The Beauty of the Research-Funded Option-Based Acquisition

Posted by on Feb 3, 2012

Gone are the days of the once-commonplace $300M acquisition post-Phase II.  At least mostly gone.  Now, more than ever, pharma are buying small biotechnology companies only after paying the biotechs to do more research – research that the pharma specify, and in some cases, control.  And even then, the buy-out terms are pre-negotiated before the first dollar of research funding goes in.  This is the age of the research-funded option-based acquisition.

Take Pfizer’s late 2010 deal with LPath: $14M up-front, plus shared expenses on Phase I and II, followed by an option to acquire the lead program for just under $500M in total if further milestones are met.

Sure, there are still a few acquisitions here and there more representative of the days of old.  Take Amira, for instance, acquired in 2011 by Bristol Myers Squibb for $325M up-front plus a potential earnout of $150M.  I can even accept some of the arguments that big pharma may be more willing to buy with up-front dollars in 2012:  patent cliffs loom even closer, the big pharma to big pharma merger dust is settling, R&D remains unproductive, and there is cash to be spent after having largely sat on the sidelines for the past couple of years.

But there are many reasons on both sides of the fence why option deals are becoming more popular.  Most of these reasons are underappreciated, and some are even surprising.

First, and most obvious, option-based deals diminish risk for the acquirer.  Why shell out $100M for a program that will fail in the next clinical trial?  Plain old milestone-based acquisitions may offset some risk, but unlike funded research deals, they don’t give the potential acquirer a flavor for the asset, or a flavor for the management team and style that brought the asset to where it is today.  Both could be important.  How many times have you had buyer’s remorse after finding out something bad that decides to reveal itself a day or two after the purchase instead of during the weeks or months you spent in diligence?  There’s a reason for this.  Once you start paying for research, you become part of the company in some way, and people tell you things you didn’t know before.

In many cases, the tiny option fees and often-shared research funding can come directly from the R&D budget of the big pharma, without having to draw down on business development reserves typically employed in larger deals.  This means that, in a sense, the money is already budgeted – it is already there if you will – and the deals can be done more quickly if senior management and boards of directors don’t have to weigh in heavily during the deal process.  Said another way, if only the big pharma R&D group buys in to the technology and agrees to share the R&D budget, that may be enough.

My suspicion is that it is easier for a big pharma to close on an acquisition via a research-funded buy-out option.  Imagine approaching your senior management telling them that you’ve worked together with this company for a couple of years, that the relationship is good, that the data has panned out well, and that you’ve done all this with small dollars.  Seems to me it would be harder to say no to this, whereas it would be easier to say no at the end of a fast-paced auction process that began two weeks ago.

In the heady days of healthcare venture capital, there were lots of venture capital funds willing to plunk down millions here and there in order to finance clinical trials.  But the number of such funds is dwindling fast, and those that remain are plunking down money for other things, like diagnostics, medical devices, and healthcare services and IT.  These days, the small biotech finds the big pharma research funding a more attainable source of capital than ever before, and in some cases much easier to close than VC money.  Because the pharmaceutical industry depends in part on biotech successes, big pharma are likely to partially cover for sources of funding that are drying up, and the option-based research deal is one way to do it.  (Check out the January 9, 2012 BioCentury article on page A11 regarding pharma stepping in to fund biotech IPOs for a similar take.)

The clincher is that, from a biotech investor standpoint, the risk-adjusted investment multiple of a research-funded option-based acquisition is actually higher than the risk-adjusted investment multiple from taking companies through Phase II and hoping for an all-upfront acquisition.  Here’s an example.  Let’s suppose you are a VC and you have invested $10M in a company at a valuation of $10M.  In the go-it-alone scenario, suppose that you get Phase I data and you then decide to invest (at a flat round) another $25M to get Phase II data.  Assume there is a 20% chance the Phase II will work (more or less the average these days) and that if it works, the company will be bought for $300M upfront.  Here, the VC would own about 78% of the company, reaping a risk-adjusted $47M at a 1.3x.  But assume instead that after Phase I, a large pharmaceutical company offers to pay for Phase II (the research-funding phase), and in the 20% chance that it is successful (possibly higher since you have the expertise of the big pharma), there is an agreement to purchase the company for $300M (the option).  In this case, you would own only 50% of the company, and you would receive a risk-adjusted $30M, but your multiple more than doubles to 3x.  In the end, VCs are in the multiples business, and the research-funded option-based acquisition should be more appealing than ponying up to shoulder risk alone, even if the meager to non-existent up-front won’t get you the Bentley SUV that you’ve been eyeing.

My own view is that risk sharing will continue to grow in popularity.  Sure, there are lots of reasons not to do these deals.  For example, what if you get good data but the option isn’t exercised?  (My response: if you really have good data, you will sell the company to some other big pharma notwithstanding the odd decision of your former partner.)  But all in all, these relationships are good for both parties, and I think the growth of such structures will go a long way to restoring the once-vibrant ecosystem of biotech-partnered-with-pharma successes that we all long to see return.

Todd Brady is a Principal at Domain Associates, LLC – www.domainvc.com

 

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