A New Investment Vehicle for Financing Biotech Companies
For nearly a decade we’ve been hearing about the need for a new financing model for biotech start-ups. It's high-time one was introduced.
For nearly a decade we’ve been hearing about the need for a new financing model for biotech start-ups. Biotechnology is a capital-intensive endeavor, and biopharmaceutical applications in particular have development timelines and funding requirements that are far in excess of many investment alternatives.
Fundamentally, there are two forms of capital to fund biotech start-ups – debt and equity. Traditional debt financing lacks sufficient risk tolerance to participate extensively in this sector. Other than equipment and facility financing, debt issuances to biotech start-ups have largely been bridge financing or convertible notes, but these debt instruments are still backed by equity.
Until around 2005, equity-based models for financing biotech start-ups performed reasonably well. The cash-on-cash returns to private investors in venture-backed biotechs that had their initial public offerings (IPOs) between 2003 and 2006 averaged 1.8 to 2.0 times invested capital, based on the IPO price. Similarly, the internal rate of return (IRR) on these investments averaged 17-18% on all invested capital, again based on the IPO price and the date of investment. Nonetheless, these returns marked a substantial deterioration from earlier periods. For example, average cash-on-cash returns to private investors in venture-backed biotechs that had IPOs in 2000 were 4.4 times invested capital, and IRRs averaged 44% on all invested capital.
More ominously, late round investors in biotechs that went public in 2005-06 achieved IRRs that were nearly twice as high as IRRs of early round investors (30-34% versus 16-18%). This inversion of the risk/return tradeoff for staged investments in biotech start-ups was the first since the industry’s emergence in the early 1980s, and it proved to be a harbinger of the tough financing environment to come.
After a smattering of biotech IPOs in 2007, there were essentially no venture-backed biotech IPOs in the US for two years, leaving venture investors with a large inventory of aging portfolio companies and only a limited number of acquisition-based exits. The biotech “IPO window” re-opened in early 2010, however, and has remained relatively open through 2012, during which 34 venture-backed biotechs had their IPOs in the US.
Unfortunately, both IRRs and cash-on-cash returns to private investors have deteriorated substantially – venture-backed biotechs that had their IPOs between 2010 and 2012 averaged 4% IRR on all invested capital, and only 1.3 times invested capital. Average total invested capital climbed to $133 million per biotech (as compared to $79 million in 2005-06), suggesting that investors had committed substantially more capital to achieve significantly worse returns.
Demand Dividend Financing – A Third Way
The concept of a Demand Dividend Investment Vehicle was conceived by Professor John Kohler, the Director of Social Capital Programs at Santa Clara University’s Center for Science, Technology and Society (CSTS). CSTS is a unique practice-based academic institute that applies technology to solve global development challenges by incubating and growing community and regional-scale social enterprises capable of extending important goods and services to base-of-pyramid populations. Research by Prof. Kohler and others has confirmed that capital mobilization for social enterprises has been constrained by the lack of appropriate investment instruments. Prof. Kohler has proposed a novel investment instrument: a defined claim on free cash flow that he calls a Demand Dividend.
Key features of the Demand Dividend (as modified to be applicable to the biotech industry) are as follows:
- Medium term debt structure: A financing round (other than seed) will be placed as debt and carry a fixed (4-5 year) term. Like equity, it would be largely unsecured and subordinate to operating lines of credit such as equipment leases.
- Payable from enriching alliance payments: The Demand Dividend would hold a claim on a share (40-50%) of Enriching Alliance Payments (EAP) from commercialization alliances commenced during the term of the instrument. Upfront fees, milestone payments when received and equity investments in excess of fair market value (FMV) would constitute EAP. Exclusions from EAP would be similar to the amounts typically excluded from sublicense revenue sharing (e.g. sponsored R&D payments post-signing, loans, payments for supply, equity at FMV).
- Cap on return multiple: A claim on EAP will remain intact until a 3x return on the original investment amount has been paid out. Once complete, the obligation will extinguish.
- Protective and governance provisions: Like equity rounds, the Demand Dividend financing will include provisions to protect investor interests in the ongoing operation of the biotech, as well as in the structuring of commercialization alliances. Most terms would be identical to the protective provisions and governance terms found in biotech equity rounds. A board seat may be associated with the financing, depending on scale.
Why a Demand Dividend Makes Sense – Four Key Constituencies
Realistically, four constituencies need to reach consensus on a biotech financing vehicle for it to occur and endure. These constituencies are company management, pre-existing investors, investors in the vehicle, and subsequent investors. We believe a solid argument may be made for each, as follows:
Company management: As aggregate private capital raised by biotech start-ups has risen, so too has the pressure to provide investor liquidity. Biotech management is keenly aware of investor expectations but is severely constrained by the step-wise nature of the product development process. Alliance formation is the one key aspect of strategy that biotech management has the ability to accelerate if motivated to do so. Demand Dividend financing would allow management the option to accelerate alliance formation and so lower the valuation threshold needed to provide investor liquidity. Additionally, in those instances where alliance formation is currently a performance objective, management generally ignores revenue expectations and budgets full development costs until a specific alliance is negotiated. Demand Dividend financing would provide a mechanism for reflecting alliance impact, though variable, on operational budgets.
Pre-existing investors: As noted above, early round investors in start-up biotechs have been substantially diluted by successive later rounds of financing. If one or more such rounds could be replaced by a non-dilutive Demand Dividend financing of equal amount, the effect would be to increase the returns to these early investors. To quantify this effect, we analyzed the 34 biotechs that completed IPOs between 2010-12, asking which might have replaced an equity financing with a Demand Dividend round.
Ten of the 34 companies commenced one or more commercialization alliances pre-IPO, so these 10 were the focus of our analysis. For each of the 10 biotechs, we identified the equity financing that most closely preceded the first commercialization alliance and designated that financing to be replaced by a Demand Dividend round of equal dollar amount. We then tracked the actual EAP received to date, as well as EAP potentially payable based on achievable development milestones. Three of the 10 biotechs had already obtained sufficient EAP to return 3x the presumed Demand Dividend financing based on 50% payout of EAP. Three more had “returned” 1-1.8x the round size to date, and all but one had sufficient EAP potentially payable on current alliances to return 3x on the Demand Dividend financing if development milestones are met.
We then assumed that each subsequent financing, including the IPO, would have the same valuation characteristics – i.e. pre-money valuation and amount raised – notwithstanding the substitution of the Demand Dividend round for the specific equity financing. The effect of substituting a non-dilutive Demand Dividend round was to increase substantially the cash-on-cash return for early round investors (from 1.7-5.5x to 2.1-7.6x) and for all investors in these 10 biotechs from 1.2x to 1.5x. Similarly, IRRs for early round investors almost doubled (from 4-7% to 12%), and aggregate IRRs rose from 2% to 6%. These increases suggest that pre-existing investors should be supportive of a Demand Dividend financing in lieu of an intermediate equity round.
Investors in Demand Dividend investment vehicle: Presumably, a 3x return on invested capital within 4-5 years should attract investor interest. Diligence will be needed to ascertain the alliance prospects of each biotech and to approximate the scale and timing of EAP. However, since roughly 600 commercialization alliances are commenced each year in the biotech industry, as compared to less than 40 product approvals per year, prospective investors should be comforted by the knowledge that, for any given R&D project, alliance formation is at least 15x more likely than successful commercialization. In addition, the partial payout of EAP should alleviate some investors’ concern that biotech management would otherwise take the EAP of an alliance and plow them into an unrelated and unspecified R&D project with an ongoing incremental burn rate.
Subsequent investors: An investor in a round subsequent to a Demand Dividend round would likely view the EAP payout obligation as a drain on cash, whether historical (if already capped) or ongoing. However, since biotech valuations are event-based (e.g. completed clinical trial, FDA approval, etc.) and a prospective investor is generally bringing cash sufficient to reach the next value inflection point, such investors tend to be less concerned about available cash than is the case in other industries. As Fred Frank once observed, “cash to a biotech company is just work-in-process.” This suggests that a subsequent investor, including an IPO investor, is primarily concerned about the stage of development and potential future value of the biotech, rather than claims on cash versus equity.
Demand Dividends for All
It may be that a Demand Dividend financing vehicle makes sense for public biotechs caught on the treadmill of private equity (PIPES) and secondary financings. Such companies may find that the cost of floating a secondary, including the dilutive effect of equity that under-priced due to share price erosion post-filing, is greater than the returns promised to Demand Dividend investors. For a subset of public biotechs, it may even be possible to combine EAP with free-cash-flows associated with product sales to reach the payout cap as quickly as possible.