Guest Column | September 27, 2023

Why Royalty Financing Is A Smart Funding Alternative For Small Life Science Companies

By Jody Staggs, president and CEO, SWK Holdings

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Small life science companies are the driving force behind groundbreaking medical innovations that have the potential to transform lives. Yet in a market with strong headwinds, securing financing has emerged as a central challenge. A sector once flush with cash is facing a liquidity crunch as the COVID-19 pandemic recedes from memory and capital markets are more discerning in funding the sector. Without the same sense of urgency prompting widespread investment in the life science sector, companies are left to compete for fewer dollars.

Royalty financing has emerged as an attractive solution to secure funding in the current challenging fundraising environment, offering a range of advantages tailored to the unique characteristics of small life science companies. From preserving ownership and operational and intellectual property (IP) control to providing accessible funding for high-risk ventures, this funding mechanism empowers small enterprises to focus on what matters most, innovating and advancing therapeutics that can shape the future.

Royalty financing, whether the sale of an existing royalty or via the structuring of a synthetic royalty, allows owners to receive up-front capital in exchange for expected future royalty payments. Royalties can be structured as a sale of the entire royalty stream or only a portion if the royalty owner wants to maintain the future cash flows after the royalty is repaid. In either case, the royalty owner receives liquidity today and reduces or eliminates entirely the commercial risk of the product. As an alternative to traditional equity or debt financing, royalty financing offers several advantages.

Small life science companies should carefully evaluate several factors when deciding whether to pursue royalty financing as a funding option. Life science companies need to research potential royalty financing partners and their ability to close a transaction in a timely and cost-effective manner, evaluate the cost of capital compared to debt or equity alternatives, and decide if they desire to sell the entire royalty or retain a residual interest in the royalty stream and share in potential upside.

Customizable Terms

No two life science companies are the same, and their financial needs can vary widely. Royalty financing, and particularly synthetic royalty financing (also known as royalty interest financing or RIF), offers the advantage of customization, allowing companies to negotiate terms that align with their specific circumstances. This flexibility extends to factors such as the royalty rate, payment caps, and other contractual provisions, ensuring that the financing arrangement serves the company's unique requirements.

Non-Dilutive Funding

Royalty financing offers a way to raise capital without diluting the ownership interests of existing shareholders. This means that founders and early investors can maintain their ownership in the company, which is essential for preserving the company's vision and long-term potential.

Risk-Sharing And Alignment Of Interests

Royalty financing aligns the interests of the financing provider with the success of the company. By tying repayment obligations to a percentage of future revenue, financiers are inherently invested in the company's performance. This alignment fosters a sense of partnership and collaboration, particularly if the royalty is structured with a share of future cash flows and not a full sale. These structures can encourage the financing partner to actively support the company's growth and success, while ensuring the seller still has skin in the game.

Flexible Repayment Structure

Royalty financing has an adaptable repayment structure. Payments are directly linked to the company's revenue stream, meaning that during periods of lower revenue, the financial burden is reduced, providing much-needed breathing room for research and development efforts. Conversely, during periods of increased revenue, the payments rise in proportion, ensuring that the financing arrangement scales with the company's financial capacity. This is a major difference compared with traditional debt structures.

Predictable Cash Flow Management

Cash flow volatility can disrupt the operations of small life science companies, impeding research, development, and clinical trial processes. Royalty financing mitigates this challenge by offering predictable cash flow patterns based on a percentage of sales, allowing companies to accurately forecast their financial outflows, effectively allocate resources, and prioritize key initiatives without worrying about sudden financial constraints. The structure is particularly beneficial to companies in which sales do not achieve lofty expectations.

Accessible Funding For High-Risk Ventures

The inherent risks associated with research and development can deter lenders and equity investors from supporting small companies in the life science sector. Royalty financing bridges this gap by providing an accessible funding source tailored to a specific asset, which may be more conducive to investor risk appetites. This is particularly true if the asset is already commercialized.

Preserving IP Ownership And Control

Royalty financing allows companies to secure funding without relinquishing ownership stakes or ceding control over IP and research programs. Unlike equity financing, royalty owners do not demand a share in the company and board representation. Unlike debt financing, royalty owners typically do not have a lien on all corporate assets, although the RIF structure may require a lien on the IP of the product generating the royalty-producing sales.

Long-Term Support For Complex Processes

Royalty financings generally offer a longer-term funding solution compared to debt financing, which often has a four-to-six-year maturity. The royalty structure’s longer repayment period ensures that companies have the resources needed to navigate the entire drug development journey, from research and testing to commercialization.

Potential For Upside Gains

Royalty financing can be a long-term commitment, so life science companies must consider their growth prospects and revenue projections as the sharing of royalties may impact near-term profitability. In many royalty financing agreements, there is a cap on the total royalty payments, or a sharing of payments once certain hurdles are achieved. These features mean that if a product becomes remarkably successful, the company may eventually retain all or a portion of future revenue beyond a certain threshold.

This feature may also narrow the “bid-ask” spread between buyer and seller with each side compromising to complete the transaction. The buyer pays less upfront and takes less risk but does not fully participate in the upside if the drug achieves management’s sales projections. This structure demonstrates the seller believes in the drug’s potential and the potential for upside gains provides an incentive for companies to strive for excellence and work collaboratively toward maximizing the impact of the product.

Final Thought

Overall, royalty financing can present a compelling funding alternative for life science companies, however, the structure is not a panacea. Life science companies considering the structure should work with a trusted advisor to benchmark a royalty financing option against other alternatives.

About The Author:

Jody Staggs is president and CEO of SWK Holdings, a life science-focused specialty finance company catering to small- and mid-sized commercial-stage companies. He initially joined the company in August 2015. Prior to joining SWK, Staggs served in various finance and executive roles at Annandale Capital, Alistair Capital, Highland Capital, and Raymond James. He co-founded PBS Capital, an investment management business investing in pharmaceutical royalties and healthcare equities. Staggs, who has earned the right to use the Chartered Financial Analyst (CFA) designation, was a Walton Scholar and graduated with a B.A. in finance from the University of Arkansas.