Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.
I have started to write a newsletter on a weekly or bi-weekly basis to supplement my reports and blogs. In this week's edition, I start with some thoughts on financing strategies for biotechnology companies. This can have an impact on stock prices second only to product development news. I follow this with some brief comments on recent events that affect companies that I follow or recent reports that I have written.
Thinking About Financing Biotechnology Companies
I get many comments and questions from readers on financings of biotechnology companies. This prompted me to write this note that gives an overview of how I think about financing options for biotechnology companies and how they can affect companies and their stock prices. No two situations are the same and a financing strategy that is good for one company may be bad for the next. This note is by no means definitive and I offer it only as a starting point.
The business model of biotechnology companies requires that they conduct clinical trials that can take several years to complete and this is followed by a regulatory process that may add a year, or sometimes much longer, before they can begin to sell their product. From when research begins on a new drug to when it ultimately generates sales and profits can be seven to ten years. During this time, hundreds of millions of dollars may be required to fund operations. Even after a product is approved and launched there can be an additional period of one or two years before the product reaches profitability. Gaining access to funds necessary to fund this long development effort is a daunting financing challenge.
Let's trace a typical biotechnology startup to see how management might meet this financing challenge. In its first few years of existence, it is likely that the Company will be funded by management and/or venture capitalists. The VCs make their investment based on looking at the clinical development plans of the company and concluding that they will be able to bring the Company public if the company achieves its objectives. They hope to then pass the financing baton to the public markets through an initial public offering. The proceeds from the public offering will then provide financing for the Company for some period.
It is seldom the case that the initial public offering will provide all of the funds necessary to carry the Company through to profitability. It will likely have to come back, probably several times, to the equity market for additional funding. Because it is in a development stage and has no revenues or earnings, investors value the Company on its ability to meet clinical trial milestones set by the Company. These are based on the design of its clinical trials and results it hopes to show as determined by the primary and secondary endpoints (goals) of the trials. These are meant to establish proof of concept and that the product addresses an unmet clinical need that promises commercial success.
Throughout the long process, there are many potential milestones. The Company starts with pre-clinical studies and then moves to phase I trials that are primarily designed to demonstrate safety and may or may not give a signal of efficacy. Product development then proceeds to phase II trials that test the product in patients who may benefit from the drug with the goal of showing improved patient outcomes relative to standard of care. The next step is confirming in large well controlled phase III trials the hypotheses generated by the results in phase II. The NDA or BLA can then be submitted and hopefully gains regulatory approval so that the Company can launch the product.
The probability for clinical and commercial success increases as the company successfully passes from pre-clinical to phase I to phase II to phase III to receiving approval and then executing a successful launch. As each step is successfully negotiated, the value of the Company is increased and the investor receptivity to providing the company more funds is enhanced. At the point of achieving a successful milestone, the Company can turn to an excited audience of investors if it needs to raise funds. This is all pretty fundamental, but it is good to understand the facts of financing life for a biotechnology company.
Financing Options for Small Biotechnology Companies
If you are an investor in biotechnology companies, periodic financings are a fact of life and necessary for the company to survive and be successful. Nevertheless, there is a belief among some investors that anytime a Company raises money through issuing shares, it dilutes and harms existing shareholders. However, issuing new shares is not always a bad thing for existing shareholders. The willingness of new investors to put money into a company to allow it the financial strength to continue to develop its products and can enhance value for existing shareholders
Management faces an ongoing challenge of keeping a Company well-funded. Other than through partnering, the issuance of straight debt or receiving grants, the Company has to issue shares that increase share count. The key for investors is to assess that the Company is using the appropriate mix of financing instruments and is timing share offerings and partnering at optimal times and from a position of strength. Analysis of this is only slightly less important than understanding products under development. The goal for management and shareholder is to finance the Company through issuing the least number of shares possible and to maintain as much rights to its products as possible.
I can't list all of the financing options that are available for emerging biotechnology companies, but let me go through the ones that are most frequently used and that I am most familiar with. These are traditional underwritten equity offerings in which stock is sold through investment bankers; shelf registrations; partnering; grants; at the market equity lines (ATM) or other forms of equity lines; convertible debt; and straight debt. Let me discuss these.
Traditional Underwritten Equity offerings
This is the most frequently used form of financing, but it is also the one that can be quite onerous for small companies. There is an interval required for marketing the deal from when it is announced to when it is closed which can be a problem. The deal announcement can lead to shorting by hedge funds who know from experience that natural buying dries up in anticipation of the stock offering. They also know that the market capitalizations of small biotechnology companies often are not large enough to interest large institutions. This means that there are a small number of potential buyers and the aforementioned hedge funds may be the major players in closing the deal.
Buyers often have the leverage to demand a significant discount to the recent price, which is probably already down from the time when the offering was announced. To top it all off, the underwriters usually take a 6% or more commission on the offering price. When all is said and done, the price received by a company can be 15% to 25% below the price at which the deal was announced or even more. In the more difficult to sell deals, buyers often demand warrants that may amount to around 50% of shares issued. The deck is really stacked against emerging biotechnology companies.
The earlier a company is in the stages that begin in the pre-clinical setting through phase I to phase II to phase III to regulatory approval to market launch, the more likely it is that it will have to do an underwritten equity offering and at terms like those described in the previous paragraph. Also, missing on a clinical milestone or having a regulatory setback can also force a company into this type of stressful offering. Traditional underwritten equity offerings can work well for later stage companies that are meeting milestones, who have established proof of concept and whose product is viewed to have promising commercial prospects. For smaller companies or those who have suffered a clinical setback, this can be a punishing exercise.
Shelf registrations are a type of public offering that allows a company to sell multiple offerings to the public based on just one prospectus filing. As an example, a company might elect to file to sell 20 million shares, $50 million of convertible notes, $50 million of bonds and 20 million warrants. Off of just one registration statement, the company is allowed to sell any combination of these financing instruments over a period of years.
One important advantage of a shelf is the ability to negotiate in private with one or a small number of buyers. A stock or other form of financing can be executed without announcing the proposed transaction until buyers have committed and this avoids the short selling during the marketing period that often causes a meaningful price decline. This can often be a better alternative for companies than underwritten equity offerings, but not all companies are eligible.
At the Market (ATM) and other Equity Lines
These can be a very favorable form of equity financing for small biotechnology companies and are my favorite method of selling equity. Let's look at how an ATM works. The ATM provider will agree with the company to sell a set amount of shares over a period of time. The company can determine when and at what price the shares are sold; the company can decide to sell on any given day without announcing it to the public. For example if the stock is trading at $3.00 bid and $3.05 asked, the Company might tell the ATM provider to sell a certain number of shares at $3.03 or higher; no shares can be sold below that price.
The discount is usually on the order of 2% to 3% as opposed to 6% or more for underwritten deals. Because there is no pre-announcement to the public, there is no pressure on the stock in anticipation of shares being sold and since the shares are being sold in the open market, there is no further discount to induce institutions to participate. And of course, there are no warrants. If you consider the discount for a traditional equity offering to be the difference in the price from the announcement of the deal to the pricing, the discount can be on the order of 10% to 25% versus 2% to 3% for an ATM.
The one drawback of an ATM is that the company must have good trading liquidity and it takes time to raise significant amounts of money. Usually, an ATM can sell about 15% of the shares that trade daily without affecting the stock price. Let's think of a $5.00 stock that trades 500,000 shares per day. They could raise about $400,000 dollars per day (this is $5.00 x 500,000 x 15% of daily trading volume). Over the course of a quarter in which there are roughly 66 trading days, this Company could raise $9 million by executing the ATM on one of every three trading days. To see how this might work for a company you might be interested in; you can do the math by plugging in share price and average daily trading volume. ATMs require companies with liquidity, for less liquid companies other versions of the equity line may be more suitable. These usually require the provider to hold some of the purchased stock in inventory unlike ATMs.
ATMs and equity lines work especially well when there is a major catalyst that drives up the stock price and trading volume. Let's look at an example of the hypothetical company with a $5.00 stock price that announces extremely good news that cause the stock to surge to $10.00 and trades 2,000,000 shares per day; not an infrequent event. Using the ATM, this company could raise $3 million in a single day ($10.00 x 2,000,000 x 15% of daily trading volume) with a 2% to 3% discount. This underlines the great advantage of the ATM that it can be implemented on same day notification that allows the stock to be sold at a time when the market is receptive to buying the stock. I think that every emerging biotechnology company should have an ATM or equity line.
I often hear investors say that partnering is a non-dilutive form of financing because no shares are issued. It is true that partnering avoids the issuance of shares, but this doesn't mean that it is not dilutive. The partnering company is giving up a large share of future sales and profits for the geographic region in which the product is partnered.
As a rule of thumb, the acquiring company gets 50% of more of sales and profits. Let me make up an example to show how dilutive this can be. Let's say that a product in partnered in year one for $100 million, that the company gives up 50% of future sales and earnings. Let's then hypothesize that the product five years later has sales of $300 million. The market might value this product at five times revenues so that its value is $1.5 billion. In this case the partnering company receives $100 million immediately and gives up $750 million of value five years later.
Some investors immediately proclaim that a partnering deal is good for shareholders, but I think that you can see that it has its own form of dilution. Moreover, the partnering company may give up control of development to a larger company that could let the development flounder if problems develop or it becomes pre-occupied with some other project. Partnering is the best option if the company does not have the financial resources or infrastructure to develop a product. It is often the case that partnering a product in foreign markets is by far the best or only option for a small company.
Grants from governments or other institutions are the only truly non-dilutive source of capital. However, the amount of money received in this manner is usually relatively small and can only be a supplementary source of capital.
Companies sometimes issue convertible bonds in an effort to reduce share dilution. Let's take the example of a Company with a $5.00 stock price. Let's hypothesize that it is able to sell a $100 million convertible bond issue with a ten year maturity at a 5% annual interest rate and that the debt is convertible into common stock at $6.50 per share. If all goes well and the stock is at or above $6.50 in ten years, the $100 million can convert into 15.4 million shares (at $6.50). This would compare to 20 million shares if the stock were sold at $5.00 per share to raise $100 million. There is also the added cost of $5.0 million of annual debt service.
There are investment funds that concentrate on buying convertible notes and that use a hedging strategy. Let's say that such buyers purchase the entire $100 million convertible bond offering. Their strategy is to then short the stock, selling 15.38 million shares (I'll explain the 15.38 million shortly) at the current price of $5.00. The shorting results in $76.9 million of cash so that their net exposure is $23.1 million ($100.0 million less $76.9 million.) Throughout this report, I ignore transaction costs, the time value of money and the probability that the note might be callable in order to reduce the complexity of the calculations.
In the situation in which the stock goes up and surpasses $6.50, regardless of how high the stock goes, they can ultimately cover their short position of 15.38 million shares by converting their $100 million of convertible bond holdings into the identical 15.38 million shares. They also will receive $5 million of annual interest payments as long as they hold the bonds. The $5 million of interest payments could cover their $23.1 million exposure in 4.7 years. Over ten years, they would receive $50 million of interest payments versus their investment of $23.1 million.
If the company were to fall on hard times with say the stock dropping to $2.00 at the end of ten years, the short position established at $5.00 could be covered in the open market and would be worth $46.1 million. However, the company would also owe the buyers $100 million to repay the debt and the bondholders continue to get $5 million of annual interest payments. In this scenario, over a period of ten years, bondholders could receive a profit of $196 million; this would be $46.1 million for covering the short position plus $100 million for the debt repayment plus $50 million in interest received. This would be a massive win for the convertible bond holder.
From the standpoint of the Company and shareholders, this can be a very cheap source of capital if the Company executes on its strategy and the stock rises quickly to above the conversion price of $6.50. In the short term, it is bad for shareholders because as the bondholders establish their short positions, it puts pressure on the stock. If the company fails and the stock remains below $6.50, the convertible debt become the equivalent of standard debt and is a massive overhang on the company. In this example in which the stock drops to $2.00, the company might have to issue 50 million shares at $2.00 to repay the $100 million of debt.
Issuing convertible debt allows no room for setbacks and if they do occur, there can be disastrous consequences for the company and shareholders. I do not like the risk profile on this financing instrument. This is the situation that Dendreon (NASDAQ:DNDN) now finds itself in.
Increasingly, small companies are turning to venture debt for financing. This avoids the issuance of shares and may or may not have warrants. This financing is fine if the Company anticipates that the debt can be used to bridge between milestones. For example, let's say that the stock of the hypothetical company I have used in previous examples is selling at $5.00, but that it thinks that a milestone that may occur in a year could double the stock price. It might elect to postpone an equity offering until the milestone is reached and use venture debt for interim financing needs.
I think this is a very risky financing strategy and one that I don't like. If it works as planned, it can reduce the number of shares that need to be issued. However, a major problem arises if something goes wrong as so often happens in biotechnology such as a clinical trial setback or a regulatory issue and the stock declines. This could force the company into issuing shares (at a lower price) for both operational needs and to retire the debt.
Equity Offerings Can Be Good for Existing Shareholders
This is clearly illustrated by a recent financing of Trius (TSRX). The Company announced an equity deal on January 18 2013. The closing price on the day of the offering was $4.90. As investors realized that this deal meant that the company was now well funded to take its lead product tedizolid through product approval in mid-2014 and was in a strong position to bargain with partners, the stock has performed very well. At the latest closing price of $7.95, the stock is up 62% since the offering. See my report on the financing.
I think that it is in the interest of shareholders that a company incorporates all of these financing options in its strategy. The goal is to always keep the company in a position of financial strength. It is an unavoidable fact of life that biotechnology companies will have to raise a great deal of money and issue shares or partner to do this. The goal is to issue the fewest number of shares possible and to give up minimal product rights to a partner.
Updates and Thoughts on Companies
Cadence Pharmaceuticals: Patent Concerns Linger
I continue with my buy recommendation on Cadence (CADX). There are two fundamental issues that are key to the stock. The first is the performance of Ofirmev. There was a time when some were questioning whether the launch of Ofirmev was successful. That issue has been largely answered as the product appears to be on a strong growth trend. See my recent report.
Now, the overriding issue relates to generic challenges to the patents that protect Ofirmev. This note provides a brief update on the patent issues. A settlement was reached with Perrigo in December 2012 in which that company has agreed not to launch a generic until 2020, providing no other generic comes to market before then. Cadence and Exela, a small privately owned company, are now litigating the patent challenge. The trial began on Monday, May 20 and will conclude on May 29. Based on prior experience, the judge's decision could be released in six to nine months, possibly in 4Q, 2013 or 1Q, 2014. However, a settlement with Exela could be reached at any time before then. I believe that the patents are strong and Cadence will prevail, but there can be no assurance. My best judgment remains that Exela and Cadence will reach an agreement that allows Exela to introduce a generic in 2019 or 2020.
Two other companies have subsequently filed ANDAs against Ofirmev. Fresenius filed an ANDA in December 2012 and Cadence sued them for patent infringement in January 2013. This means that the earliest Fresenius could launch a generic would be July 2015. Sandoz filed an ANDA in January 2013 and was promptly sued by Cadence. The earliest they could launch a generic is August 2015.
There are two divergent reasons for diametrically opposite explanations as to why these two ANDAs were filed. They may believe that even if Exela doesn't prevail that they have discovered new grounds that might allow them to overturn the patent. On the other hand, they might be positioning themselves to be able to reach a settlement that would allow them to launch a generic at the same time as Perrigo and Exela, assuming this company decided to settle. I am inclined to believe the latter. As I have written earlier, the Markman hearing went very well for Ofirmev and shortly thereafter Perrigo elected to settle. I think this was important because Perrigo has the financial strength to pursue this case as it has a market capitalization of $11 billion.
There are strong reasons to believe that Exela also will settle with Cadence. Perrigo has much greater financial strength and infrastructure than Exela and its decision not to fight the patents, suggests that the patents are strong and defensible. My best estimate is that Exela will ultimately settle and this tactic aimed at getting better settlement terms.
The stock seems to be stuck in a trading range due to the patent issues. A favorable resolution with Exela would be a significant catalyst. However, there will remain an overhang until we can determine the intent of Fresenius and Sandoz to go to trial or settle. This would be sometime after the outcome with Exela is known.
Neuralstem: Some Additional Thoughts on Phase I Results
There were some comments on Seeking Alpha about my recent article on Neuralstem (NYSEMKT:CUR) that I wanted to share with readers who may not have seen them. The comments were based on the thought that the impressive results shown with four patients in the phase I trial may have been the result of the trial including patients who were more likely to respond or who were fortunate enough to have a spontaneous improvement.
I responded as follows:
"ALS is a disease in which neurons are progressively destroyed in the spine. Other than in the hippocampus, I am not aware of any region in the body in which neurons are regenerated. In ALS, neurons are progressively destroyed in the spine through a mechanism that is not well understood. For spontaneous improvement to occur, the body would have to create new neurons in the spine which seems unlikely based on current knowledge. Hopefully, this is what CUR's neural stem cells are doing. This is what makes the Ted Harada experience so interesting as clearly his condition improved.
You are quite correct to be skeptical that this proves that CUR's neural stem cells work based on only four truly evaluable patients. However, it is very definitely a strong signal of potential efficacy that is very unique in the long disappointing history of trying to find an effective treatment for ALS.
I did talk to ALS specialists who tell me that in the vast majority of patients that they treat, the disease causes a linear decline of about 0.9 points per month on the ALSFRS scale and that at best they see a stabilization for one, two or three months before the patient continues to decline. This is of course anecdotal information. And, there are atypical patients like Stephen Hawkins who live a long time. The ALS society says that 50% of patients live two to five years from time of diagnosis. They also estimate that 5% of patients live 20 years of more."
Northwest Biotherapeutics: Phase III Begins in the UK - On May 16th, Northwest (NASDAQ:NWBO) announced that the phase III trial of DC Vax-L had begun at King's College Hospital in London. I thought that readers might be interested in seeing the news release from King's College Hospital.
A.P. Pharma: Waiting to Hear From New Management - I recently wrote that the management change at A.P. Pharma (APPA.OB) was a positive catalyst for the stock. I am waiting for the new CEO, Barry Quart to begin a dialogue with the Street. After his success at Ardea, Mr. Quart has "Street cred" and investors will be listening to hear what he has to say about the company, the NDA resubmission and the launch of APF530. One of my sources tells me that Mr. Quart is likely to become more visible in coming weeks or months.
Disclosure: I am long APPA.OB, CUR, CADX, NWBO, TSRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.