The biotech industry has a long history of creative financing structures - proving the point that necessity is the mother of invention. A common structure that has existed in some form or fashion since the early days of the industry involves the use of a special purpose entity to fund the development of a particular product or set of products. Simplistically, this involves the licensing of products or technologies under development to a new entity that is controlled and funded by investors. The sponsor company is typically hired to perform some of the R&D and retains an option to acquire the newco at a pre-established price. The risk of the development is transferred to the investors - albeit with a built-in healthy return if the option is exercised.
These structures have come in an out of use over time due to changes in tax laws and accounting rules and the funding needs of the various participants. The initial version of the structure was the R&D Limited Partnerships used by Genentech in its early years. These partnerships provided a new source of capital to fund innovation and immediate tax deductions for the investors. Tax law changes made the structure obsolete (although, interestingly, BIO has recently proposed amendments to the US tax law that would permit a similar structure for defined types of R&D based on provisions that exists in the code today for oil & gas exploration).
The next evolution, the so called, SWORD or SPARC transactions, often involved companies that had access to capital but were reaching profitability and were seeking a measure of P&L relief by moving certain projects “off balance sheet.” The idea was that the market was beginning to value these companies on earning multiples, constraining R&D investment for the future. I had the opportunity to be involved with a couple of these at ALZA Corp., but many companies including Elan, Genzyme, Centocor and others executed similar transactions. The same basic structure was used by Symphony Capital, whose founder Mark Kessel has played a role in most of these transactions over the years. The Symphony structures were directed at biotech companies that had robust pipelines and were seeking capital to fund development. There was also a value arbitrage thesis in play - if the underlying products worked, the value of the company would presumably increase, allowing the biotech the capital necessary to exercise the option with lower dilution than if they raised the capital along the way from public investors. Unfortunately for many of these transactions, the value arbitrage concept ran into the financial crisis and a stock market that was no longer rewarding companies for their pipeline progress.
Over the last couple of years, interest in these funding models has moved from biotech to the pharma industry. We have been involved in numerous discussions with private equity and venture capital firms, and large and mid-sized pharmas exploring this type of structure to address more constrained R&D budgets and the reality that the companies cannot afford to develop all of the assets in their pipelines.
The accounting rules related to these deals - in particular around consolidation - have also moved over time. For biotechs involved in the Symphony structure, who did not trade based on their financial results, consolidating the losses of the newco was not important. For Pharmas considering versions of this structure, a primary reason for doing the deal is to reduce consolidated R&D expense (along with sharing R&D risk), so the consolidation answer is critical. Getting to that result requires the sponsor company to give up important control and decision making authority over the newco and the programs within the newco, which can be a difficult trade-off. For those considering navigating these rules, a more in-depth discussion of the accounting considerations can be found here.
While the accounting answer is normally a driver for the sponsoring company, investors are often interested in tax efficiency. In future posts, I will discuss the tax considerations for investors.