A banker calls me. I don't know him, he doesn't know me. He calls me Dave. Only six people in the world call me Dave. I have known five of them since grade school and I am married to the sixth. The banker will not be number seven. He wants to sell something to me, so he acts like an old friend. I have dear friends in the investment banking industry but he is not one of them.
His is an "over-the-wall" call. Not Number Seven has a stock deal for me and once he tells me the name of the company that has engaged him to raise money I'll be "locked up" and unable to trade the company's stock until the transaction is completed and made public. I promise to behave and he gives me the details.
The bad parts come first. The bad parts are that I am the biggest shareholder in the company and do not want more stock, the stock price is already low and the deal price will be lower, and the company will not benefit form the paltry amount of money being raised. The good part? There is no good part.
This deal came about when a fellow fund manager wanted to buy the company's stock, but rather than venture into the open market and do so he calls the company, or worse, calls a banker, and offers to buy a big block from the company at a further discount to the market. The resulting transaction is good for the buyer, since he or she gets to name the price. It is great for Not Number Seven, who gets a check for 6% of the proceeds of the deal. It may be good for the company, if the company actually needs the money and the current market price is not too low.
But in this case the current market price is too low, and the correct answer for management should be, "We would love to have you as a shareholder. If you wish to purchase the stock you have a marvelous opportunity to do so in the open market since it is so cheap." Fellow fund manager would then soak up the excess supply of stock, the share price would rise, the company's future fund raising would occur from a position of greater strength, and the interests of current shareholders would be protected.
Instead the company chose to sell a piece of itself at the bottom of the market, to the detriment of its current shareholders. My fund is the largest current shareholder. On the surface Not Number Seven's call to me was an offer to participate in the offering; in reality it was a cover-management's-rear end call that allows them to reply that "you had the opportunity to participate too" to any subsequent angry phone call or 13D activist filing.
With minor variations, much of the biotechnology industry finances itself in this manner, with each development stage company selling chunks of itself to a mixed group of fundamental investors and arbitragers who game the volatility of the risk capital markets so that the interests of shareholders, founders, management teams and future stakeholders (patients, most importantly) are often misaligned.
Three factors contribute to make biotechnology financing uniquely arduous:
1) Major disconnects between value creation (most clearly seen in the advancement of therapeutics from discovery through preclinical and clinical development) are frequently disconnected from valuation. Development stage biotech companies fall together when risk capital dries up and the public market prices of even the best life science companies drop. As development costs rise in later stage development, these financing down periods ratchet down the value of the founders' and early investors' stakes. These down periods are an industry-wide issue, yet the small companies carry the burden.
2) Companies have one shot to monetize each development asset and the transactions are unidirectional. Big pharma can discard an unwanted asset, but small bio has no means to retrieve a valued one. When an asset sold under distress later skyrockets in value, the small company has limited means by which to participate in that appreciation. Tough luck, you say? Maybe, but a financing infrastructure that pretty much guarantees a series of tough luck events for each company is going to run out of companies to finance. Even the longest time horizons can become predictable, and motivate entrepreneurs (and early stage venture capitalists) to triage their time and money elsewhere.
3) These first two factors combine to give the development stage biotech company few means of risk mitigation, and make it unhealthily dependent on the investment banking industry to provide a lifeline.
…which would be fine if the investment banking industry rose to this particular challenge by creating novel financing vehicles that 1) fostered more equal risk sharing between investors, companies, and their larger deal partners, 2) created different means of monetizing the very real value creation that occurs in intermediate development steps and 3) stimulated transaction types that provide for liquidity through mechanisms that did not involve severing a limb or selling a child.
Sadly, our bankers have not been equal to this task. While the Not Number Sevens may protest that the smorgasbord of IPO's, reverse mergers, secondaries, PIPEs, and overnight flip-to-public's represent real choice and variation, in reality they are only the most narrow variations of self-immolation through equity sale.
Surely an industry that has found ways to securitize and trade the value of each public airing of "Suffragette City" can come up with novel ways for development stage biotech companies to tap into the value created when a drug candidate makes a quantum leap in proof of concept, safety or efficacy; or a way for small companies to retain an option to buy back programs at a later date at a pre-negotiated return to their counterparty; or a means by which parties can trade options or partial options on large, expensive development programs through a centralized exchange.
Of course the bankers themselves are not alone here. We on the buy side are part of the equation, and the company boards have input into this situation as well. But as brokers and advisors (as they describe themselves), my friends in banking should be well-equipped to accept this challenge.
Much has been made of the biotechnology "valley of death" into which numerous promising small companies fall, when a lack of financing options forces an ill-advised transaction that compromises years of brilliant and courageous entrepreneurship. There are too many smart and talented people in investment banking for them to come up with something other than the same broken ladder as a means to climb out of that valley.