Why can’t big pharma invest in my company?
Velocity Pharmaceuticals’ CEO David Collier explores the challenges in pharma partnerships and questions why it is so hard for big pharma companies to invest in smaller startup biotechnology companies.
Big pharma companies today are “balance sheet rich” but “P&L poor“. They would like to invest in startup biotechnology companies in order to foster innovation and have access to new drugs. Investment by pharma companies in biotechnology companies could help fill the void left by vanishing venture capital firms. But if pharma companies are required to consolidate their investments, then the development spend of their startup investees hits the pharma R&D budget and P&L statement. This is a big problem for pharma. Wall Street values pharma stocks by multiples, so any increase in R&D spend could lead to a significant decrease in stock valuation, even if this “spend” is really investment into small companies discovering and developing new drugs.
In the old days, a pharma company could avoid consolidating an investment in a biotechnology company if it owned less than 20% of the biotechnology company’s equity. Many deals were struck with pharma companies purchasing 19.9% of the equity in their smaller biotechnology company partners. But today, in the wake of the Enron debacle, the rules for consolidation are much more complex. Today, FIN 46 and FASB Statement 167 set forth guidelines for the consolidation of “variable interest entities“. These rules are subject to interpretation, so different pharma companies may come to very different conclusions about the criteria that determine whether they need to consolidate investments. Ultimately, all decisions about consolidation of investments in “variable interest entities” boil down to “facts and circumstances,” which eventually are ruled upon by the pharma company’s auditors.
“Wall Street values pharma stocks by multiples, so any increase in R&D spend could lead to a significant decrease in stock valuation…”
The decision about whether a pharma company needs to consolidate its investment rests upon a determination of whether the pharma has “control” of the entity it has invested in. Facts and circumstances such as board membership, voting rights in a joint development committee, and options to license or purchase drug programs or the investee company itself may lead to a determination that the pharma has de facto control and must consolidate its investment. Facts and circumstances that may lead to a determination that the pharma does NOT have control and does NOT have to consolidate its investment include board observation rights rather than board membership, a non-voting advisory role in the development committee, and a right of first negotiation rather than an absolute right to purchase a company or drug program. Investments in biotechnology companies with multiple drug programs may still be deemed non-controlling even if the pharma company has considerable control over a single drug development program of interest.
Many large pharma companies have corporate venture capital funds which make direct investments in companies that are of strategic interest to their parent companies. Some of these venture capital funds have investment guidelines designed to ensure that the pharma companies do not have control and do not have to consolidate their investments. These funds often are limited to owning less than 5% of the equity (different pharma companies have different percentage thresholds), board observation rights rather than board seats, and so forth. Other pharma companies allow their venture capital funds more flexibility and simply accept the necessity of consolidating their venture investments. This does have an impact on the parent pharma’s P&L, however the impact is relatively small and can be planned for, based on the overall size and investment parameters of the fund.
Similarly, for pharma deals with biotechnology companies that are highly strategic and involve large investments by pharma into biotechs, pharma companies may simply accept the need to consolidate the investments as a price of doing business. At the end of the day, accounting treatment of a transaction is unlikely to be the final determinant of whether a deal gets done or not.
Another area of strong interest across the pharma industry today is the question of how to partner with the venture capital and private equity communities to fund the development of drug programs that pharma has discontinued due to decreases in their R&D budgets. Many big pharma companies are facing dramatic declines in their overall revenue due to patent expirations on their blockbuster drugs. Since Wall Street penalizes pharma companies whose R&D budgets are high relative to their top-line revenue, the loss of a blockbuster drug usually means a deep cut in the R&D budget, which means that attractive drug development programs have to be de-funded. Pharma companies are eager to find financial structures which will allow them to fund the development of these drugs using “other people’s money” while still allowing them to re-acquire the programs if they are successful in clinical development. The problem is, that even though these programs are funded by private investors, the pharma companies still have to consolidate these entities and show them on their P&L if they are deemed to have control. Having the right to buy a program back again usually is enough to trigger a determination of control.
The accounting rules for the consolidation of pharma investments into biotechnology companies are constantly evolving, as are the interpretations of these rules. Business development professionals in both biotechnology companies and in big pharma need to be alert to these issues and to how they may affect the ability of pharma to enter into different deal structures. Ultimately, accounting treatment is unlikely to determine whether a strategic deal gets done or not, but it may have a large impact on how a deal is structured and, at the margin, on whether a less-strategic deal can be consummated at all.
About the author:
David Collier, M.D., is Chief Executive Officer of Velocity Pharmaceutical Development and Managing Director of CMEA Capital.
As CEO of Velocity Pharmaceutical Development (VPD) since its inception in 2011, Dr. Collier is pioneering a new business model for the development of promising drug candidates. VPD acquires the rights to individual therapeutic drug candidates from biotechnology companies, academia, and pharmaceutical companies, and invests in their development through clinical proof-of-concept (generally phase 2). Following proof-of-concept, VPD seeks to sell each drug asset to a major pharmaceutical company. VPD is structured as a holding company, owning a portfolio of virtual companies, each of which develops a single drug candidate, all managed by a single expert team. This development team includes several highly experienced former Chief Medical Officers from the biotechnology industry.
Dr. Collier joined CMEA Capital in 2001 to focus on investments in biotechnology companies developing drugs through clinical trials across many different therapeutic areas. Examples include Ardelyx (minimally-absorbed drugs acting on the GI tract), Auspex Pharmaceuticals (Huntington’s Disease), Arcion Therapeutics (neuropathic pain), and Sorbent Therapeutics (congestive heart failure). Dr. Collier currently serves as Chairman of the Board of two CMEA drug development portfolio companies and as a board member of four others. Before joining CMEA, David was a Managing Director at Burrill & Co., a private merchant bank focused exclusively on life science companies, where he played a leading role in the management of the company’s life science venture capital funds. Earlier in his career, David was Assistant Vice President at First Options of Chicago where he directed a group of traders and managed a large portfolio of futures and options.
Dr. Collier holds an M.D. from the University of Pennsylvania School of Medicine, an M.B.A. from the Wharton School, and a B.A. in Physics from Wesleyan University.
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