Capital Financing Options for Early-Stage Life Sciences Companies

David H. Crean, the Managing Partner for Cardiff Advisory LLC, offers his guidance to company executives of emerging life sciences companies on the various funding avenues to consider and pursue in building value, especially in today's volatile marketplace. Recently, this topic was discussed in part in a webinar hosted by California Life Sciences (CLS) in which Dr. Crean and other thought leaders addressed the topic of "A Roadmap to Seed Funding and Commercialization Strategy for Early-Stage BioPharma."

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Life sciences company startups work on innovative solutions to solve critical problems that have the potential to address some of the biggest unmet medical needs in today's healthcare environment. Beyond having the right team and a compelling and differentiated investment thesis in place, these emerging companies require the necessary resources and capital financing to advance their important work forward.

The capital financing environment in 2022 has not brought much solace to most entrepreneurs, CEOs, and Boards of Directors looking to raise private or public funding for their companies. Despite the fact that there is plenty of money and dry powder out there to be accessed in the marketplace, roughly 25-30% of all public biotechs are trading below the value of their cash reserves leading to negative enterprise values. As valuations have declined, especially later-stage company valuations, the initial public offering (IPO) as a vehicle for raising capital for life sciences companies has nearly dried up.?The pace of life sciences IPOs in 2022 (Q1-Q4 YTD) is trending well below the previous three years and the average size of biotech IPOs has also declined. Moreover, equity venture funding in life sciences has also declined through Q4 2022 YTD versus prior periods as investors see a more limited upside in life science investments with a need to reserve a significant portion of their capital to invest in existing portfolio companies and extend runways.

While the current funding environment is challenging compared to 2021, raising money must still be a central and highest-priority task for entrepreneurs and C-level executives. For this reason, it is important that company executives understand the various capital financing alternatives to consider in funding the venture, how to attain the capital, and create a comprehensive strategic financial plan prospectively rather than in an ill-planned, retrospective manner.

Capital Financing Options

There are numerous alternative options for life science companies to consider in raising capital along the evolution of their pathway. The appropriateness of each option is based on company objectives, stage, and various other attributes. The options include equity, grants, SAFEs & convertible notes, incubators, collaboration and licensing, venture debt, royalty monetization, fee-for-service revenues, tax incentives, M&A, and a combination of the various options.

Additionally, there are key considerations for selecting the financing options that include the cost of capital, dilution of ownership, stage of development, amount and use of proceeds in order to meet value inflection milestones, ultimate strategic pathway and exit plans, types of investors you can access with a given type of financing, and investors and creditors demands/covenants for various fundraising options.

Equity

Equity is the primary source of capital for most emerging life science companies.?Seed-stage companies usually start with equity, perhaps a tranche from friends and family or they acquire early funding from angel or venture capital (VC) investors.?Emerging companies that locate in incubator business models may even trade equity for in-kind services and benefits.?

Angel investments are typically made in the discovery-to-early stage of a business. These investments are typically made by individual investors or groups of investors (often referred to as angel groups or networks). In exchange for the investment, angel investors will typically require a certain percentage of ownership of the company, a certain level of control (usually in the form of consent or veto rights) over the decision-making of the company, or some combination of both. Beyond simply providing funding, these relationships can be valuable for early-stage biotech and life sciences companies because angel investors often have the ability to provide invaluable expertise in a given field. The angel investors can be useful mentors in areas such as capital formation, business development, and people and process management, and can provide access to networks of other investors.

Most early-stage biotech companies eventually take on institutional funds from VCs with the goal of raising successive rounds at increasing valuations, culminating with an IPO offering or trade sale.?Beyond providing capital and adding value as board members, VC investors can also bring valuable networks, enhance a company’s visibility, help to recruit key hires, and land business development opportunities. Venture capital investments are typically made after the startup stage. Venture capital funding in the biotech and life sciences sectors typically comes from venture capital firms that specialize in, and have an understanding of, the biotech or life sciences industries. Venture capital investments are typically higher-dollar investments that are made with the expectations of high returns within a defined period of time. In addition, these investments typically require the business owner to give up a certain percentage of ownership and control of the business to the venture capital firms, and they also often come with restrictions on the ability to undertake certain corporate actions.

In addition to traditional venture funds, there are various sources for equity financing that include corporate venture capital (CVC), family offices, hedge funds, and sovereign wealth funds.? There are also specialist investors that may include impact investors such as non-profits looking to fund the development of products for specific diseases or populations or by companies operating in specific regions.

Grants

Many US federal agencies provide grants to early-stage companies and startups in the biotech and life sciences fields, including Small Business Technology Transfer and Small Business Innovation Research (SBIR) grants. While these types of grants do not typically require the owners to surrender any ownership or control of a company, they often contain strict requirements with respect to the number of employees and the ownership and control of the grant recipient. These restrictions may limit the ability of a company to undertake certain actions or enter into certain strategic partnerships or ventures while the grant recipient is still using the funds.

In addition to federal funding, many US states, cities, and regions have economic development agencies or public universities or institutions that provide grants and awards. The one downside to the pursuit of grants to funding your business is that the grant process is lengthy and competitive and requires a significant amount of time devoted to grant writing.

SAFEs & Convertible Notes

Startups?looking for pre-seed or seed funding have several options available to them, including SAFE notes and convertible notes. SAFE notes are not debt; they’re convertible equity. They have been around and implemented since 2013. There’s no loan or maturity date involved like in convertible notes. ?Convertible notes are debt, allowing companies to get the funding they need without selling shares for a marked increase in a short amount of time.

Which is the best option for you? As with most choices, it depends on your?particular circumstances. To decide if SAFE notes or convertible notes better suit your?emerging company, you need to understand the differences between the two. Convertible notes offer?startups?the crucial benefit of delaying valuation and focusing on getting your company up and running, while SAFE notes may still require a 409a valuation. SAFE notes do offer several key benefits, such as fewer points of negotiation and more company control. However, depending on investor comfort, if they can’t attract the investors you want, you may need to go with convertible notes as they are more familiar to investors. Please contact your financial and legal advisors to explore which option is best for you and your circumstance.

Collaborations and Licensing

A very popular option that many life sciences companies pursue is partnerships and collaborations. Many life science companies allow third parties access to their platform technology or obtain rights to develop and sell their product candidates.?These business development transactions can take the form of fee-for-service R&D or intellectual property licenses that combine some or all of an upfront fee, ongoing R&D support, contingent payments tied to R&D, regulatory and commercial milestones, and royalties on product revenues.?A potential partner may also provide R&D support and other payments during an initial trial period after which the larger company may have the option to license certain assets.

Emerging life science companies can leverage business development funding and the expertise they gain in working with partners to build out their platform technologies and develop proprietary product candidates.?Funding through this mechanism can extend a life science company’s cash runway and provide external validation and bolster valuation.?Partner relationships can also bring valuable expertise (e.g., clinical development and other general R&D, therapeutic area, commercial or regulatory) to the emerging company.

Venture Debt

Debt financing is not likely an option for many emerging life science companies, which typically lack recurring product revenues and profits to pay interest and repay principal. Venture debt is one vehicle for a venture-backed life science company that wishes to extend its cash runway in order to achieve a milestone or have more time to raise money.?A venture debt deal may rely on the borrower’s venture investors to backstop the company’s ability to repay a loan by investing additional equity, if necessary.??

Venture debt can be less dilutive than equity when the borrower repays the debt with non-dilutive financing or equity raised at a high enough premium to the last round.?Venture debt can be more dilutive than equity when the borrower fails to raise equity at a premium and the debt must be repaid with more expensive capital.? Debt adds financing risk, as interest and principal amortization are fixed, and debt may add operating constraints including financial and operating covenants and the requirement to pledge assets as collateral.

Debt financing can be an attractive option for advanced life sciences companies looking to finance to a milestone such as product commercialization and launch that can lead to self-sustaining cash flows.? Debt can also work in situations where a life science company borrows money backed by a royalty interest; using debt instead of selling the royalty is one way for the borrower to retain the upside from the royalty interest.? Other kinds of debt include capital equipment financing; working capital or cash flow-based financing for more mature, revenue-stage companies; and bridge financing, which often takes the form of debt convertible at a discount into a later equity round and may be useful if a company needs time before completing a fully priced round.

Royalty Monetization

Beyond bank financing arrangements, some biotech and life sciences companies are able to enter into revenue royalty financing arrangements whereby investors are entitled to receive a certain percentage of a company’s revenue generated from specific products or operating lines or divisions of a company. As with traditional non-dilutive financing, royalty participation arrangements do not dilute the ownership percentages of founders or entrepreneurs, but they allow companies to raise capital without the drawbacks of borrowing money as noted above.

Life science companies with marketed products (or close to commercialization) can sell a royalty interest, agreeing to pay a percentage of revenues on an ongoing basis in exchange for one or a series of upfront or other contractual payments.?Future revenues or royalties can also be monetized by using the royalty stream to support a debt financing.?Royalty investors are increasingly looking at earlier-stage investments, including obtaining royalty rights to products before they enter FDA registration trials.

Fee-for-Service Revenues

Life science companies can bootstrap their proprietary programs or build out their platform technologies by selling R&D services.?For companies whose principal business is developing their own product pipeline, these R&D revenues are rarely enough to offset significant clinical development expenses unless they lead to a larger pharmaceutical license arrangement. Of note, service-based companies (CROs, CDMO, Life science tools, genomics) generally get to break even sooner than most therapeutic-based companies. Private equity (PE) as an investment asset class is highly attracted to these companies assuming predictable recurring revenue and not having a highly concentrated customer base.

Tax Incentives and Credits

A number of geographies offer tax and credit incentives to entice life science jobs, spending or pursue rare disorders (e.g., Australian R&D tax incentive enables Australian companies, including wholly owned subsidiaries of companies located elsewhere, to obtain cash funding equal to 43.5% of spending on approved R&D projects).?The orphan drug tax credit (ODC) is a federal tax credit available to pharmaceutical companies working to find cures for certain rare diseases that affect small populations.?Much like the traditional R&D tax credit, the ODC provides pharmaceutical companies an opportunity to increase cash flow and reduce the cost of their development operations.

Mergers & Acquisitions (M&A)

A source of capital for life science companies is to combine with a second, well-funded company whose products may have failed and with cash that can be redeployed and investors seeking an opportunistic home for their capital.? These companies can be private or public and may come with obligations including ongoing operations that need to be shut down or merged as part of the combined business.?These complex transactions, which may take the form of a reverse merger, can be expensive and time-consuming to complete.??

A business combination may make sense for life science companies that can’t raise equity in a traditional round or it meets their exit strategies.?This may be the case if existing investors are tapped out and the only alternative would be to raise money from new investors in a recapitalization. An acquisition by a more mature, well-funded company affords the seller to achieve liquidity for its shareholders while seeing its technology progress through deeper resources. For the buyer, the acquisition can add needed capabilities and assets to bolster the pipeline and strengthen its intellectual property to achieve greater competitiveness in the market.

Final Thoughts

As we enter into 2023, and with economic headwinds mounting due to recessionary fears, inflation, and rising costs of capital, it’s recommended to be prudent about managing the downside while being courageous about pursuing the upside. While cutting-edge research is important for any life sciences company, management teams must manage operating and R&D spending in this challenging climate of rising cost of capital. Raising money has become much harder with higher interest rates and inflation changing prior assumptions about capital markets.

There is no one-size-fits-all path for capital formation, or funding options available to early-stage life sciences companies. These companies have potential access to a wide variety of funding options depending on various considerations specific to the company and its circumstances. Companies seeking capital financing must put their best foot forward to achieve their funding goals, optimize valuation, and attract the right type and kind of investors. Allocating time and resources to formulate a solid and believable capital financing strategy at the outset is highly recommended. It's important to contact your advisors and discuss the best alternatives to pursue.

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Disclosure

David H. Crean, Ph.D., is Managing Partner for Cardiff Advisory LLC, an M&A investment banking strategic advisory firm focused on the Life Sciences and Healthcare sectors. This article is provided for informational purposes only and does not constitute an offer, invitation, or recommendation to buy, sell, subscribe for or issue any securities.

The principals of Cardiff Advisory LLC are registered representatives of BA Securities, LLC Member FINRA SIPC, located at Four Tower Bridge, 200 Barr Harbor Drive, Suite 400 W. Conshohocken, PA 19428. Cardiff Advisory LLC and BA Securities, LLC are unaffiliated entities. All investment banking services and securities are offered through BA Securities, LLC,?Member FINRA SIPC.