High public markets and vibrant cash flows make it easy to forget the importance of equity capital efficiency in the development of new biotech companies. But equity capital efficiency is a core element of generating high returns in any market, and if the initial expensive capital is used carefully and carefully, a start-up can have the upper hand in the market competition.
The impact of capital efficiency on investment returns has been discussed many times before, but a recent report by Silicon Valley Bank (SVB) has once again raised my concerns about the issue. The report said that in order to obtain attractive returns through mergers and acquisitions, the smart use of capital investment will play an important role.
SVB's report covers a range of investments and "export" environments in the biotech sector (after venture capitalists invest in start-ups, they want a huge return on profits, so they need an export, the most common of which are two: 1. IPO, they can make a profit by selling shares; 2. The companies they invest in are acquired at high prices, I .e. "export mergers and acquisitions"), the report said: the booming healthcare market drove financing, investment and export M & A to the highest level in years in 2014 and exceeded expectations a year ago.
Report authors Jon Norris and Christina Pilata analyzed 85 large "export mergers and acquisitions" (over $75 million) in the biopharmaceutical sector, including Johnson & Johnson's $1.75 billion acquisition of Alios, Roche's 0.725 billion acquisition of Seragon, a breast cancer drug company, and Teva's $0.825 billion acquisition of Labrys. In recent years, there has been a lot of M & A activity in this market.
The authors calculate investor returns (weighted average returns for investors) based on 85% of the acquisition amount and 25% of future "milestone payments" (setting specific progress milestones as acquisition or partnership segment targets and payment points). Based on the recent milestone payment environment, this expectation is relatively reasonable and even somewhat conservative. The authors classify investor returns into four levels (see chart below).
From these data, we always give two conclusions: 1) There is a clear inverse correlation between investor returns and the use of equity capital: investment does not drive M & A returns, in other words, the value of M & A does not grow in proportion to investment. Although investment is growing, the return to investors from "export mergers and acquisitions" is declining; 2) The highest level of return on investment is coveted: the return on investment is as high as 8.1 times. Obviously, companies at this level are undoubtedly the biggest winners, and they have also attracted M & A bids of more than $75 million. These investment returns account for 3% to 5% of the overall return on venture capital.
In addition, the report also pointed out: 1) in the first-level rate of return, 19 of the 22 transactions received less than $50 million in capital investment, and none exceeded $0.1 billion; 2) in the first-level rate of return, 10 transactions received a merger return of more than 10 times the invested capital, and 3 exceeded 20 times; 3) in the fourth-level (lowest) rate of return, only two deals received a capital investment of more than $70 million and a return of more than 4.5 times.
There are several points to be made here: 1) If the milestone payment has been paid, the valuation of these large "export mergers and acquisitions" may be overvalued; 2) From these data, it is not yet possible to judge whether the low-level investment return is more risky than the high-level investment return; 3) The investor return mentioned here refers to the "weighted average return", therefore, there may be a large gap between the returns of early and late investors, depending on the price of the investment. However, based on historical records, weighted average returns are a better indicator of investor returns.
In the current IPO-centric market environment, the cost of capital has fallen sharply compared to the period between 2003 and 2012, and the ability to win large-scale investment at the beginning of the life cycle also provides new options for startups. Mergers and acquisitions that have replaced pharmaceutical manufacturers through the IPO route have improved return on investment and strengthened management teams, paving the way for the creation of the next Genentech, Vertex and Regeneron.
Some companies, including Agios, have demonstrated extraordinary equity capital efficiency through IPO opportunities, with Agios receiving a $33 million investment in Series A financing at a valuation equivalent to $3 per share. But today, Agios shares are trading at 35 times that valuation. Companies like Agios have been so successful largely through innovative business development. For example, Agios has partnered with Celgene to develop new anti-cancer agents, and the deal allows Agios to expand through non-diluted financing during a critical period for the company. This also provides new options for other companies.
If innovative partnerships can lead to well-structured, non-dilutive financing mechanisms that can lead to significant value growth for startups, as the authors of the SVB report say: "Firms should take advantage of this non-dilutive form of financing where possible. Since 2009, many companies have multiple asset models, and working with large pharmaceutical companies will benefit from their non-dilutive investments and proven technologies. In addition, a growing number of patient advocacy agencies are offering non-dilutive subsidies to help cover the cost of specific clinical trials. It also provides clinical development opportunities for businesses that do not have access to equity capital."
Under the current market conditions, it is not uncommon for some young startups to actively strive for capital and expand the company's scale, because it is very attractive to IPO as soon as possible and obtain a higher valuation. If the timing is right and market conditions permit, these businesses can bring significant returns. If public market investors want to invest at a higher valuation in the early stages, then startups need to be seriously considered, which may be a way to achieve escape velocity (overcoming gravity constraints). In the past 10 years, many companies have succeeded in doing this, but many have not turned their capital intensity into escape velocity.
This rocket push is suitable for active markets, but there are certain risks that need to be balanced. Over-investing in a start-up at an early stage increases the risk of unreasonable resource allocation and greatly reduces the freedom of potential companies, thus losing potential new attractive "export M & A" opportunities (I. e. excluding M & A and choosing only IPO). While there are exceptions, pharmaceutical companies typically don't pay billions for some preclinical assets. Therefore, there is strategic value in retaining the "export M & A" option.
Thus, whether biotech startups choose "export mergers and acquisitions" or IPOs, reasonable equity capital efficiency and innovative business development are the key to ensuring huge returns.