Financing 101 – Funding the Life Science Mission

David Johnston CFO

December 7, 2021

One of my favorite expressions is that there are three critical components to having a successful biotech company:

• Great science
• Great people
• A boatload of money

I’m going to assume the first two conditions are already met.  So, the question is, “how big of a boatload do we need?”

The rule of thumb is that it often takes about $1 billion to get the first drug through FDA approval.  Better and faster development strategies have lowered that estimate, but not always and often not by a lot.  Even with that, it is safe to assume the following cash needs by stage of development:

• $60-100 million to get through Phase 1 testing ($10-20 million direct clinical trial costs)
• Another $100 million to advance through Phase 2 ($20-40 million direct trial costs)
• Additional $200 million to finish Phase 3 pivotal trials ($60-100 million direct costs)

These are all rough estimates, but the point is you need a pretty big boat!  As with clinical trials, there are normally multiple steps to acquiring the necessary capital for success.  These start out as privately funded rounds and eventually progress to accessing the public equity markets.  Let’s take these from the beginning.

Private Funding

Private funding often starts with seed funding, sometimes called “friends and family rounds,” to launch the company.  These are generally small rounds in the $1-5 million range.  The next step is to attract venture capital investments, denoted as “series” A, B, C, etc., generally increasing in size and valuation with each round as the company makes scientific or clinical progress over several years.  Historically, each round has been less than $100 million and funded the company through Phase 2 proof of concept.  However, we are now seeing fewer venture rounds before the crossover round, and the size of the rounds have grown.

Companies looking to go public often do what is known as a crossover round, the last round of private funding before going public.  It is called a crossover round because you want participation by funds that will ultimately invest in your IPO.  The crossover round accomplishes three major tasks:

• “Tops up” the funding before that IPO
• Establishes leading investors in the coming IPO
• Signals to the world that an IPO is coming soon

There are fewer crossover investors than either venture funds (strictly private) or funds that only invest in public companies.  Messaging and outreach to these crossover funds are critical to the success of the future IPO.  A strong crossover round is a proxy for a strong IPO.

Public Funding – IPO

The Initial Public Offering of equity (IPO) transitions the company from the private world to the public.  Becoming a public entity has two significant advantages over remaining private.  First, it provides relatively quick access to capital in the future compared with lengthy private funding negotiations.  Next, it provides liquidity to investors and employees, some of whom may have had their money tied up in the company for some time.  There are some big hurdles that need to be met, primarily infrastructure requirements and the need to report on a quarterly basis.

The company’s role in the IPO process includes:

• Understand regulatory and compliance requirements and make sure they are resourced
• Fine-tune investor communication materials and pressure test
• Pick a syndicate of bankers to underwrite and market your offering
• Prepare and file registration documents, mainly the S1
• Conduct a “roadshow” telling your story

The underwriter’s (banker’s) role includes:

• Due diligence to assure that the company is what it claims to be
• Assist in developing investor communication materials
• Identify potential investors
• Market the deal to those investors
• Negotiate a price and build “the book” of investors
• Collect an ungodly amount of money for their fee
• Host a closing dinner (make sure they go big on the wine budget)

There are a couple of essential points to remember.  This is the beginning of the public equity journey, not the liquidity event.  Also, you want to price the offering such that investors can make money, so they are likely to invest more in future fundraising rounds.  In other words, don’t be piggy on the pricing.  There’s more to come!

Public Funding – Follow-ons

As their name says, they are equity offerings made following an IPO, generally at least six months to a year or more afterward.  The hope is that catalysts have been met, share value has increased, the IPO investors made money, and demand for this offering is high.  

It is best to make the offering on the back of good news, like positive clinical data, major partnering, etc.  Such catalyst-driven offerings tend to do well.  Opportunistic offerings are done simply because the company needs capital; they tend to do less well and carry a higher discount.

The Bankers

While it has been done, it is extremely rare to enter the world of public equity financing without using investment banks.  It is important to understand the various roles of the banking team. The relationship banker is responsible for day-to-day communication with the company.  This is the representative you will see and hear from the most.

The Equity Capital Markets (ECM) group is the team that has the relationships with the institutional funds that will purchase your equity.  ECM capabilities vary dramatically across banks, and it is best to invest the time to meet your ECM team and get recent feedback from others in the industry.  The ECM team is the primary reason to choose one bank over another.

Banks will often commit to analyst coverage when you use their banking services.  Analysts provide quasi-independent reports offering opinions about your company’s future performance and are considered essential to be optimistic about your prospects.  Due to a consent decree many years ago, most banks have a “Chinese wall” between banking and analysts, preventing the analysts from being unduly influenced to write glowing reports to get banking business.

Building a Syndicate – the Good

When planning for an IPO or any public equity offering, one of the first things that need to be attended to is choosing which banks will do the deal for you.  This group is the syndicate and is made up of book-runners and co-managers.

Book runners are the banks that will do the marketing of the deal, “building the book.”  Their ECM team will determine the success of your offering.  Banks will quite often push for “sole books,” meaning they want the entire book running role for themselves.  There is usually no benefit to the company for a sole book-runner.  Choose two banks to share and widen the marketing effort. More than two banks in book-running roles can be messy and are usually done for very large deals.

The lead book-runner is listed on the top left of the offering document called “lead left.”  Lead left usually manages the stock stabilization and over allotment of 15% of the offering (more on that later).

Building a Syndicate – the Bad

Right up to the moment you start building your banking team, the banks will have tried their best to impress upon you that your company’s success is their top priority.  You will immediately find that, in fact, their top priority is precedent among other banks.  Precedence applies to both the positioning on the offering document and relative fees.  This is where the pecking order matters.  Top banks will fight desperately for “lead left” positioning.

Those on the top try to keep precedence, and those below try to move up.  Top-tier banks prefer to share book-running responsibilities with other top tiers.  However, the tier-two banks have made tremendous inroads, and in many offerings, the tier-ones are absent entirely.

Co-managers are banks listed on the deal but don’t have much, in any, role in filling out the investor book.  It is mainly a way to give relatively modest fees and publicity to banks that have been supportive.

Speaking of banking fees, they will all say it’s not about the fees, and then…

Building a Syndicate – the Ugly

Banks usually get about a 6% fee on an equity offering.  For a $100M IPO, that’s a whopping $6 million!  Some CFO’s brag about beating up the bankers to lower the fee, but my approach has been to tell the banks I accept their fee but expect them to outperform to earn it.

The total fee is split up among the banks based on percentage points.  It always amazes me that bankers seem to forget that there are only 100 points to share!  Book-runners get much of the share, roughly 70-80%, leaving the rest for the co-managers. 

• An example with two book-runners and four co-managers might look like 40-35-8-8-5-4%.  My experience is that the banks will fight tooth and nail for even a half percent.  Over the years, I’ve learned to get recent precedents from my IR firm and base the percentages on recent prior deals.
• Then, when they argue, I go back to their beloved precedent standard and shut it down.
• The “Shoe”
• There is an arcane rule named after the first company that applied it, the Green Shoe Company.  The rule is called Green Shoe, or often just “the shoe.”
• This is the 15% over-allotment of shares granted to the bank that manages the stock stabilization; usually, the lead left banker on the deal.   Once the stock is trading, that bank has the role of buying shares should that price slip and can sell an additional 15% shares should the price stay up or increase
• The proceeds from the sale of the overallotment go to the company at the offering price and any profit made from the sale go to the bank, making this a highly desirable role for the bank.
• Exercise of the entire shoe is a signal that the stock was well received in the market.
• After the IPO
• In many ways, the IPO is the easy part.  Now the less exciting but perhaps more critical activities start.  The days of leisurely quarter-end audits when you were private are over!  Tighter schedules and a myriad of Sarbanes Oxley controls measures kick in.  Rules number 1, 2, and 3 are “no surprises.”

Investor relations is now a big part of future success in financing the mission.  This includes attending conferences and non-deal roadshows (NDR’s), visiting significant current or potential investors.

• Assuming you now have analysts covering your stock, care and feeding of analysts are critical.  Provide access to your CMO, CSO, and CEO.  Some analysts will love you, and some will hate you.  Treat them all with respect and hospitality.  It pays off.
• Inevitably, the company will need to raise more capital.  Hopefully, between the IPO and the next raise, the stock has done well, and the investors in the IPO made money, and there is demand for your stock.  Again, try to focus the raise on some positive catalyst.
• Mix up your syndicate, giving other banks a shot.  Your IPO syndicate will scream bloody murder, but it is important to signal banks that there isn’t a “house band.”  This will keep other banks calling on you because now they know there is a chance to do business.  
• The simple answer is, “you were on the last offering, and you may be on the next, but this time it’s another bank’s turn.”

Converts

• A convertible bond is a hybrid security that offers investors the option to cash it in at the end of its term or convert it to shares in the company.  Convertible bonds offer lower interest rates than comparable conventional bonds, so they’re a cost-effective way for the company to raise money.
• Their conversion to shares also saves the company cash, although it risks diluting the share price.

In other words, the company issues a note (debt) that pays a low annual interest rate with a maturity of typically five or seven years.  The holder of the note has the option to either get paid back in cash at the end of the term or convert the value into stock at some percentage premium to the price of the stock on the issue date.  For investors, it provides a way to participate in future stock value appreciation while minimizing downside risk by holding a note.

For companies, it is often a good way to raise a substantial amount of capital, betting that the stock price will, in fact, appreciate above the conversion price, effectively issuing stock at a premium.  However, it is still debt and converts are best used when future cash flows are highly likely or guaranteed.  A classic use of a convert is funding the launch of a newly approved drug.  

Converts are a complex instrument, and it is best to align with an advisor who can walk you through all of the subtleties to maximize your experience.

Non-Dilutive Financing

There is no such thing, period, full stop.  Any time somebody gives you money in exchange for something, your shareholders now own less of the entity than they did before, so don’t get fooled by such talk.  

That said, there are many ways to raise money without selling shares:

• Partnerships for development candidates
• Geographic commercialization rights licensing
• Royalty stream sales
• Sale of assets

These are all valid sources of capital, particularly if they involve assets or rights that the company wasn’t planning to exploit on its own.

Finally

Of course, the paths to funding your mission that I’ve outlined above aren’t exhaustive. There are many permutations that can be and have been used in addition to these.  Also, funding strategies are constantly evolving.  If you could use some help sorting through your options, give us a call or shoot me an email.

Dave Johnston

[email protected]  508-864-7410