By Michael O’Donnell, partner, Morrison Foerster
With the exception of several mega-financings for blue chip management teams in companies such as Juno and Denali from syndicates of well-heeled venture funds such as ARCH Ventures and Flagship Ventures, venture financing for startup life science companies has been relatively lean for the last several years. However, the good times were rolling in 2014 and early 2015 for later-stage biopharmaceutical companies with a substantial number of IPOs, which in turn led to a significant increase in the number of mezzanine financings, representing easy money for later-stage biopharma companies. Mezzanine financings are intended to be the last financing round prior to the IPO with investments being made by so-called crossover investors such as RA Capital and Deerfield, which participate in both private and public financings. Mezzanine financings are attractive to companies because they can be completed faster and more easily than an IPO without the necessity of public disclosure of company information, and they provide the company with a group of new investors who are likely to participate in the company’s IPO, priming the pump for successful marketing of the IPO to follow. Mezzanine financings are attractive to the crossover investors because they enable the investor to invest at a discount to the IPO price and provide the investors with a high degree of assurance that they will be able to fully participate in the IPO syndicate when they might otherwise be shut out of a hot offering.
When things go according to plan with the mezzanine financing followed by a well executed IPO, it is a win-win for the company and the investor. IPOs with crossover investors have performed better than IPOs without crossover investors. However, if the IPO window begins sliding shut (as has happened recently) following the mezzanine investment, the company is stuck with impatient investors desiring liquidity, which can lead to tension between management and the investors due to divergent interests. As would be expected, the recent tightening of the IPO market, with deals getting smaller and being done (if at all) at lower valuations, has had a severe impact on the current availability of mezzanine financing.
So what’s a later-stage biopharma company (BioCo) to do? One alternative that has been used by a number of my clients is an option deal with a Big Pharma company (PharmCo) which is interested in acquiring BioCo or rights to a particular BioCo product but wants to see more progress before actually doing so. In exchange for a large (say $50-$75 million) up-front cash payment, PharmCo is granted the right for a period of time (usually until the achievement of a specified clinical milestone) to acquire BioCo or exclusive rights to the product on pre-agreed terms including the purchase price. Note that the up-front cash payment can be structured either as an option fee, which is better for BioCo but will have adverse accounting treatment for PharmCo, or as an equity investment at a price favorable to BioCo, which will involve dilution for BioCo shareholders but may enable more favorable accounting treatment for PharmCo. Also note the option may be structured as a “put” where PharmCo must exercise the option if the specified milestone is met (which is better for BioCo but may lead to a considerable amount of negotiation over what exactly it means to meet the milestone), or a “call” where PharmCo can elect to exercise the option whether or not the milestone is met, which is simpler to implement.
Once again, when things go according to plan, the option deal structure can result in a win-win. BioCo can raise the cash necessary to achieve the clinical endpoint enabling a successful sale of the company or the product rights while PharmCo can mitigate the risk that the milestone may not be met. But there is the rub for BioCo. If PharmCo does not exercise the option, BioCo is left at the altar with a program perceived to be a failure and therefore difficult to further finance or sell to someone else. To avoid that problem, BioCo needs to raise enough cash in the initial option payment to not only fund all development costs to achieve the milestone but also to fund all of its operating expenses for at least 12 months, but ideally 18 months, after the expected date of the milestone completion. In doing so, BioCo will have enough time for the taint of PharmCo’s decision not to exercise the option to wear off and allow BioCo time to come up with plan B.
The changing winds of mezzanine financing require later-stage biopharmaceutical companies to constantly seek creative alternative financing structures. Option deals can provide companies with the cash necessary to obtain sufficient clinical data to raise additional private or public equity financing or achieve liquidity for the company’s shareholders.