sciences has grown.

However, the reduction in early-stage investing in the life sciences and the restrained response by the public markets for the few biotech IPOs we saw this year demonstrated that investors are still cautious.

In another trend, a number of regions around the country that are enticed by the obvious economic benefits are offering big incentives to try to emulate San Diego and jump-start local biotech clusters. The Scripps Research Institute announced this year that it will open a Florida campus, lured by $600 million in subsidies. Colorado is hoping to grow a biotech industry with the launch of its Fitzsimons Health Sciences Center in Aurora, and Hawaii is building a new medical school and bioscience park following the "build it and they will come" philosophy.

One critically important variable these regions need in order to succeed is the presence of venture capitalists willing to fund early-stage companies.

When my colleague, Dr. Ivor Royston, founded Hybritech 25 years ago (and in the process started San Diego's biotech industry) he had to travel to San Francisco to find funding. Lucky for Royston and Howard Birndorf, Hybritech's co-founder, Bay Area venture capitalists considered San Diego their backyard. The same cannot be said for other regions of the country.

Not only are region's of the country trying to emulate biotech hotbeds like San Diego, big pharmaceutical companies are trying to reinvent their R&D operations as biotech startups in an effort to tap into this font of creativity. Specifically, pharmaceutical giants, including Pfizer (NYSE: PFE) and GlaxoSmithKline (NYSE: GSK) are restructuring their research organizations into small, entrepreneurial units to foster competition and innovation.

But in spite of these trends, as more venture capitalists have turned their attention to the life sciences recently, early-stage investing has waned.

There are several reasons for this: investors want to minimize risk; early-stage investing requires specialized scientific knowledge not possessed by all venture capitalists; and with 10- to 12-year product cycles, biotech investing can be a daunting challenge for investors looking for a quick return on investment.

The result has been a contraction in the biotech industry. This has taken the form of a weeding out of weaker biotech companies; a trend toward consolidation through biotech mergers; and a focus on business plans that emphasize products rather than platforms or are a hybrid of the two.

This isn't necessarily bad -- market forces tend to create a survival of the fittest and the result is a stronger industry. However, in the currently cautious climate, companies with good science that could lead to cures for diseases will find it more difficult to survive.

And as more venture capitalists who lack the expertise for early-stage investing continue to focus on later stage deals, there may be another surprising effect over the next several years.

Venture capitalists focusing on late-stage biotech companies may enjoy the fruits of their labor in the short term, but down the road there could be a dearth of new investment opportunities as they experience a gap in the pipeline that their own strategy created.

What the less experienced life sciences investors fail to take advantage of is the fact that the best early-stage companies will succeed and offer the greatest return on investment, especially with low current valuations. While not all of these companies may evolve into fully integrated pharmaceutical companies, through smart licensing of their products or technologies and through alliances with big pharma, they can still provide a handsome return on investment for shareholders.

The fact is, most innovation in the life sciences occurs at small independent biotech companies. Big biotechs and large pharma recognize they are dependent on their smaller brethren and for that reason support them.

With pharmaceutical companies looking for new blockbusters to replace products with expiring patents and an aging population that is going to demand new, better therapies, the long-term outlook for biotechnology is promising.

Biotech startups in particular offer the right environment to develop the kind of breakthroughs that big pharma craves.

San Diego, with its rich ferment of research institutions, uniquely entrepreneurial scientists and venture capitalists experienced in early-stage life science investing, stands to gain as biotechnology begins to soar.

Walker is an administrative partner and CFO of Forward Ventures, the largest Southern California venture fund focused exclusively on the life sciences. Based in San Diego, Forward Ventures has $450 million under management and 46 portfolio companies.