A Biotech Structure For A Tough Financing World
By Joe Comeau, office managing director, WTAS’ New England practice
The current world of biotech start-ups is experiencing a real crunch obtaining financing. VCs are very particular, having investors who may not have the patience for very long times to commercialization and payday. Big Pharma appears to be all over the place, with T money to spend on good IP, but with huge bureaucracies and infrastructures that can sometimes stifle good science and often choke entrepreneurial spirit. Bio is unique as a business space because so many companies are driven by people who are brilliantly creative and who have ideas about how their science can change the world in good ways. Often those dreams fail, but so do many start-ups in any space. However, bio company founders also remain undaunted by the fact that they typically take considerably longer than other start-ups to get to commercialization events that allow investors to see a return on their investments. This confluence of factors has distinguished the bio world as being especially leading edge when it comes to creatively financing their projects. Based on the unique characteristics of the bio world, it is time for these companies and their founders to take a look at a page from big business — with a modern twist.
There was a tech-oriented company in greater Boston called Thermo Electron (now called Thermo-Fisher). The company had many people investigating many different discoveries, including people who came over in acquisitions. However, the discoveries led to technologies that were not all best applied in the company’s core business. Management distributed promising tech into subsidiaries and took those subsidiaries public, keeping a majority stake for the parent. As an early pioneer in what was essentially a public venture investment, the company was able to finance good ideas and give its investors access to public market liquidity. Bio can use a variation on this theme with very powerful results.
Application in Today’s World — Hub and Spoke
The proposition is that a new bio enterprise be formed as an LLC, not as a regular corporation. That LLC would own the core IP and the founders would be LLC owners. The LLC will be a holding company for all IP — the hub for all future expansion. On day one, it will contribute a specific subset of the core IP to a subsidiary LLC (Sub1) in exchange for its equity. This would be the first spoke of potentially many. Then, external investors will contribute cash in exchange for typical preferred equity financing in Sub1. Sub1 will perform the development activity — and any other activity that an otherwise single corporate entity would accomplish. Other applications for the core IP will be contributed to sister subsidiaries from the holding company LLC, as the times and markets develop demand for those applications (additional spokes). The same or other investors could participate in those new subsidiaries, and the pricing, financing, and terms could all be specifically tailored to the value proposition of that subsidiary.
why doesn’t everyone do It?
Why is this worthwhile? The founders can concentrate investment dollars on specific applications without needing to convince existing investors to participate and without requiring expensive taxable separation of valuable IP components. Furthermore, if BIGCO comes by and wants to pay up for the first IP slug, the other applications — in which BIGCO may not even be interested — can be further developed and harvested with different players. The structure gives the operators and the investors incredibly more flexibility than a single entity for the entire package.
This is a more tax-effective approach than the one used back in the day by Thermo and others. With a traditional corporate structure like theirs, if StartupCo had investors that wanted to harvest value from one IP but not others (because, for example, the others are in different fields for which current buyers of the extant IP are not willing to pay), its investors would likely experience double taxation. With the LLC model, that does not need to happen, and that means more aftertax cash for all.
So why doesn’t everyone do this?
First, traditional corporations are simple. Companies have been started in that way for decades. “Keeping It Simple Stupid” is an easy approach to take when all you really want to think about is the IP development. Second, most founders focus on their “best shot” within their IP, with the hope that they can develop the rest later. Having it all in one corporate pot is easy to understand. Finally, LLCs are different tax animals, and some investors shy away from them for that reason. Although most VC funds are LLCs or their rough equivalent, the funds themselves are used to investing in traditional corporations, and they usually eschew anything more tax-complex.
However, the laws have evolved, and more importantly, the vast majority of start-ups focus on one product/suite of tech for their value proposition. Bio is more diverse, at least right now. There are fascinating caches of IP that have the potential for application to widely diverse therapies, and those applications could have very different ultimate consumers and ultimate interested buyers. This represents an opportunity for investors and founders to maximize their value with very little brain damage due to structure. Nowadays, any investor reluctance to invest in LLCs for tax reasons can be very effectively managed, and, in the end, the advantages will likely outweigh any added complexity.
Some other flexibility advantages for this approach include:
- Companies can issue “cheap stock” to key employees even when subsequent financing rounds value the company higher. This helps the company attract and retain key people more effectively than a traditional corporation.
- Traditional corporations in the bio world can lose their ability to carry over their tax losses due to ownership changes or simply length of time. The LLC approach fixes that by stapling any losses to the investors present when they are incurred.
- The LLC vehicle can allow the company to position a sale of one or more of its component IPs to a buyer in such a way that the buyer can eventually tax deduct its purchase price.
- If “public venture funding” becomes a viable prospect for a given IP, this approach easily allows a SubX LLC to legally become a traditional corporation and do an IPO.
Times They Are a Changing
The old Bob Dylan song couldn’t be more apropos to the bio world today. All things considered, bio has demonstrated an excitingly creative bent on financing that appears to be far ahead of the curve in the overall start-up space. It is time to consider adding something like the hub-and-spoke approach to the bio toolbox.