The recently announced rescue financing deal for Knight Capital Group (KCG) serves as an object lesson for investors in speculative biotech companies such as Talon Therapeutics (TLON.OB) and Navidea Biopharmaceuticals (NAVB). The capital structure of the firm, taking into account issued and issuable preferred stock, warrants and convertible debt, should be examined carefully before investing.
After a software "glitch" caused KCG to vaporize $440 million dollars in 45 minutes of haywire trading, Knight found itself out of cash with a 40% hole in it's working capital and on the brink of bankruptcy. Management held marathon negotiation sessions over the weekend and ultimately secured $400 million in financing via a convertible preferred share offering to a consortium of investors.
The $400 million restores 90% of KCG's pre-glitch cash, fixes the working capital deficit, and allows KCG to move forward on firmer footing; however, the cost to holders of KCG common was very steep. The convertible preferred shares carry a 2% annual interest rate, a conversion price of $1.50 per share, and a mandatory conversion provision should the price of KCG common stock stay above twice the conversion price for 60 consecutive trading days.
The $1.50 per share conversion price means that, when the $400million worth of preferred is converted, 266.7 million new shares of KCG common stock will be issued. Prior to the trading glitch, KCG had approximately 90 million shares of common stock outstanding, thus the issuance of 266.7 million shares results in dilution of nearly 300%.
Effect on Share Price
On Tuesday, July 17, just 15 days before the glitch, KCG stock closed at $11.74, representing a market cap of about $1.04 Billion. On August 7, KCG closed at $3.06 representing a market cap of $274.25 million based on the 90 million outstanding shares of common stock. However, KCG's market cap is actually $1.1 Billion on a fully diluted basis when one takes into account the convertible preferred shares. Though KCG's balance sheet has been restored to pre-glitch levels, the market is discounting KCG's share price due to the dilution attributable to the preferred shares. Herein lies a lesson for investors in many small biotechs.
Implications for Biotechs
Biotech companies often issue preferred stock or convertible debt to raise capital when issuing common stock is uneconomical. The preferred shares or convertible debt can often have conversion prices that are very unfavorable to investors in the common stock.
Let's take a closer look at Talon Therapeutics as an example. Talon is a development stage biotech company working on cancer therapies. It has developed a liposome (fat bubble) encasing technology that can increase the time a cancer drug spends in the blood stream thereby increasing the dose delivered to tumors without increasing toxicity for the patient. Talon's lead product, Marqibo, is up to FDA approval on August 12th.
In a previous article we outlined Talon's capital structure and the dilutive effect of the Series A preferred shares for holders of Talon's common stock. A casual look at a stock screening tool or popular financial websites would show Talon having 21 million shares outstanding but would miss the fact that holders of the common face up to 1000% dilution in the future when all issued and issuable convertible preferred shares are taken into account.
A July 3rd 2012 sec filing from Warburg Pincus indicates that it beneficially owns 264.3 million shares of TLON common stock. Since Warburg Pincus and Deerfield have a roughly 90/10 split in the financing deal with Talon, Deerfield beneficially owns at least another 26 million shares. (Note, these share counts are as of July 3 2012, after giving effect to the 4 to 1 reverse stock split which took place in 2010).
Unlike KCG, TLON's preferred stock does not have a mandatory conversion provision; however, there is a provision of the investment agreement that investors need to carefully understand. In January of 2012, Talon entered into its second investment agreement with Deerfield and Warburg Pincus. The company sold 110,000 shares of the series A2 convertible preferred stock for $100 per share. Here is the an excerpt from Talon's 8-k disclosing the investment agreement:
The Investment Agreement provides that, from the date of the Investment Agreement until the first anniversary of the Company's receipt of marketing approval from the Food and Drug Administration for any of its product candidates (the "Marketing Approval"), the Purchasers have the right,[ed. emphasis added] but not the obligation, to purchase up to an additional 600,000 shares of the Company's Series A-3 Convertible Preferred Stock (the "Series A-3 Preferred") at a purchase price of $100 per share.
Investors might think that, once Talon receives FDA approval for Marqibo, the company's financing options are wide-open and that it won't need to tap the Series A3 preferred. However, a proper reading of the passage above implies that, since Deerfield and Warburg have the RIGHT to purchase the Series A-3 preferred shares, the company has the OBLIGATION to sell those shares. In other words the company has no choice but to sell those shares at the previously agreed upon price and terms including the very low conversion price of 35 cents (each share of the A3 converts into 285.71 shares of TLON common).
The right to acquire series A3 preferred expires within one year of Talon's first FDA approval. This expiration date virtually guarantees that holders of TLON common will face a very large degree of dilution in the coming year should Marqibo gain approval. It is only logical that Deerfield and Warburg Pincus would exercise their right before it expires.
Change in Intrinsic Value
KCG's recapitalization to fix a trading error left the company's business prospects unchanged. In contrast, when a small biotech company receives approval to market its first product there is an increase in the intrinsic value of the firm. This happens because the company goes from historically generating little to no revenue to potentially generating significant revenue going forward.
In Talon's case, the company estimates that the current indication for its lead drug candidate presents a $100 million per year revenue opportunity. Based on a 4X sales multiple, TLON's market cap could reach up to $400 million on a fully diluted basis if Marqibo is approved.
However, just like for KCG after its rescue, there is a strong possibility that the approval of Marqibo will not have a huge positive impact on TLON's share price because the market will factor in the effect of the 600,000 shares of series A3 preferred, which, when converted to common, represent 171.6 million new shares on top of the approximately 140 million shares currently outstanding on a fully diluted basis. In the longer term, the stock will factor in actual revenue and future catalysts such as full approval, label expansions and development of the pipeline if and when these events occur; however, the dilutive effects of earlier investment agreements represents a major headwind for TLON's stock price into the future.
Preferred Stock is Not Always Bad
Another biotech company with a rapidly approaching FDA decision date is Navidea Biopharmaceuticals. Navidea serves as a counter example to TLON. NAVB has warrants outstanding for 17.5 million shares of common stock and series B and C preferred shares totaling about 36 million shares for a grand total of 53.5 million shares of common stock issuable. Since NAVB has 94 million shares of common stock outstanding, the warrants and preferred shares, though dilutive, will not overwhelm the common stock as TLON's does.
Navidea's management has demonstrated the ability to negotiate financing that is favorable to holders of the common stock. Indeed, it recently secured $50 million in non-dilutive financing, which positions the company very well to move forward with commercialization of its lead product, Lymphoseek, while giving flexibility to develop the rest of their promising pipeline.
The company estimates worldwide revenue from Lymphoseek will be around $450 million per year. Since Navidea receives 50% of Lymphoseek revenue and using the same 4X revenue multiple for valuation, Navidea's potential market cap on Lymphoseek approval could reach $900 million. On a fully diluted basis this would be about $6 per share. Some analysts have 12 month price targets as high as $9 for NAVB based on discounted cash flow models indicating that our back-of-the-envelope calculation of a $6 near-term price target is reasonable. In Navidea's case, the change in intrinsic value of the firm will be larger and the degree of dilution from conversion of preferred stock and warrants will be smaller than for TLON, resulting in a more favorable likely outcome for holders of the common.
KCG longs experienced an unexpected "cram-down" financing round. They had no reason to factor a 70% haircut into their financial projections when looking at the company prior to July 31st. In contrast, investors in TLON, NAVB and other small biotech companies should carefully examine the full capital structure of the firm to account for the effects of future dilution due to existing investment agreements and issued preferred shares or warrants.
As TLON shows, sometimes the wording of the investment agreement gives clues to future dilution over which the company has no control. Navidea is a counter-example to TLON demonstrating that issuance of preferred stock or warrants by small biotechs is not always a negative. As long as management makes prudent decisions about how much preferred stock to issue and at what prices, holders of the common stock can still do well on a fully diluted basis once the company's intrinsic value increases due to approval of a revenue generating product.
Disclosure: I am long NAVB.