In the article series “Investing in biotech”, BioStock addresses important aspects for those who are interested in investing in the biotech sector. In this third part, we take a closer look at the financial side of a biotech company, with a particular focus on share issues.
As with all companies, biotech companies need capital to be able to run their businesses. Companies with commercial products often have a cash flow from their sales revenue and are also able to finance the business through loans. For smaller biotech companies, however, sales revenue are often a long way away, and it is usually the shareholders who finance the business until then. So what really happens when money starts to run out, or when companies need to raise capital for other reasons?
For example, the companies can get access to different types of research grants, so-called soft money, but there are also other ways to finance a company’s activities. In this article we cover the most common form of financing for listed biotech companies – new issue of shares.
What happens in the event of a new share issue?
In a new share issue, the company issues new shares and sells these to investors. This way, the company strengthens its cash position and can continue to run the business.
Creating more shares in this way means that those who owned the company before the issue will own a smaller part of the total number of shares after the issue, unless they can pitch in more money and thus defend their owner position. In stock market parlance, this is called dilution – you simply own a smaller percentage of the cake, while the total cake after the issue is larger.
Why are new shares issued time and time again?
Developing drugs is a cost-intensive activity, especially in the clinical development part where you test whether the drug is safe and that it works and benefits the patient. Advancing a drug candidate through clinical development and all the way to market costs between 33 – 240 million USD and takes approximately 15 years.
Given the risks that are present during development, the entire pharmaceutical project is usually not financed at once. Instead, capital is raised incrementally as progress is made in the development process. In this way, the risk is spread over time and the use of capital is optimised in the longer term.
Capital rounds are thus a natural part of an investment in a biotech company. A long-term investor should have the upcoming capital needs in mind – either in order to divide the investment into several parts, to contribute with more money to defend his or her position, or simply to prepare for the dilution that will come.
It is also important to remember that even if you do not choose to participate in the share issues, the original investment can grow in value despite dilution – given that the development work continues to move forward. As the company’s projects advance, the development risk decreases and the opportunity to realise the potential increases – which is positive for the valuation of the project.
From an investment perspective, it is usually better to own a smaller part in something that grows than a larger part in something that is static or that stagnates.
Who can participate?
There are different ways to carry out a share issue – the company can control who are able to participate in the issue. A common way is to offer it to the general public, which means that anyone is allowed to participate.
Often, however, the company wants to give preference to existing shareholders and carries out a so-called preferential share issue that gives the existing shareholders priority. The most common procedure is that existing shareholders are granted a subscription right that is used to subscribe for the newly issued shares.
In order to “defend” his or her original ownership stake, the existing owner needs to participate in the issue – i.e. buy the corresponding part of the newly issued shares – and thereby contribute capital to the company.
Should an existing owner not want to participate in the rights issue, he or she can choose to sell the subscription rights on the market, if they are traded there. This provides a kind of compensation for the dilution that often occurs in connection with the issue. If you do not already own shares, but want to participate in the issue, you can often buy subscription rights via the market. Alternatively, you can register for subscription without the right to preferential treatment, which means that you queue up to invest if existing shareholders waive their right to participate.
Directed share issue fast and cost-effective
Another common way for a company to raise money is to carry out a directed share issue. This procedure means that the company offers selected investors to participate in a new share issue. A common argument for a directed share issue is that the company wants to carry out the capital raise as quickly and cost-effectively as possible.
Another argument for directed issues is that it provides the opportunity for larger investors to buy a large stake in companies whose shares are too illiquid in the daily trading. By purchasing newly issued shares the investor can carry out his placement and contribute capital to the company, at the expense of the dilution for existing shareholders.
Units and warrants
Carrying out frequent capital raises is costly for the company. An arrangement that has become popular in recent years is therefore the issuance of so-called units, a package of several financial instruments. Typically, each unit consists of a certain amount of newly-issued shares as well as one or more warrants.
The warrant gives the right to purchase additional shares at a specific time in the future at a price that is either determined in advance, or decided along the way. Commonly, the warrants are listed on the market and traded in parallel with the stock.
You can liken a unit issue to getting two, or more, issues in one. It may therefore be wise to think about the total investment and not just take into account the initial capital injection. When the time for redemption of the warrant occurs, the holder needs to decide whether or not to participate in the financing round.
How do you value a development project?
The funding rounds are a prerequisite for driving the long-term development work in biotech companies, with the goal of creating an innovation that can change the situation for patients. A successful project is often synonymous with an increased shareholder value. But how do you assess the value of a development project? This will be discussed in the fourth and final part of the article series, which can be found here.