Asked & Answered

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Compiled by Amber Lepage-Monette

Understanding firm performance is important to strategy development and firm operations. Yet, with the innovative, costly and lengthy nature of biotechnology operations, and the fact that relatively few have products, customers or earned revenues, is it appropriate to apply traditional accounting-based measurement systems to biotechnology firms, their individuals and their activities? And if not, then what sort of metrics and frameworks do you use to measure the performance of biotechnology firms and their employees?

The following question was prepared for Asked & Answered by Ian McCarthy, PhD, associate professor, Management of Technology MBA Program, Simon Fraser University (Burnaby, BC).

Cameron Groome, director of Investment Banking, Biotechnology and Healthcare First Associates Investments Inc. (Toronto, ON)

Traditional accounting-based measurement criteria are certainly important in assessing the performance of biotechnology companies, but such tools highlight only part of the picture. To clarify a company’s overall performance, analysts and investors must soon turn to other sources of illumination beyond generally accepted accounting principles (GAAP).

Where GAAP accounting plays a vital role is in measuring the financial strength of a biotech company and (sometimes) how efficiently it uses shareholders’ capital. It would be impossible to gain a clear understanding of the health of a biotech company (e.g., burn rate, months of cash) and whether management is appropriately using capital (e.g., overspending, excess G&A) without the use of traditional financial statements. Accordingly, accounting measures are crucial for assessing the financial risks of biotech firms.

But GAAP accounting does not blaze so brightly when it comes to assessing whether a given biotech firm will ultimately be a gloomy failure or a shining success. To assess whether management is doing a good job brightening the prospects of a given biotech company, investors must look to qualitative measurements. In so doing, the best way is to spotlight the scientific basis and market rationale for a product and then put the clinical, regulatory and commercialization strategies under a microscope. Not a PhD, MD, MBA, CFA with 30 years’ experience and lots of time? Not to fret, I’ll tip you off to a shortcut that will beam almost as much light on these questions, but requires a lot less energy.

For an investor with less time or expertise, I suggest another way of looking into a company’s dark corners: Go to a firm’s Web site, or better yet, to an unalterable regulatory document depository, such as SEDAR or EDGAR, and look at prior filings and presentations by the company. Does what it promised match what it actually accomplished? Were the clinical trials completed on time with good results? Did the company sign the partnerships it sought? Is the business plan consistent, or does it resemble a shell game?

While past performance is not necessarily an accurate gauge of future results, it’s the best we have. By combining traditional GAAP accounting with a qualitative review of whether management is accomplishing its own goals and a bit of effort, even a non-technical investor can rapidly assess the brightness of any firm’s outlook.

Grant Tipler is the head of the Life Sciences and Health Care Markets for RBC Royal Bank in the Greater Toronto Area, and the Toronto Biotechnology Initiative board member responsible for Membership Services.

Can you apply traditional accounting measurement systems to biotechnology companies?
Yes, you can, but you only go so far. A review of the financial statements will show how much equity has been injected into the company to date and how much cash remains on the balance sheet. A review of the assets will show if there is capitalized research and development, patents, fixed assets or in-licensed products. A review of the income statement will show the R&D expenses and the cost of running the company. This information, along with the cash on hand, will enable one to determine the burn rate and months of cash on hand. If there is less than two years’ cash on hand, the financing strategy must be questioned.

What other metrics do you look at besides the financial statements?
The science, strength of leadership, scientific advisory boards, and independence of directors are all reviewed. A company’s leadership should have successful operating experience: having successfully run another business demonstrates your capabilities. A positive track record is invaluable when sitting across the table from a potential investor.

Does the company have more than one technology? If one fails, is there a backup?
Multiple technologies are helpful in attracting new investments into the company. VCs are reluctant to fund “one-trick ponies.”

Is the corporate structure simple or complex?
Structures set up for tax reasons can be very hard to finance. Lawyers and accountants like to set up multiple legal entities, but you should resist the urge. I have had more than one CFO tell me that the desire to save taxes has stunted the company’s growth, as it was not able to raise sufficient funding from conventional sources.

What is the competitive landscape for your product or service?
Can the executive team define the market and know how the enterprise will compete? Have both direct and indirect competitors been identified? They usually exist in one form or another. If the therapeutic or product is too expensive, then “doing nothing” is a viable alternative. In what price range will the product sell? Will a direct sales force be used, or a partnership with a distribution company? If some of these decisions have not been made in the early stage of a company’s development, that can be acceptable.

Conclusion:
Whether the company is arranging an equity round, a private placement, or the financing of scientific research and experimental development tax credits, proper preparation and execution are as important as the science. Financiers are investing in people, and leadership can make the difference. Whether the technology is mediocre or excellent, strong leadership will determine the level of success.

To participate in the A&A section of a future issue, please contact Amber Lepage-Monette at amberl@promotive.net .