Passing the Baton

Given the magnitude of the capital required for drug development, many players must participate in the successful funding of a start-up biotech company, with no one player having the capacity to fund the entire amount on its own. These different players have a unique role to play in the capitalization of the biotech, depending on its maturity. The sources of capital typically include many of the following:

• Angel or other “seed” stage investors
• Venture capital firms
• Corporate venture capital
• “Crossover” investment funds
• Public investors such as mutual funds, hedge funds, and retail investors
• Grants from governments and disease foundations
• Collaborations with larger pharmaceutical or biotechnology companies

In the future, new sources of capital from crowdfunding platforms and nontraditional backers, including information technology or healthcare services companies, may play a larger role as well. While not strictly drug development, the Grail financing transaction noted in Chapter 1 is a relevant example.

At the start-up stage, this journey is analogous to a relay race in which the job of management is to cultivate relationships and market the company's story so that the next group of investors is ready to “take the baton” when needed. But even experienced management teams with strong business and financing strategies can be subject to the inevitable ebbs and flows of the biotech financing market. Some of this volatility is inherent in all sectors as investors look broadly for value-creating opportunities and periodically shift their investment focus to sectors that appear poised for a rise in value. As noted earlier, however, drug development is a particularly high-risk, high-reward proposition, with risks coming from many parts of the business model.

Worries about general economic trends, or sector-specific concerns, such as the growing influence of healthcare payers on drug prices, may drive investors to look for relatively safer investments. This situation tends to result in pronounced fluctuations in the availability of capital for biotech companies and can lead to protracted periods during which the public financing market is virtually closed, especially for initial public offerings (IPOs) (Figure 2-3). This has happened on multiple occasions over the history of the biotech industry.

At a macro level, the biotech financing ecosystem breaks down if one class of investors is not available or interested when needed. For example, in periods in which a market for IPOs is not available to biotech companies, venture capital investment comes under enormous strain as venture capitalists (VCs) must continue to fund their portfolio companies for longer than anticipated. This, in turn, has an impact on their rate of return, which can result in fewer dollars invested in such venture capital firms and, therefore, fewer start-ups financed down the road.

First-time biotech chief executive officers (CEOs) are frequently surprised at the amount of time they spend raising capital and communicating with existing investors, both as private enterprises and especially following an IPO transaction. But, given the underlying risks, drug development and company building require both scientific and financial optionality. Management teams must build in the financial optionality to ensure that there are sufficient resources to enable the scientific pivots that may be necessary as greater knowledge regarding a technology or product candidate is obtained. Katrine Bosley, CEO of gene editing pioneer Editas Medicine, notes, “Even if the CEO thinks two or three steps ahead, the reality he or she responds to will be different from the plan. By thinking through multiple scenarios over several years, the CEO has a better grasp of how much capital will be required to reach the next value-creating milestone” [6].

Successful companies must have two core capabilities: first, the discipline of understanding the interests and needs of investors and strategic collaborators; second, the ability to explain the company's story. Both capabilities are critical from a company's earliest days and never lose importance.

While the total amount of equity financing for pre-commercial companies has recovered since the global financial crisis in 2008 (see Figure 2-4), it is also true that the investment is heavily concentrated, with approximately one-third of all companies raising equity capital in the United States in 2015 commanding 80 percent of capital raised. For pre-IPO, venture capital-backed companies, the picture is similar [7]. Thus, devising and executing the right fundraising strategy can be a source of significant competitive advantage, allowing companies to pursue multiple technologies or therapeutic areas.

How Much Capital to Raise

There is an adage in biotech to always “take the money” when it is available, although the reality is often more nuanced. When raising capital—whether as a privately held company or following an IPO—it is the responsibility of the management team to have formulated a plan that clearly explains to investors how the available invested capital will be utilized to provide a return commensurate with the risk.

In difficult financing environments, a company may only be able to raise enough capital to take its lead product to the next scientific or clinical milestone (referred to as a value inflection point). In this situation, it is critical that companies raise sufficient capital to reach this point, building in a cushion that accounts for potential unanticipated hurdles. That is because it is extremely difficult, not to mention dilutive to the interests of current shareholders, to be forced to return to investors for additional capital to complete the necessary research effort. At the same time, in periods where capital is relatively more available, it may not be advisable to take capital at levels well beyond the company's needs or managements plans to create value for shareholders. The greater the sum raised, the more difficult it is to achieve the high rate of return that investors (especially VCs) require, which may result in unforeseen pressure on a company's strategy or even pressure to sell the business entirely. Said another way, the financing and capital allocation strategy of the company must be closely linked to the research and development and business strategy, including defining priorities (reallocation of capital if a product candidate is delayed or fails during development), related budgets, and key milestones. Editas Medicine's Katrine Bosley notes, “In flush times, raising more money is tempting because it's easy. Still the CEO must understand why she is raising the money. Will the capital allow the company to pursue productive activities at a faster pace, or is the additional money simply more runway? Both options are legitimate, but the CEO should be able to articulate why she is raising that specific amount of money and how it fits with the company's overall capital strategy particularly alongside business development and grant activities” [8].

Pricing and Dilution

Equity capital is the lifeblood of every biotech company and is necessary to maximize the creation of value. That said, each financing transaction dilutes the holdings of founders and existing investors. As a result, determining the price per share can be a sensitive negotiation. Given the serial nature of biotech fundraising (i.e., companies need to return to the same investor groups repeatedly), it is important for management teams to balance the desire to maximize the price per share at each fundraising (thereby minimizing their own dilution) with the reality of needing to leave some room in the valuation for shareholders to earn a satisfactory return.

So-called nondilutive capital can be an important complement to the sale of equity. Most commonly, this term refers to out-licensing of some of the company's technology in exchange for a license fee and other consideration. While not dilutive from the perspective of voting equity securities, these arrangements do “dilute” the value of the enterprise by transferring ownership of a potential income-earning asset to the licensee. Nevertheless, for a variety of reasons discussed in greater detail below and in Chapter 3, strategic alliances are a critical component of any financing strategy.

True non-dilutive capital, in the form of research grants from government agencies or from disease foundations, can be an important component of an overall financing strategy, especially for companies working in areas of high unmet need or where governments have a strong public health interest (e.g., in infectious diseases). These sources of capital are discussed later in this chapter.

When to Raise Capital

The reality is that biotech management teams typically feel like they are always in the process of raising capital because of the need to be in continuous dialog with existing and potential future investors. The timing of successive rounds of financing is an important consideration, however. While financing after a value-creating event (e.g., an important proof of concept or a clinical trial readout) is most desirable from a valuation and dilution standpoint, it is important not to underestimate how long it may take to close a financing round, even in a healthy investment climate. Management teams that delay too long may find that they are left with fewer options. Further, a company is in a stronger negotiating position with potential investors if it has a comfortable cushion of cash on its balance sheet. In fact, it is not uncommon for companies to close a financing round in advance of a value-creating event, accepting a lower overall valuation in exchange for removing the risk of not being able to close a deal if the event outcome is either unclear or negative.

Adaptations to Preserve Capital

Most companies follow a traditional financing model, consisting of multiple rounds of venture capital, one or more strategic collaborations with larger pharmaceutical or biotech companies, an IPO, and then a series of follow-on public equity offerings. However, biotech companies have, because of necessity, become adept and creative in accessing nontraditional sources of capital and developing new business models to minimize net cash outflows.

Through the experience of managing difficult financing cycles (or closed “windows,” as they are referred to in the industry), companies and investors have devised various strategies preserve scarce capital, including:

• Outsourcing certain noncore functions to lower-cost markets
• Developing new sources of cash flow by broadly licensing a core technology on a nonexclusive basis or performing research services for other companies (a strategy that gained traction in Europe in periods of relative scarcity of capital)
• Pursing orphan or ultra-rare diseases, which typically require smaller, less expensive clinical trials
• Utilizing biomarkers or other precision medicine techniques to more precisely identify patients likely to benefit from a particular therapy
• Adopting “fail-fast” (and cheaper) development models in which experiments and trials are designed to find the flaw in a particular technology as early as possible and certainly before expensive late-stage clinical trials
• Participating in precompetitive industry consortia that are working on shared (underlying) scientific issues or combining data to discover new insights and improve efficiency
• Repurposing existing drugs for new markets

Whether developing a broad technology platform or adopting a more targeted approach, companies and their investors must be single-minded in the execution of their chosen strategy

Seed Capital

Sometimes referred to as the “friends and family” round, small, pre-venture capital financings are actually less common in biotech than in high technology, where it is not uncommon for a company to reach the market and begin generating revenue with a relatively small amount of equity capital. Given the product development timelines and the substantial capital needs that are the norm in biotech, most companies begin with a round of venture financing that, as discussed in greater detail below, typically comes with at least a soft commitment to provide additional capital in the future. That said, if a start-up company requires some capital to achieve an early research milestone or early proof of concept in order to interest venture investors, there are a few sources beyond mortgaging the house or tapping friends and family.

Venture Capital

The vast majority of biotechnology companies receive their start-up funding from VCs. In the early days of the industry, the leading venture capital firms were typically high-technology focused or diversified firms that saw biotechnology as the next frontier of innovation. As the industry matured, and the business models and risks associated with biotech investing became better understood, life science–focused venture firms became much more common. These funds frequently include partners with substantial investing and operating experience in the industry.

While biotech entrepreneurs seeking to start a company continue to meet with many potential investors before securing an initial financing round, it is also common for a VC firm to do its own research into a promising new technology area, license the necessary intellectual property, identify the management and scientific advisory team, and launch the company. This co-creation model makes fundraising at scale a much more challenging prospect for the first-time entrepreneur. Thus, it is important to understand which venture firms may have interest in a particular technology and to establish relationships as early as possible, even before formally incorporating a company. Biotech entrepreneurs should expect those potential venture investors who express interest to perform extensive due diligence about the technology, the underlying patents, the competitive landscape in a chosen therapeutic area, potential reimbursement challenges, and the experience of the management team.

In the traditional investment model, the company founders hold shares of common stock and the VCs invest in convertible preferred stock. A company typically closes between three and five rounds of venture capital investment (labeled Series A, Series B, Series C, etc.), prior to undertaking an IPO. According to company financial statements, the 224 biotech companies in the United States and Europe that completed an IPO in the period from 2013 to 2015 raised a median of $62 million of venture capital prior to the IPO transaction [13].

Upon the IPO, the preferred stock automatically converts into common stock based on the terms defined in each series. Preferred stock derives its name from the fact that it has certain features that give its holders rights in preference over the holders of common stock. Such rights typically include:

• The right to receive a specified amount upon the sale or liquidation of the company before any return is provided to common shareholders (liquidation preference)
• The right to have the shares repurchased by the company after a specified event or date (redemption right)
• The right to receive dividends, if declared, prior to common shareholders
• The right to be represented on the board of directors
• The right to vote on all matters on which common shareholders vote and to approve certain transactions, including the sale of the company and the issuance of new shares
• The right to receive additional shares of common stock upon conversion if the company sells shares at prices below the original amount paid by the VC (anti-dilution protection)

Frequently, later series of preferred stock may have terms that are more beneficial than an earlier series; for example, upon sale of the company, holders of Series C may be entitled to receive a full liquidation preference prior to the Series B, Series A, or common stockholders receiving any return.

Although certain venture firms may choose to invest in the entire Series A round themselves, more typically, two or three firms will invest as a syndicate. Upon making the Series A investment, these firms will also reserve some of their capital in order to participate in future rounds of financing (the terms of preferred stock agreements often include significant penalties for firms that do not invest their pro-rata share of future rounds, including the automatic conversion of existing rounds to common stock at a less favorable exchange rate). It is common for one or more new investors to be added to the syndicate in subsequent financings to help establish a price for that round of financing. It is also increasingly common for a particular venture capital round to be invested into a company in tranches. For example, in a Series A financing with an announced value of $10 million, investors may agree to contribute $5 million upon closing and the remaining $5 million upon the achievement of a specified objective (e.g., hiring of management or achieving an early clinical result) or upon the passage of time. Investing in this manner allows the VC firm to mitigate its risk a bit and to improve its overall rate of return.

Most of the preferred stock preferences described above serve to provide a degree of protection should the company not end up being as successful (or as valuable) as originally anticipated. Each of these preferred stock preferences must be negotiated by management and the investors. Given the complexity of these terms, it is important to engage outside legal counsel with appropriate experience in negotiating such arrangements. A side benefit from the issuance of preferred stock is that, on a comparative basis, the company's common stock will be worth a lower amount per share. This allows the company to issue options to employees to acquire common stock with a lower exercise price, which can be a critical recruitment and employee-retention tool.

Venture capitalists are, by and large, not passive investors—they expect to be closely involved in overseeing the company's strategy and operations and leveraging their networks to bring value to the company. As such, just as VCs will perform company diligence, it is important for entrepreneurs and early stage management teams to perform their own inquiries into potential investors. While a company's negotiation leverage may vary considerably with the investment climate, there are several important factors to understand about a potential investor including:

• Investment philosophy: Does the firm typically invest in technology platforms with broad product opportunities, or more targeted single product candidates?
• Relevant experience: What can the firm and the individual VC bring to the company beyond the cash invested in terms of industry experience and network?
• Future rounds: How much has been committed to future rounds and the decision-making process at the firm related to those rounds?
• Age of fund: Venture capital funds typically have 10-year lives and become fully invested (including committed funds for future rounds) in the first 5 years. To avoid divergence of strategy within the funding syndicate, it is better if all members are investing from funds with similar remaining lives.

Corporate Venture Capital

In recent years, venture capital investment from the venture arms of large pharmaceutical companies has become a more significant source of capital for biotech companies. These groups have different missions depending on the pharmaceutical company; some are managed solely for return whereas others have a dual mission of helping the company stay informed about new and emerging technology areas. Corporate venture capital is most typically invested as part of a syndicate with traditional VCs and rarely leads or controls a financing round. Because many of these early stage companies will be acquired by larger pharma players in the future, start-ups often want to have more than one corporate investor in the syndicate. This helps the company to stay closer to potential acquirers' interests and needs. It is also a hedge; multiple corporate venture groups have an interest in the entity so the company is not viewed as being captive to single big pharma investor. There also can be a perception that having a corporate investor provides an aura of scientific validation to the company's technology, although there is little correlation between a corporate venture investment and a later strategic alliance with, or acquisition by, the same entity [14].

As noted in Chapter 1, information technology companies have become very active in health and also have active venture capital units that invest in health technologies. While this investment has primarily been targeted to Internet and software entities focused on healthcare, certain companies (including Alphabet) have also invested in traditional drug development companies [15].

Venture Debt

In the United States, certain lenders have created loan products targeting pre-revenue biotech companies. While it may seem counterintuitive that a company with no cash flow would borrow additional funds, the thesis for these arrangements is built around the idea of extending the funding runway to increase the chance that the company will hit its next value-enhancing milestone. The loans are typically secured by all of the company's assets, which may include, or specifically exclude, its intellectual property. The banks that provide these loans base their decision, in part, on the company's technology and its management team, but more fundamentally on their perception of the quality of the venture capital syndicate, including the likelihood that they will provide additional rounds of financing (enabling the loans to be repaid). The lenders seek a return both from the interest and fees they earn on the loan and from receiving warrants to purchase shares of preferred stock.

Crossover Investors

In recent years, it has been more common for biotech companies to close a final private round of financing immediately before launching an IPO with certain “crossover” investors—firms that invest in both private and public entities. In addition to strengthening the company's financial position, these transactions serve to strengthen a company's overall chance of successfully completing the IPO by adding a group of investors who will likely also be purchasers in the IPO transaction. The investors benefit by acquiring a portion of the investment at (lower) private valuations.

Public Investors: The IPO Process

An IPO is an important milestone in the life of a company, not just due to the funds raised in the transaction, but because it opens up the opportunity to access even greater sums of capital from public investors in the future. An IPO is often described as an exit event for investors, however, in biotechnology, it is more appropriately referred to as a liquidity event. In fact, it is not uncommon for venture investors in a biotech company (and the crossover investors mentioned above) to purchase shares in the IPO to signal to the market their support and to ensure the company raises sufficient funds to meet its near-term R & D objectives. Eventually, venture investors do sell (or distribute to investors) their shares, and most will then transition off the board of directors in order to focus on new investments.

Broadly speaking, there are two types of investors that acquire the majority of shares offered in an IPO: dedicated specialist investment funds that focus on the sector and generalist investors who invest across sectors. The generalist investors, including large diversified mutual funds, represent much larger pools of capital. When an IPO “window” opens wide for biotech, as it did in the period from 2013 to 2015, it is frequently driven by enthusiasm of generalist investors looking for market-beating returns.

The management teams behind successful transactions frequently start by building relationships with key specialist investors on so-called “non-deal road shows” months before the formal IPO process commences. The purpose of these meetings is to allow investors to become familiar with the company's management, its technology, the market opportunity, and key upcoming milestones. When management teams visit these potential investors during the more time-compressed IPO process, the conversation can focus on progress made as opposed to an initial introduction to the company and its technology. This process also can build the credibility of management in the eyes of investors who will have seen the company deliver on its strategy.

The actual IPO process (Figure 2-5) typically kicks off with the selection of investment bankers and is a multi-month process involving many players and significant expense. Beyond the capital raised in the IPO transaction itself, the IPO event sets the stage for companies to raise substantial future capital through subsequent follow-on offerings. Management teams should recognize, however, that this access comes with the high cost of complying with public market listing requirements and the expectations of public investors. This translates into the need for more administrative employees and higher legal, accounting, insurance, and other external costs. Operating as a public company also requires a significant time commitment by the CEO, chief financial officer (CFO), and other members of management to communicate with shareholders, as well as enhanced transparency regarding the affairs of the company. Lack of compliance with disclosure and communication obligations can result in significant penalties and a loss of market confidence.

In addition, management teams must take into consideration the expectations of public investors and regulators. As such, prior to or coincident with the IPO, companies should identify gaps between current practices and regulator/investor expectations to develop a plan to close any gaps. Common areas to be addressed include:

• The composition and independence of the board of directors
• The bylaws or corporate charter, which address issues such as the frequency of election of directors
• Board committees (audit, compensation, etc.) and related committee charters
• More formalized lines of reporting and employee policies
• Strengthening the overall internal control environment and processes

Companies typically select three to four investment bankers to participate in the IPO transaction. One of the bankers is selected as the overall lead or “book running manager.” The role of the investment bankers is to underwrite the IPO (i.e., agree to buy all of the shares and then resell them to investors). To accomplish the task, the bankers perform extensive diligence on the company and, along with management, market the company to prospective investors. In addition to the bankers, the IPO transaction team typically includes legal counsel, external auditors, patent counsel, and an investor relations/communications firm. The investment bankers are also represented by their own legal counsel, which assists in the due diligence process and participates in the drafting of the offering document (the drafting is led by the company and its legal counsel). The investment banks are paid a percentage of the transaction proceeds (typically 6 percent) and certain out-of-pocket expenses for their services. In addition, the company can expect to pay an additional $2–3 million in professional services costs related to the transaction.

As noted previously, following the close of the transaction, the company must stay in full compliance with all securities laws including those around quarterly and annual disclosures and communications with shareholders. A company that remains in good standing can then raise subsequent rounds of capital with far less effort and time required.

Government Grants and Disease Foundations

Grants from government and private sources such as foundations and, increasingly, patient advocacy groups and disease-focused foundations are an important source of non-dilutive funding. All of the parties have an interest in seeing innovative science and research advance for reasons that go beyond a pure financial return. For governments, it is often a matter of economic development or achieving broader health outcomes for society, including preparedness for infectious disease epidemics or warfare. Grants can frequently be sourced at national, regional, or local levels. Private philanthropic sources may also seek specific health outcomes (e.g., the Bill and Melinda Gates Foundation focuses on eradicating malaria) or to advance promising but high-risk therapies to address significant unmet medical needs. In addition to funding, working with patient advocacy groups and disease foundations may provide access to a qualified pool of potential clinical trial participants, which is especially important if the company is pursuing a rare disease. In addition, involving interested patients in the development process may provide the company with invaluable information on how to develop truly patient-centric therapies by more fully understanding the real-world challenges of patients, for example, around drug administration and adherence (see Chapter 6 for more discussion on this topic).

While funding from these sources may be modest in size—for example, enough to offset a portion of the cost of a clinical trial—in many cases, the sums received have been quite significant, at times exceeding $100 million. Many companies have become adept and creative (see the Vertex Pharmaceuticals case study that follows) in accessing these sources of capital.

Strategic Alliances

Strategic alliances, which are covered in greater detail in Chapter 3, have been an integral part of the biotech financing landscape since the birth of the modern biotechnology industry and are a critical component of virtually every biotech company's financing strategy. In fact, each year billions of dollars of license payments, R & D support payments, and milestone payments flow from big pharma to emerging biotech enterprises.

Asset-Based Financing

A variation on the strategic alliance that has emerged from time to time in the industry is asset-based financing. In these structures, a financial investor provides R & D funding to a biotech company, in exchange for taking an economic interest in the product under development. This interest could be in the form of the right to receive future success payments and royalties as the product progresses toward and eventually enters the market. The total return may or may not be capped, but is intended to reward the investor for the risks taken (in other words, a higher overall return is required, the earlier a product candidate is in development). In one form of these arrangements, the biotech company out-licenses its technology to a new company founded by an investment fund. The investment fund then pays for the continued development of the product, including at times engaging the sponsoring biotech company to perform R & D services for a fee. If the development progresses as planned, the biotech company can exercise an option to reacquire the technology at a premium to the amount invested by the investment fund. If the option is not exercised, the investment fund owns the product and can seek a different partner, chose to develop it itself, or shut down all R & D.

The rationale for a biotech company to enter into such arrangement is based on access to capital and value arbitrage. If the company perceives that its stock is undervalued by the market and is concerned about raising capital at a depressed value, then this structure allows the research to continue with funds provided by a third party. If the R & D effort is successful and relevant milestones are achieved, the theory is that the public market will recognize these events and the stock price will rise, allowing the company to finance the milestone payments or buyback of the technology at an overall lower level of dilution. Given the complexity and risks, these structures have not been widely adopted and tend to be more common when the IPO market is closed to biotech companies. However, these structures remain an available option with several investment funds interested in providing the capital.