Financing in life sciences biotech companies

Content

1 Introduction

2 Life Science – An Overview
2.1 Red, Green and White Life Science – What is the difference?
2.2 Current Trends in the Biotech Segment
2.3 Business Models in Biotech

3 Transparency in the Biotechnology Sector
3.1 Specifics in Investor Relations
3.2 Specifics in Corporate Governance
3.3 Specifics in Financial Accounting and Reporting

4 Company and Sector Valuation
4.1 Valuation Approaches
4.2 Five-Forces Model for the Sector
4.3 Traditional Valuation and Specifics for Biotech
4.4 Specifics for Pharmaceutical Development
4.5 Specifics for Technology- / Service- Providers

5 Financing Sources
5.1 Initial Financial Sourcing
5.1.1 Governmental Funds and Politics
5.1.2 Incubation Concept
5.1.3 Private Equity
5.1.4 Venture Capital
5.1.5 Business Angles
5.1.6 Strategic Investments and Other Financing Possibilities
5.2 Secondary Financial Sourcing
5.3 Investor's Strategies
5.3.1 Direct investments
5.3.2 Private Equity Funds
5.3.3 Fund-of-Funds
5.3.4 Comparison of Risk Profiles
5.3.5 Alternative Investment Vehicles
5.4 Exit Options for Initial Capital Providers

6 Summary

Sources

Appendix

Table of Figures

Figure 1: Importance of IR Activities for Investment Decisions and Analysts’ Recommendations (Source: DVFA (2005), p. 32).

Figure 2: Forms of the Incubation Concept (Source:Böhringer/Bukowsky/Maurer (2005), p. 322).

Figure 3: Incubation Concept concerning the Pre-Investment Stage of Biotechnology (Source: Domdey (2006), p. 124).

Figure 4: The Risk Profile of a US Venture Capital Direct Investment (Source: Cochrane (2003)).

Figure 5:The Risk Profile of European Venture Capital Funds (Source: Weidig/Mathonet (2004), p. 14).

Figure 6:The Risk Profile of European VC funds-of-funds (Source: Weidig/Mathonet (2004), p. 17).

Figure 7: Application of Porter’s 5 Forces Model in the Biotechnology Segment (Source: DVFA (2005), p. 50-51).

Figure 8: Capital Sources in Biotechnology according to an Ernst & Young Survey (Source: E&Y (2005), p. 97).

Figure 9:The Risk Profile of Venture Capital Investment Vehicles in the US

1 Introduction

Biotechnology is a more and more important field of research in present. Publicly we are currently confronted with many questions about the rights and wrongs within this field of science, like how to handle the issue of gene manipulation or stem cell research. However, biotechnology is more than just an accumulation of ethical questions and science – it is a whole industry and as such interesting for investors.

The scope of this paper is not dealing with the topics discussed in glossy magazines, but it addresses the issues of corporate finance in biotechnology. In order to get an overview of the industry from a finance point of view, the industry has to be portrayed. Hence, this is the topic of chapter two.

From the point of the investors, and therefore of the capital markets, the understandability of the segment biotechnology, and thus the availability of crucial information has to be ensured.

Consequently the transparency of the biotechnology segment and of the individual enterprises, respectively, are the topics of the third chapter. The implications of this chapter have a strong impact on the valuation of biotechnological companies and the sector as a whole – a subject dealt with in chapter number four.

The fifth chapter is concerned with the core topic of this paper and identifies and analyses different sources of finance for biotechnology enterprises. Thereby it is taking the point of view of the biotechnology firms and the potential investors. The paper is showing important difficulties and advantages connected with the different approaches. Additionally the chapter also describes and evaluates the risks of different options of investors.

The paper is concluded with a summary of the findings in chapter six showing that investing into biotechnology is worth thinking about for a responsible and sophisticated investor, although the segment is a difficult field incurring many risks, however opportunities for the “big win”, as well.

2 Life Science – An Overview

As there is no fundamental definition of what life sciences includes, however most of the institutions adapted the definition of the OECD - Organization for Economic Cooperation and Development – that consists of two more or less consistent parts. The OECD offers a deliberately broad definition:

“The application of science and technology to living organisms, as well as parts, products and models thereof, to alter living or non-living materials for the production of knowledge, goods and services.”^[1]

However, the OECD points out that a more specified explanation of the definition used should be given. The second part of the OECD definition lists therefore the activities it sums up under its definition of biotechnology:^[2]

DNA/RNA: Genomics, pharmacogenomics, gene probes, genetic engineering, DNA/RNA sequencing/synthesis/amplification, gene expression profiling, and use of antisense technology.

Proteins and other molecules: Sequencing/synthesis/engineering of proteins and peptides (including large molecule hormones); improved delivery methods for large molecule drugs; proteomics, protein isolation and purification, signaling, identification of cell receptors.

Cell and tissue culture and engineering: Cell/tissue culture, tissue engineering (including tissue scaffolds and biomedical engineering), cellular fusion, vaccine/immune stimulants, embryo manipulation.

Process biotechnology techniques: Fermentation using bioreactors, bioprocessing, bioleaching, biopulping, biobleaching, biodesulphurisation, bioremediation, biofiltration and phytoremediation.

Gene and RNA vectors: Gene therapy, viral vectors.

Bioinformatics: Construction of databases on genomes, protein sequences; modelling complex biological processes, including systems biology.

Nanobiotechnology: Applies the tools and processes of nano/microfabrication to build devices for studying biosystems and applications in drug delivery, diagnostics etc.

Nevertheless, the capital markets understand under Life Sciences the fields Biotechnology, Pharmaceuticals, Pharmaceutical Technology, and Health Care. The differentiation of Red, Green and White Biotechnology is another distinction that is made in modern biotechnologies.

2.1 Red, Green and White Life Science – What is the difference?

The color differentiation within the life sciences is mainly based upon the prevailing application. However, aspects such as the acceptance by the population, the importance of the market, its maturity and its growth potential are also considered.

The red biotechnology deals with the matters of human and beast health and therefore receives a high acceptance in the population.^[3] This toleration is also due to the fact, that new and innovative medications have been developed for treatments of formerly incurable diseases. The dominating driver of innovation in this field is the biotechnology that is also the main driver of the pharmaceutical industry – an industry currently under pressure due to the expiration of many patents. Most of the biotechnology businesses traded on stock exchanges are situated in the red segment of biotechnology.^[4]

The green biotechnology is concerned with agricultural and food development and is currently struggling with consumer's acceptance. Especially in Europe and above all in Germany “Gen-food”^[5] is disapproved. Most of the activities in this sector are integrated in the activities of large groups, e.g. BASF, Bayer, Monsanto, Syngenta.^[6]

The use of biotechnological methods in the industrial production, as well as environmentally save production processes, environmental protection and redevelopment are part of the white biotechnology. However, its use in specific processes are rather difficult to identify for investors without profound knowledge of the processes within a business.

The focus of this paper is the red biotechnology due to its attractiveness for investors. The importance for the pharmaceutical industry that incurs high growth potential, as well as a generally high acceptance, is the foundation of the strong interest of the capital markets in the red biotechnology.

2.2 Current Trends in the Biotech Segment

The current situation of western societies is the predominant driver in biotechnology, especially the demographic challenges have a strong impact on the growing recognition of the biotechnology sector. Particularly in Germany the demographic structure is transforming from a pyramid form in the 1950s towards a mushroom form in the near future.^[7] The ageing population is the reason and the source of the current and future potential that is seen in biotechnology.^[8] As there is only therapy for one third of all known diseases, new therapies that are based upon biotechnological substances may offer innovative treatments. Furthermore the traditional diseases that are associated to ageing, such as rheumatism, diabetes and cancer represent a high potential and are in the focus of many biotechnological R&D projects.^[9]

Molecular diagnosis is another interesting field in modern biotechnology. It represents a possibility to diagnose bacterial and viral infections and is applied to identify hepatitis and HIV germs in stored units of blood.^[10] Other imaginable applications are certainly considering new treatments for influenza viruses and related diseases like SARS. These new diagnostic applications imply an enormous growth potential for the biotechnology segment and related industries such as the pharmaceutical industry that provides the preparation kits for subsequent analysis.^[11]

Many of the big pharmaceutical companies are currently very eager in investing in biotechnology, because the patents for their blockbuster products are expiring or expire in the near future. This has crucial implications for their sales and their turnover, as cheaper imitations will float the market immediately.^[12] Thus the new biotechnological medications are a welcome new business line that is both unique and (currently) hard to copy. Additionally to the investments in a wide range of biotechnological activities and supporting technologies that cover the whole value chain^[13], the pharmaceutical companies are anxious to acquire niche products in order to diversify on the one hand and to be a first mover in an upcoming market on the other one.^[14]

Another crucial factor for newcomers in the market are the new regulations by officials, such as the new department of the FDA^[15] for post market surveillance of new medications.^[16] However, the improved terms of contract for partnerships, licensing agreements and cooperation are also a strong incentive for start-ups in this market.^[17]

All of the above mentioned effects, especially the commercial interest of the big pharmaceutical companies, are increasing the value of the whole biotechnology segment and improve the financing possibilities for new companies.

2.3 Business Models in Biotech

The businesses in the biotechnological segment are characterized by their activities and may be differentiated accordingly. The different business models do have distinguishable cash flows, risk profiles, and growth and business potential.^[18] However the classification seems difficult, as the enterprises constantly adopt to the market circumstances. Furthermore the market is in constantly changing.

The pharmaceutical development companies are goal oriented and try to develop new products to cure known diseases or to reduce handicaps caused by diseases. There might be a differentiation according to presence in the value chain. A fully integrated biotechnological enterprise is present at all steps of the value chain and produces a turnover by selling its products.^[19]

The companies that offer molecular diagnostic instruments may be differentiated from the pharmaceutical developers as there are viewer and less strict official licensing regulations, shorter development cycles and therefore lower development costs.

The technology and service providing enterprises are subordinate within the whole value chain. However, they have a strong impact on the sector as they provide technologies that increase productivity in production and R&D.^[20] Often such enterprises own patents for their technologies and lease them to third parties.

Moreover, research indicated that most business models have also and “extended”^[21] version. Additionally to the core competency consideration stated above, these versions try to include other important measures, such as financing, product and market development, return mechanisms and resources.^[22] Therefore many of those versions exist and it would exceed the scope of this paper to examine all of them.

3 Transparency in the Biotechnology Sector

Fundamentally the transparency of businesses financed by the capital market needs to be rather good in order to gain the trust of investors. Therefore the information concerning products, activities, financial results and strategies have to be communicated in a clear and effective way. The official rules and regulations are a set of minimum standards. The importance of different investor relations instruments is to bee seen in Figure 1.^[23]

illustration not visible in this excerpt

Figure 1: Importance of IR Activities for Investment Decisions and Analysts’ Recommendations (Source: DVFA (2005), p. 32).

A professional investor relations management is beneficial especially for the biotechnology businesses as most of them are not yet profitable and are evaluated according to their future potential to generate profits.^[24]

3.1 Specifics in Investor Relations

Due to the fact that biotechnology businesses do usually not generate enough profits to cover their costs, a steady and reliable information is therefore requested by investors. Instruments that play a major roll in the biotechnological segment are: press conferences, individual conversations with major investors, participation in branch conferences, R&D days, biotechnology forums, phone conferences concerning publications, as well as any other form of information events.^[25]

Concerning press conferences the issue for biotechnology businesses is not only to inform the general public and the investors about the current implication, but certainly analysts. Especially when major strategic decision have been made, such as acquisitions, discontinuance of a product line or the sale of a division, analysts might not only be interested about current, but about the mid and long term implication.^[26] Therefore many biotechnology enterprises organize a special conference for analysts at least once a year, where the future effects of the decision on potential future cash flows and the value of the company are discussed, background information may be distributed and questions concerning the rationales behind decisions may be answered.^[27]

Some analysts play an even more important roll. Big investors and many important groups of investors employ their own analysts which have to be considered opinion formers and multipliers. Therefore it is often crucial to keep a good relationship to those analysts and organize a fluent information flow, often more detailed and complex in nature than the general publications. This process is managed by a IR-Manager that is also the person to turn to for “One-on-One-Meetings”^[28], on which usually a member of the board is present as well. Due to the multiplier function of these crucial analysts the whole capital marked benefits from this special relationship.^[29]

3.2 Specifics in Corporate Governance

Corporate Governance – the management and revision structure of an enterprise with a management board, a supervisory board and a general meeting – is gaining importance under the aspect of transparency. Since 2002 there is a legal standard in Germany (TransPuG + KonTraG in 2005) that supports the corporate governance idea of national and international investors.^[30]

Major elements of the corporate governance codex are the independent supervisory boar, an adequate remuneration of the management in comparison to the sector, an adequate proportion of personal liability of the management for careless actions, the quality of share option remuneration in order to increase lasting employer-employee relationships, and the compliance with accounting regulations.^[31]

3.3 Specifics in Financial Accounting and Reporting

All biotechnological enterprises have to comply with their national GAAP. However, to attract international investors many companies also publish their financial statements according to US-GAAP or IFRS.^[32] In Germany this is even required by law for companies oriented to the financial markets since 2005 (4. Dec. 2004), however there is an extension of two years period for companies using US-GAAP.^[33]

Regardless whether the companies us national GAAP, e.g. German HGB, or IFRS, they do face the problem that the standards have been created for traditional and profitable companies. Therefore their information content concerning a biotechnological enterprise is rather deficient. This is a result of the business model that is based upon long initial research periods where no profits are generated. Part of this problem is, that all investments in R&D are accounted for on the cost side, meaning that non of the medications and other new biotechnological products that are being developed are assets in a balance sheet. Even though under IFRS it is possible to capitalize^[34] immaterial assets, there is the restriction to do this only if a commercialization is probable. For all other R&D projects the capitalization is, however, still forbidden. The picture that is created by a financial statement according to these regulations does not reflect the true and fair view on a biotechnological company as it neglects the value drivers in this industry – namely the research and development. This is a disadvantage for both investors and enterprises seeking financial sources.

[...]

---

^[1] OECD (2006), p. 1.

^[2] OECD (2006), p. 1.

^[3] Cp. DVFA e.V. (2005), p. 2.

^[4] Cp. DVFA e.V. (2005), p. 2.

^[5] Genetically modified food is regularly in the news.

^[6] Cp. DVFA e.V. (2005), p. 3.

^[7] Cp. Statistisches Bundesamt (2003), Graph 2003-15-0220.

^[8] Cp. DVFA e.V. (2005), p. 5.

^[9] Cp. DVFA e.V. (2005), p. 6.

^[10] Cp. DVFA e.V. (2005), p. 8f.

^[11] Cp. DVFA e.V. (2005), p. 9.

^[12] E.g. Ratiopharm in Germany.

^[13] Cp. DVFA e.V. (2005), p. 20, 21.

^[14] Cp. DVFA e.V. (2005), p. 22.

^[15] US American Food and Drug Administration

^[16] Cp. DVFA e.V. (2005), p. 17.

^[17] Cp. DVFA e.V. (2005), p. 19.

^[18] Cp. DVFA e.V. (2005), p. 22.

^[19] Cp. DVFA e.V. (2005), p. 22.

^[20] DVFA e.V. (2005), p. 23.

^[21] DVFA e.V. (2005), p. 24.

^[22] Cp. DVFA e.V. (2005), p. 24.

^[23] DVFA e.V. (2005), p. 32.

^[24] Cp. DVFA e.V. (2005), p. 28f.

^[25] Cp. DVFA e.V. (2005), p. 27.

^[26] Cp. DVFA e.V. (2005), p. 33.

^[27] Cp. DVFA e.V. (2005), p. 33.

^[28] DVFA e.V. (2005), p. 33.

^[29] Cp. DVFA e.V. (2005), p. 34

^[30] Cp. DVFA e.V. (2005), p.36. see also: www.corperate-governance-code.de

^[31] Cp. DVFA e.V. (2005), p.36f.

^[32] Cp. DVFA e.V. (2005), p. 37

^[33] Cp. BilReG, Artikel 10, 4.12.2004.

^[34] Translation of the German word: aktivieren. Gräfer/Scheld (2005), p. 664.