Tissue engineering's only pure play reminds me of the title of 50 Cent's breakout album. Bulls believe that it is on the bleeding (sorry) edge of a global revolution that will transform everything from drug development to disease management to organ transplants. Bears believe that it is merely another sexy story that will ride Gartner's Hype Cycle and then fade away into obscurity when the profound technical hurdles prove to be insurmountable and the market moves on to "the next big thing".
Personally, I perceive that reality resides somewhere in between these two extremes. Organovo (ONVO) is, indeed, a leader in an emerging space that has substantial growth potential. To accomplish its goals, though, substantial money and patience will be required. This is why I chose the title that I did. It perfectly describes two investor groups. The "Get Rich" crowd comprises certain executives, a private equity group and its network of dealers and early investors who participated in the financing events surrounding the reverse merger in early 2012. As I explain later, these individuals have done extraordinarily well financially. The "Die Tryin" group consists of retail investors who literally buy into the story as most of the current shareholders/insiders cash out (Prospectus filed 4/4/13). Another jab to the chin will be significant stock dilution in the medium term as ONVO invests in new technologies, patents and/or acquisitions as it develops its business. The CEO states in his presentation to retail investors that there may be future share dilution resulting from raising cash to pursue growth opportunities. The cash required to do this may be as high as 2x - 3x current levels. This will create headwinds for share price appreciation. The big payday is possible, but it will take Buffett-esque patience to get there.
Here are the firm's latest financials.
The numbers are typical for a development stage company. Of the $2.8M in revenue since inception, only ~8% is product. Collaborations and government grants have been and will remain a significant portion of revenue in the near term.
The company is the only publicly traded firm operating in the tissue engineering segment, principally bioprinting, of regenerative medicine. As we all know, regenerative medicine has the awe-inspiring potential to redefine many aspects of traditional medicine. Although, enormous technical challenges remain unconquered, some observers believe that many will be eventually overcome transforming a select group of innovative companies into mega-caps. Whether or not ONVO has first mover advantage is debatable, but it appears to be one of the early leaders.
The company intends to make money three ways:
1. Develop 3D disease models as part of research collaborations with drug firms. According to Mr. Murphy, anticipated revenue will be royalties (3% - 7%) plus milestone payments.
The two collaborations ONVO has closed thus far appear to be more preliminary in nature. The Pfizer (PFE) agreement, valued at $600k, closed in December, 2010. It focused on developing tissue-based drug discovery assays in two therapeutic areas. The company delivered constructs to PFE last year for evaluation. A subsequent study report completed the deliverables. In October, 2011, a research collaboration began with United Therapeutics (UTHR) to discover treatments for pulmonary hypertension utilizing the NovoGen Bioprinter. Services were rendered on a fixed-fee basis for a total value of $1.365M. In November, 2012, the parties extended the agreement for an additional $135k. At the end of 2012, 75% of the work was complete. The remaining $376k will be recognized this year.
A collaboration with the Knight Cancer Institute at Oregon Health & Science University (OHSU) was signed in late January of this year. Its purpose is to develop more clinically predictive in vitro 3D cancer models. This agreement does not appear to be a significant near term revenue producer since no financial terms were disclosed.
2. Develop (and eventually market) 3D human tissues for use as therapeutic regenerative medicine products. Blood vessels, nerve grafts and cardiac patches are the initial target areas. Printing large tissues and fully functional organs is the ultimate goal. This is a very long term objective so patience will be the prescription because here is where the technical hurdles are most pronounced. ONVO's collaborations with Harvard, Sanford Consortium and Wake Forest, all academic institutions, reinforce today's experimental nature of the science.
3. Develop and market 3D cell assay products. These will be sold "off the shelf" in a catalog. Data on its first product, a liver assay, was presented last month at the Experimental Biology conference in Boston. ONVO plans to complete its functional validation by the end of this year, initiate alpha testing with key opinion leaders by April, 2014 and avail it commercially by late 2014. Other targets are heart and kidney tissues.
In the medium term, ONVO's principal value driver will be bioprinting 3D human tissue products for research use. These constructs more closely resemble the in vivo microenvironments than monolayer cell models. Researchers will benefit from significantly better drug study data in areas such as ADME, TOX and DMPK.
In its liver assay, for example, the 3D architecture of the tissue enables organ-like functionality such as albumin and transferrin production, biosynthesis of cholesterol and inducible cytochrome P450 (group of enzymes instrumental in drug metabolism) activities. Albumin production is five to nine times greater than 2D models on a cell-to-cell basis. Progress has also been made on the technical problem of microvascularization, which is the limiting factor to tissue size and shelf life. Although not determined conclusively, the functional life of the liver assay has been as long as 135 hours.
The long-term value driver will be constructing tissue therapeutics via bioprinting for implantation in humans. This represents a colossal commercial opportunity for the firm(s) that can get through the regulatory process, but it is years away. The current state of affairs remains experimental. It could be a decade or more before a company can establish a viable business in this arena, in my opinion.
All companies have the usual laundry list of boilerplate risks, but ONVO has two significant ones that warrant mentioning:
1. Building in-house cell culturing and tissue engineering competencies. The company intends to outsource its base cells (e.g., Zen-Bio, Inc.) culture them internally, bioprint the tissues and then grow them in preparation for implantation. These processes are extraordinarily complex and extremely technically demanding. ONVO will need a world-class organization to be successful. For example, strict quality control is mandatory for cells to grow, aggregate and develop properly. The smallest deviation is ruinous. This will require enormous investments in personnel and equipment. As I mentioned in my earlier article, the Wake Forest Institute for Regenerative Medicine, a global leader in the field, employs ~300 MD/PhDs. As far as I know, it is the largest regenerative medicine research organization in the world and it has only produced a small number of experimental implantable tissues (bladders, blood vessels) despite 18 years of effort. ONVO allocates only ~10% of its R&D budget to therapeutic tissue development so there is a long road ahead.
2. Insufficient capital. ONVO will be a voracious cash consumer for its entire lifetime. Revenues from collaborations, government grants and from the sales of cell assay products will be relatively modest. They should be able to sustain a moderate growth rate for the firm, but there is no way that it will adequately fund the therapeutic tissue business. In my opinion, ONVO will need ~$300M to reach sustainability in therapeutic tissues manufacturing.
So should a retail investor establish a long position in light of the significant long-term potential? In a word, no. I believe that the sideline is the proper domicile for individual investors at present. There are four main reasons:
1. A large number of current shareholders intend to cash out. If you refer to the recent prospectus (filed April 4), 190 shareholders are tendering 32,095,974 shares. This represents 99.7% of their current holdings of 32,176,674 shares and ~50% of the outstanding shares. Only two investors out of the 190 will maintain modest positions. This is a classic exit strategy move, although much of the selling may have already occurred. The April 4 prospectus was a refiling of the original prospectus filed on July 6, 2012 (the S-1 was filed on June 13, 2012). If ONVO's prospects are bullish, why have so many stakeholders exited or plan to exit?
2. The company has no recurring product revenues. Since its inception, ONVO has generated only $224,000 in product sales (FY11). Its first commercial product, the liver assay, will not be available for sale until mid-to-late 2014. Research collaborations and government grants will continue to provide the bulk of revenues for the next several years.
3. More capital will be needed next year. The company's cash balance as of 12/31 was $14.8M. Operations burn ~$9M/year so it only has ~1.5 years of cash to work with. Future share dilution is a certainty.
4. ONVO is a reverse merger stock. Unfortunately, there is a substantial taint surrounding this method of accessing the capital markets, especially after the wave of odious Chinese micro caps of a few years ago. RM companies are characterized by little or no operating histories, poor financials and thin capitalizations. In other words, they are not ready for the prime time exposure of an IPO. ONVO fits this profile.
Although, I do not perceive the timing to be right for a long position today, I do agree that, at some point, the regenerative medicine firms will be on Gartner's Hype Cycle and have their bull run. I do not want to speculate as to when, but one data point should help: the appearance of regenerative medicine IPOs. This is a classic sign that institutions perceive robust demand for shares. For example, Harvard Apparatus Regenerative Technology (HART) was "on deck" to price its IPO ~1 month ago, but pulled back. I took note.
The Reverse Merger: A Case Study
My reason for analyzing ONVO's transaction was to answer one question: what is the value of an otherwise-worthless shell company to the merging party? As it turns out, quite a lot.
The first reverse merger to get my attention involved the small biotech firm Trovagene (TROV). Before it changed its name, it was known as Xenomics. Back in 2004, it consummated a reverse merger with an internet shell company called Used Kar Parts. I thought this pedigree was hilarious until I saw that Panetta Partners paid the UKP CEO ~$386,000 for the privilege of taking the shell off her hands. Not bad.
On the odd couple front, ONVO's reverse merger partner, Real Estate Restoration and Rental (RERR), compares favorably to the UKP deal. How did ONVO find it? What did it pay for it? Who made the money? I found answers to these questions and more in my analysis. Let's look at what happened.
The most entertaining part of the work pertained to RERR. This venture reminds me of what a couple of college kids would do: perceive a business opportunity and dive in without a plan, money or experience.
It was incorporated on December 15, 2009 under Nevada law by Ms. Deborah Lovig, a marketing manager for Cree (CREE), the LED lighting manufacturer. James Coker, a regional sales manager for diagnostic imaging division of Siemens (SI) joined shortly thereafter. The only relevant experience between them was Mr. Coker's brief experience buying and remodeling homes in his spare time in the Philadelphia area. The company and the founder were based in Durham, NC whereas Mr. Coker lived in Columbus, OH.
Ms. Lovig started the venture in order to take advantage of local depressed real estate prices. She planned to buy distressed properties from banks, renovate them and then rent them out. Here is the description of the business from the S-1 (10/13/10):
The Company was formed in December 2009 to take advantage of the economic downturn and the resulting depression in the real estate market, especially the vacation home market in North and South Carolina. Our plan is to purchase foreclosed and distressed vacation and rental properties at below-market prices, complete any necessary renovation work, manage and rent the properties. We will focus primarily on Real Estate Owned ("REO") properties at desirable North and South Carolina beaches. REO properties failed to sell at foreclosure auction and are therefore owned by the defaulted lender. These properties become non-performing assets on the defaulted lender's balance sheet. As financial institutions, these lenders become especially motivated to sell these properties to strengthen their own financial profile. We find purchasing foreclosed properties from the lenders significantly more attractive than from individual owners. We can more easily inspect REO properties, and assure that all liens and mortgages have been cleared and we will be dealing with a professionally managed institution during the purchasing process.
RERR's 2-person executive team, though, seemed unprepared to pursue negotiations with banks. Here's another statement from the S-1:
A substantial portion of our activities to date have involved developing a business plan and establishing contacts and visibility in the marketplace.
This sounds a bit premature. Should this not have been done before incorporating and offering shares to the public?
Comically, two pages later in the S-1 I found the following statement:
While we have had some limited success finding distressed properties, it is finding the time necessary to bring deals to a close that takes much longer than first anticipated. As a result, we also plan to explore business opportunities in other fields.
This sounds like the endeavor was taking an inordinate amount of time to gain traction. How much time were the principals putting in? Here's another gem from the S-1:
We currently have two employees: (1) Deborah Lovig, our President and Director, who works 30 hours per work as the general contractor; and (2) James Coker, our Secretary and Director, who works 2-3 hours per week.
This clearly is a side venture for both executives. So much for the original business plan. RERR then explains its change in direction in more detail:
The Company will attempt to obtain green energy solutions for its portfolio of properties and possibly for resale to other property owners. Ms. Lovig has global-scale expertise in sustainability and energy efficiency solutions and the Company will attempt to install solutions such as LED lighting, solar power and solar heating for its properties. It may act as a reseller of these solutions to other property management firms. The Company will also seek to acquire access to commercial/industrial level solutions such as geothermal and Frigitek (fan speed controls for cooling condensers) that have potential to be repositioned or re-engineered for residential applications. These solutions would be obtained through a nonexclusive patent license agreement. The company is initially working with Madison Energy Group on an exclusive licensing agreement for the sale of Frigitek products.
It appeared that Ms. Lovig planned to use her CREE network to try to drum up some business. She eventually signed a license agreement with Madison for an upfront fee of $30k plus royalties. Only one unit was ever sold, generating $1,677 in revenue (sales commission).
During the back-and-forth with the SEC on the S-1 submission (more on that later), RERR disclosed the following in December 2010:
We have not yet acquired any properties or green energy solutions. Our activities to-date have been investigative in nature and we are identifying prospects and evaluating their revenue potentials.
Our principal business strategy is to contract with development companies and hedge funds that purchase foreclosed properties from financial institutions...
The development of our operations will require the commitment of substantial resources to implement our business plan. In addition, substantial expenditures will be required to enable us to make necessary renovations and market the properties for the rental season . Currently, we have no established bank-financing arrangements. Therefore, it is likely we would need to seek additional financing through subsequent future private offering of our equity securities, or through strategic partnerships and other arrangements with corporate partners.
Over the next 12 months the company plans to focus primarily on finding institutions willing to lend into this market.
At this point, it is abundantly clear that the business was going nowhere. Negotiations with the banks hit a wall so they changed tactics and focused on development companies and hedge funds. No reportable progress was made there either, so Ms. Lovig decided to sell Frigitek products, but only one was sold. Considering the founder's lack of preparedness, lack of industry experience and the modest number of hours devoted to the venture, the outcome was predictable.
Here are the financials:
The details on the financing and capitalization fronts were interesting as well.
Shortly after the incorporation in December 2009, Ms. Lovig issued herself 4M shares at a value of $400 for services rendered. In February, she signed a consulting agreement with Europa Capital Investments, for administrative and other services for a fee of $5k/month. One of Europa's services is exit strategies. The managing director in charge of the arrangement was Peter Coker, James' uncle. My guess is that Peter was the matchmaker between James and Ms. Lovig and he provided entry into the banking/hedge fund network to access the distressed real estate.
In June 2010, RERR raised $178,250 of capital via a private placement of 1,782,500 shares @ .10/share to 44 investors. The company issued 1M shares to Ms. Lovig for $100 raising her stake to 5M shares. In September, it placed an additional 20,000 shares. This increased the total capital to $180,250. One month later, RERR submitted an S-1 to the SEC registering all 1,802,500 shares for sale by all the investors. This prompt planned exit caught the SEC's attention, among many other items, so in its first revision, RERR adjusted the amount of tendered shares down to 566,500.
RERR had to revise its S-1 six times because of various inconsistencies, omissions, misstatements and inadequate disclosures. For example, it stated that 44 investors were tendering shares, but listed only 35 in the document. The SEC finally declared it effective on May 13, 2011.
I will speculate that sometime in 2010, Peter Coker advised Ms. Lovig to pursue the registration of RERR shares in order to create a public shell. A reverse merger would provide an avenue for the shareholders to avoid a loss since the business was going nowhere and funds were being rapidly depleted. The only other alternative would have been to fold up shop and move on. I will further speculate that sometime in early-to-mid 2011, ONVO entered the picture after Peter Coker began marketing RERR's availability through his financial network. The principals agreed to the ONVO/RERR reverse merger sometime in the summer/early fall. In October, RERR received the first of three interest-free loans from an "unrelated party". RERR received a total of $9,500 from these loans in order to prepare for the merger (the second loan was made in November and the third in December). In my opinion, anyone on the ONVO side could have made these small loans, but the most likely source was Spencer Trask Ventures, a NY-based private equity group and ONVO's stock placement agent.
The reverse merger was signed on December 28, 2011.
Now let's look at what happened with ONVO. It was incorporated in 2007. 100,000 shares were authorized. In February 2008, the first of several convertible (principal and interest) notes were issued raising a total of $2.39M. The founders (CEO + 3 Directors) were issued 11,779,960 shares vesting over 4 years.
Nothing else happened with financing until mid-2011. In July, $740k of convertible notes with an exorbitant 20% interest rate were issued by Spencer Trask Ventures ("Bridge Notes"). This was the first money-making step by the principals involved in the reverse merger because the interest was convertible into shares. The timing of this transaction roughly aligns with the interest-free loans to RERR.
In October, the convertible notes were called in. $3,030,000 in principal and $459,800 in accrued interest converted into 7,676,828 shares (~.45/share). This was the second money-making step (although not necessarily the merger principals).
In December, a $1.5M convertible note was issued due 3/31/12. This was the third money-making step.
Management amended its certificate of incorporation increasing authorized shares from 100,000 to 75M. This enabled the enormous stock payouts.
The reverse merger transaction occurred next (bold type mine).
Organovo Reverse Merger Sequence of Events
Merger agreement signed between Real Estate Restoration and Rental, Inc. (RERR) and its newly formed subsidiary, Organovo Holdings, Inc. ("Merger Sub"). RERR formed "Merger Sub" by issuing one share of stock.
Subsequent to the merger, "Merger Sub" ceased and the surviving company's name was now Organovo Holdings, Inc. ("Holdings Nevada").
The sole purpose of the reverse merger was to change the name.
"Holdings Nevada" merged into its newly formed subsidiary Organovo Holdings, Inc. ("Holdings Delaware" or "Pubco"). "Holdings Nevada" formed "Pubco" by issuing one share of stock. Authorized capital stock of "Pubco" increased to 150M common shares and 25M of blank check preferred shares from RERR's 100M and 10M, respectively.
Two new "Pubco" subsidiaries are formed: Organovo Acquisition Corp. and Organovo Split Corp. ("PSOS").
RERR executives Deborah Lovig and James Coker nominate four Organovo stakeholders to the board (three Organovo executives (CEO and two Directors) and one principal of Spencer Trask Ventures) and then resign.
"Holdings Nevada" ceases.
The sole purpose of the reverse merger was to redomicile the company from Nevada to Delaware.
Organovo, Inc., the actual operating company, merges into Organovo Acquisition Corp. It survives as Organovo, Inc., a subsidiary of Organovo Holdings, Inc.
Organovo Acquisition Corp. ceases.
"PSOS" was formed for RERR shareholders as a means to exchange RERR shares for ONVO shares. Subsequent to the exchange, "PSOS" ceases.
The purpose of the reverse merger was to establish the final corporate structure and to compensate the RERR shareholders.
Trading commences on the OTCBB under the symbol "ONVO".
ONVO issued 21,247,987 shares in the reverse merger. This represents ~$96M based on the recent share price.
In February and March following the conclusion of the reverse merger, three private placements were made via issuing units (one share of stock + one warrant to purchase one share of stock for $1). The first placement also converted the Bridge Notes. ONVO raised a total of $15.2M in these three transactions but issued ~16.7M warrants and ~15.4M shares bringing the total shares offered to 32.2M representing a current value of ~$145M.
In June, only three months after the last private placement, ONVO submitted an S-1 to register the sale of 32.1M shares by 190 shareholders (99.7% of their holdings). If successful in unloading these shares to the public, insiders and early investors will have pocketed ~90% of the total capital raised. This is a classic exit strategy move that is almost totally reliant on the naiveté of retail investors.
How did the stock placement agent make out? Spencer Trask Ventures did quite well. It received 5,489,040 shares for its work on the reverse merger plus 610,155 shares for the bridge notes. At today's price, this represents ~$27.4M.
Company executives made out quite well. According to the prospectus, insiders own 16% of the 64,646,665 total outstanding. This represents a value of ~$47M. The founder, Gabor Forgacs, owns 9.7% of the shares worth ~$28M. These lofty amounts are not considered excessive, though, because ONVO's 2012 stock plan provides for the issuance of up to 6,553,986 additional shares to company personnel worth ~$29M at current prices.
So how did Ms. Lovig fare in all this? The specific purchase price that the financiers paid for the RERR shell was not disclosed, but an ONVO representative informed me that it was roughly comparable to what Xenomics paid for Used Kar Parts. This is a significantly more modest return than other participants, but still impressive for a failed venture.
This reverse merger was executed to perfection, in my view. All the stakeholders were generously compensated, ONVO obtained access to the capital markets, RERR shareholders turned a loss into a gain and certain individuals are, by now, relaxing on a tropical beach with a Mai Tai in hand. This is the "Get Rich" group to be sure.
And what about our retail investor brethren? Current longs are, unfortunately, in the "Die Tryin" group. They may be rewarded some day. Hope springs eternal. Caveat emptor.