Envisage

Biotechs and the Public Market

by Mark W. Anderson

October 2008

The biotech initial public offering (IPO) market may not be dead, but you might want to give the undertaker a call. Although past reports of its demise may have proven premature, the current state of the IPO market for biotechnology companies seems dire indeed. After years of a somewhat iffy IPO environment for biotech firms, the first half of 2008 has proven downright catastrophic: Only one biotech-related company came to market in the first half of the year, and that was at a significantly reduced price. What was once a viable corporate strategy—selling public equity shares of a biotech firm to provide operating liquidity, development capital and to “cash out” early investors—is becoming harder and harder to pull off. Even more surprising, perhaps, is the fact that in many cases, investors and companies are shunning the IPO route in favor of alternate, more attractive means of financing development.

What exactly is behind the dearth of opportunities for biotech IPOs? Certainly, traditional market dynamics, such as equity investors’ appetite for risk and global economic conditions, play a part. But more important are structural changes in the way biotech firms themselves are funded, along with the expectations and perceptions of early-stage investors, such as venture capitalists, private equity funds and pharmaceutical companies’ strategic partnering divisions.

An Unfavorable Market

The numbers help tell the story. During the first six months of 2008, for example, only one company — Bioheart, a biotechnology company focused on using autologous cells to treat heart damage — sold initial shares to the public. Even so, the Sunrise, Fla., USA-based company stumbled out of the gate, pricing its revised February offering of 1.1 million shares at US$5.25 after originally filing for 3.6 million shares at a range of US$14 to US$16. In recent months, a slew of other biotech firms put their IPOs on hold—including protein drug developer Biolex, light-activated drug developer Light Sciences Oncology, aptamer developer Archemix, diabetes treatment firm Elixir Pharmaceuticals, Peplin, an Australian creator of dermatology-based drugs planning a U.S. market offering, and others—all citing “unfavorable market conditions.” All in all, the first half of 2008 saw a meager US$6 million in initial public offerings, compared to US$819 million for all of 2005, US$920 million for 2006 and US$2.04 billion in 2007, according to San Francisco-based market tracker Burrill & Company.

Some of this IPO reluctance can be traced directly to equity market dynamics, such as volatility and the appetite for risk among investors. It can also be attributed to the relative performance of other industry sectors—such as commodities, which significantly outperformed the market as a whole heading into the second half of the year—and macroeconomic factors, such as the global credit crunch and the relative weakness of the U.S. dollar. In challenging market environments such as these, small-cap and tech-based IPOs are often at a disadvantage.

“We’ve now had about eight years of chronic instability in the IPO market and if there is a sector that’s been hurt by that, it is biotech,” says Sonya F. Erickson, attorney and co-chair of the life sciences practice group at the Seattle, Wash., USA–office of Heller Ehrman LLP.

A Question of Valuation

But beyond factors such as high volatility and the soaring prices of commodities lie other, equally fundamental reasons biotechs are finding a hostile reception at the IPO door. For one, the mechanisms of valuation in a public market—and who is assigning a company’s value—come into play. For years, those equity players outside of a specialized, core group of investors and IPO underwriters have struggled with how to assign share prices to companies that often have no product, no profit and little prospect for either for perhaps years down the road. Now, in a choppy market, these challenges have become magnified, and investors once ready to back a company’s future prospects are becoming few and far between.

“It used to be that a success from a venture capital standpoint was we create a company, the company goes public, we sell the stock, we return the capital to our limited partners and everybody’s happy,” says Donald Elmer, managing general partner of Pacific Horizon Ventures, a Seattle-based venture capital firm. “But in a lot of those cases, the companies that go public ended up failing—not because they were bad companies, but because the products under development failed.” As a result, rational investors began questioning the inherent risk of a 10-year gestation program in light of better returns in shorter holding periods from investments in other industries. “And that’s when the IPO market [for biotechs] crashed,” Elmer says.

The Changing Regulatory Landscape

Equally difficult is the burden of a fast-moving regulatory environment and its role in shaping valuations for biotech firms seeking IPOs. First, there are the regulatory requirements that all small companies trying to go public face, such as Sarbanes-Oxley accounting requirements, as well as insurance and filing costs, which can add up.

“I will say this about the costs of being public: Clearly, it’s much more expensive than if you stay private,” says Sandy Hillsberg, managing partner of TroyGould, a Los Angeles, Calif., USA-based law firm that specializes in life science companies. “If you’re doing a good sized public offering of, say, US$40 to US$50 million dollars, you shouldn’t be slowed down even if the compliance work is three quarters of a million to a million [dollars in fees]. But if you’re only raising US$10 million in an IPO, and it’s a million dollars a year [in fees], then you’re going to have to really think about it.”

More important than traditional IPO costs, however, is the changing regulatory environment for eventual marketing approval by the U.S. Food and Drug Administration (FDA) or the European Medicines Agency. In previous market cycles, investors were, by and large, more comfortable with companies coming to public capital markets at or near Phase II trials for their products, seeking more “proof of concept” bona fides than requiring a smooth flight path to commercial success up front. Today, these same investors simply have to look at news headlines to see the myriad ways a promising drug candidate can stumble on its way to marketing approval before demanding more data or simply deciding to invest elsewhere.

“In the current regulatory environment, it’s often more expensive and takes longer to develop a drug these days, and, thus, I think the challenges in getting the product approved are more significant,” says Michael D. Aldridge, chief executive officer of Peplin, Inc., the Australian-based biotech firm that decided to pull its IPO filings earlier this year. “And that’s relevant to the risk perspective—valuation is about a function of time and money, and if it takes you longer and costs you more because of regulatory challenges, then valuation is impacted.”

That means the opportunity to tap public market financing may simply not be available. “Whether the IPO window is open or shut depends on a number of things—not just risk appetite in general, but also perceptions about the industry and about the regulatory environment,” Hillsberg says. “There have been some developments at the FDA that perhaps could be viewed as positive, and other positions they’ve taken have been somewhat chilling for investors.”

Not Over, Even When It’s Over

As it turns out, even after a biotech company has gone public successfully, the potential downsides of an IPO are hardly over. For one, gaining access to public money means having to live and die by the rules of the public markets, and that may mean shutting off future financing streams, not increasing them.

To see this trend in action, simply compare the share price of a biotech firm at open with the shares of the same company 12 to 18 months later. More often than not, what was once a double-digit share price at the open is now down to the single digits, making it difficult to attract new or institutional investors—the lifeblood of any company’s additional rounds of equity sales. At the end of June 2008, for example, Bioheart, the year’s sole biotech IPO, not only had lost more than half of its opening share price—falling to US$2.30 a share on June 26 from a US$5.25 open in February—but was also forced to move its shares to the NASDAQ Capital Market, a tier of the larger NASDAQ Stock Market designed for companies with a lower market capitalization requirement.

“Biotech firms always need more money, and once they become public and then look to sell more shares [for additional financing], any offerings hinge on whether there’s a liquid trading market,” Hillsberg says. “When the stock goes down and the trading volume dries up, most of the investors after the IPO want to see liquidity. It’s a vicious cycle that just kind of feeds on itself.”

Such a scenario can make a small or mid-sized biotech firm think long and hard about launching an IPO, even if that same firm has had little trouble attracting multiple rounds of private financing in the past. “I think for any company whose plans are to become public, there are questions of sustainability, which is dependent on milestones and product pipeline and, after the company has product sales, on continuing to increase sales,” says Dr. Deborah Eppstein, a co-founder of AlteaTherapeutics, a late-stage biotech company in Atlanta, Ga., USA that is considering going public. “It’s a tradeoff between partnering with venture capital or a larger pharmaceutical company for additional rounds of financing versus getting enough money through the public markets to take the product yourself to a later stage, or all the way to new drug application.”

The Challenge of Consolidation

As a result, market observers and industry insiders point out that for many investors, the strategic path is simple: skip the IPO and move directly to the point where a successful or promising biotech firms sells itself to Big Pharma.

“For the most part, the industry’s predicated right now on exit strategy,” says Dr. Kevin Schulman, director, health sector management program, the Fuqua School of Business, and professor of medicine at Duke University in Durham, N.C., USA. “Big pharma’s pipelines are still fairly thin, so if there is anything out there that’s changed, it’s pharma companies’ ability and willingness to acquire unlicensed molecules. That is a big impact on funding.”

As a result, investors who may have been willing to support an IPO in the past now have the ultimate end game in mind—purchase by another firm.

“Historically, the IPO was the liquidity event of choice,” says Michael Sanders, a member of the Life Sciences Health Industry Group at Reed Smith LLP in Los Angeles, Calif., USA. “But over the last couple of years, I think investors have concluded that if they can structure the right deal, the M&A transaction may be a far more attractive exit strategy. Most companies that are considering an IPO in 2009 or whenever the window re-opens are going the parallel path and looking at M&A transactions [as well].”

A Better Day, Tomorrow

Of course, the market window for biotech firms has slammed shut before, only to open again later when market conditions improve. And, for every market pessimist when it comes to biotech IPOs, there is another who sees the glass as more than half full.

“I want to be very clear on what’s going on globally in the pharmaceutical arena—there are loads of opportunities,” Elmer says. “We have expanding demand for new products and new therapies all over the world. With that demand comes conditions of course, but the underlying opportunity that we see today is phenomenal. The challenge is producing a product in that environment that delivers economic value.”

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