When Foundation Medicine, a young company that performs genetically targeted cancer tests, announced in January that Roche would buy a $1 billion stake, Foundation’s stock price quickly doubled. Inside the Boston offices of Third Rock Ventures, the partners felt the warm glow of parental pride.
Third Rock calls itself a venture capital firm, but it provides much more than funding and guidance for new enterprises. Third Rock hatched the idea for Foundation Medicine in 2008. Third Rock’s team of 50 scientists and technologists designed the company’s service. Third Rock drafted its business plan. The firm then infused the startup with $25 million and picked a CEO to launch it and usher it to an IPO.
Third Rock has taken this approach with nearly all of its 36 portfolio companies since its founding in 2007, and it has enjoyed other hits: Agios, which makes drugs to treat genetic disorders and cancer, and BlueBird Bio, which uses gene therapy to treat rare diseases, were among the top four biotech stocks in 2014, with 300% ascents.
Third Rock’s strategy has been “brilliant,” says VC Bill Helman of Greylock Partners. “They’re one of the few firms I’ve seen in 30 years that have reinvented the model of venture capital.”
The firm wouldn’t exist were it not for a visit to the blackjack tables in Las Vegas. The story sounds like the setup to a cheesy joke: A finance executive and a biochemical engineer walk into a casino … In this case the two men, who had grown close while working to market the multiple myeloma drug Velcade at Millennium Pharmaceuticals, were making their annual gambling pilgrimage in 2006. They commiserated over the drug industry and its loathed reputation for valuing profits over patients.
“The patients are getting screwed,” Kevin Starr said. “We need to do something.” Now 52, Starr is a finance executive who rides a motorcycle and favors skull rings. Next to him sat Mark Levin, now 62, a biochemical engineer who worked at Eli Lilly and Genentech before joining Millennium. They soon expanded the discussion to include Robert Tepper, 59, a former oncologist at Massachusetts General Hospital who headed R&D at Millennium.
After the three left the company, they explored new ideas. They toured academic research facilities and found what Starr calls “jaw-dropping innovation.” But the ideas rarely progressed beyond scholarly journals. “We said, ‘Why is this sitting here in academia?’ ” he says.
Money was the reason. Biotech had a hot run in the 1990s. But by the early 2000s the costs of taking a drug to market had grown prohibitive, the odds slim. VCs mostly focused on later-stage companies or fled biotech altogether.
Tepper, Starr, and Levin decided to create a firm that would conceive and build businesses from scratch. (The name was inspired by a news report that discussed the changes on Earth, the third rock from the sun—not by the TV show of that name.) The trio started hiring Ph.D.s and MDs from Harvard and MIT. Many VCs scoffed, the Third Rock partners say. But by 10 weeks in, the firm had raised its first fund, $378 million. To stay focused on patients, the firm instituted a quarterly practice of inviting them to come talk about living with a rare disease or cancer. “We always cry our eyes out and get fired up to go back to the office,” Starr says.
Foundation Medicine was one of the first ideas to get traction. The concept was based on research by Eric Lander, a leader in the Human Genome Project and founder of the Broad Institute of MIT and Harvard. They wondered, what if they could sell a diagnostic test that uses DNA sequencing to help determine which cancer drugs could best fight a particular patient’s tumor?
Third Rock invited Lander to weekly brainstorming sessions along with Alexis Borisy, then CEO of CombinatoRx, which uses software to match combinations of cancer drugs to treat certain tumor cells. They discussed how to scale up testing and make it affordable.
“It was going to be hard to do,” says Borisy, who later joined Third Rock. A sequencing test then cost tens of thousands of dollars. They needed the price to sink to $2,000—and they needed to persuade insurers to pay for it. For 18 months, teams from Third Rock and the Broad Institute met with experts in gene sequencing and with diagnostic companies. They talked to pharma companies, met with cancer doctors and insurers, and worked with regulators. They built models for DNA testing. “It was group genius,” says Borisy.
When Foundation finally launched in 2010, Third Rock backed it with $25 million. Google Ventures and Kleiner Perkins later kicked in too. The total, $40 million, far exceeded the typical $5 million to $8 million Series A biotech round. The goal: Allow the CEO to focus on growth rather than the next investor.
By 2012, Borisy decided it was time for Foundation to leave the nest. He hired a CEO, and over the next two years the company rolled out two DNA-based cancer tests, collaborated with cancer centers and drug companies, and landed a $56 million investment from Bill Gates and others. In September 2013, Foundation went public.
Third Rock won’t disclose its returns. But according to the website of one of its investors, Calpers, its 2007 fund has generated an internal rate of return of 25.7%. That puts it well into the top performance quartile, according to alternative-investment tracker Preqin.
Meanwhile the hot IPO market, along with FDA efforts to accelerate approvals for breakthrough drugs, has helped rekindle VC interest in early-stage biotech. For Starr, the goal is to reach more cancer patients. “For us, these aren’t investments,” he says. “It’s validation that our babies are coming into adolescence.”
This story is from the March 1, 2015 issue of Fortune.