Biotech Finance: A “Plug” for SPARCs

By Joseph Garcia and Jeremy Feist

Introduction

Obtaining financing is one of the greatest challenges facing many biotech companies in Canada today. Ernst & Young LLP (Toronto, ON) recently reported that 56 per cent of Canadian public biotech companies have less than two years of cash. The ability to identify and implement creative solutions to overcome this funding challenge will differentiate and perhaps ensure the survival of certain biotech companies.

In the past, equity investment and venture capital funding have been the main sources of biotech financing in Canada, with debt financing playing a much less significant role. The advantages and limitations of these financing sources have been canvassed at length in a variety of publications. Rather than contribute further to a discussion of these well-understood forms of financing, this article will instead focus on a different biotech financing structure that can find application in funding the development of under-funded pipeline projects.

The History of SPEs in the Biotech Industry

In the early 1980s, the North American biotech industry was in its infancy. Conventional internal financing from revenues was not (and is still not) a viable option for most biotechnology companies, and securing external sources of funding was problematic. In addition, at that time opportunities for corporate alliances were scarce and there were significant limitations to using equity financing. In response to the funding constraints faced by the whole biotech industry, biotech companies were forced to come up with creative solutions to the significant cash-flow problems they were encountering.

In 1982, Genentech Inc. (South San Francisco, CA) created the first publicly known SPE in the biotechnology sector. Genentech Clinical Partners was a research and development (R&D) limited partnership created for the purpose of funding the development of recombinant human growth hormone. This SPE raised $55.6 million US and laid the groundwork for other biotechnology companies to use SPE financing. Between 1982 and 1997, there were approximately 39 publicly known SPEs created in the U.S. biotech industry, raising a total of more than $1.4 billion US.

The use of SPEs in the U.S. biotech industry appears to have reached its zenith in 1992. There is very little evidence of their use as a public financing vehicle after 1997, until recently. It is uncertain why SPEs fell out of favour with investors, but it has been suggested that it may have been due in large part to the significant widening of the U.S. market for secondary equity offerings and private investments in public equity beginning in 1995, providing biotech companies with easier access to large amounts of relatively inexpensive capital.

What are SPEs and How Do They Work?

Over the last two decades there have been two general forms of SPEs employed in the biotechnology industry: R&D limited partnerships and special purpose corporations (SPCs). SPCs are further distinguished into special purpose accelerated research corporations (SPARCs) and stock warrant off-balance-sheet R&D corporations (SWORDs). All of these variations have common characteristics as well as their own unique features.

An SPE is a separate business vehicle, which is often a separate legal entity such as a newly formed corporation, or sometimes a flow-through vehicle such as a partnership. Typically, an SPE is created by the sponsoring biotech company and the SPE owns the designated assets and takes on the related risk of the financing. The fundamental objective of a biotech SPE is to isolate specific assets and potential liabilities for investors. Generally, it is easier to deal with new unfunded pipeline projects since a new project can be commenced by the SPE with fewer legal, business and tax issues. Shares and other securities are typically issued by the SPE, and are backed by the underlying project and its assets.

Since a typical SPE would not have a full complement of research staff and facilities, it generally contracts with the sponsor company for R&D services. Through contract payments, the money raised by the SPE from the issuance of its securities is paid as fees to the sponsor company. Generally, the sponsor company also provides management services to the SPE in exchange for management fees. The SPE uses the proceeds of the sale of its securities to pay these fees.

Ultimately, the relationship among the SPE, the sponsor company and the investors will be governed by a complex set of legal agreements that carefully define the nature and scope of the project as well as the rights and obligations of the sponsor company, the SPE and the project investors.

Depending on the parties’ circumstances and objectives, the sponsor company may wish to negotiate the right to future reacquisition of the SPE’s assets. This might occur at a time when the project is expected to have matured to the point that the associated risks have been sufficiently reduced. Conversely, if the project has failed or has not matured to such a point, then the sponsoring company may allow the reacquisition rights to lapse and walk away from the SPE entirely, provided this is allowed by the terms of the agreements between the sponsor company and the investors.

Why Consider this Financing Structure?

A biotech company’s ability to finance the development of its pipeline will depend on its ability to raise capital. If capital is not available on reasonable terms, then the firm is likely to focus its resources on its lead product candidates and forgo the development of secondary products in its pipeline. This situation may provide investors with an excellent opportunity to identify and finance under-funded, yet attractive projects such as the clinical development of drug candidates. SPEs come into play as an intermediary between the sponsor company and the investors, separating the project from the existing liabilities of the sponsor company and clearly defining the rights and obligations of the parties.

Further protection for investors can sometimes be obtained by imposing suitable restrictions on the business and obligations of the SPE, creating a situation referred to as “insolvency remoteness.” This enables direct investment in the project with the expectation that if the sponsor company runs into problems, the investors’ rights to the assets held within the SPE will not be impaired. An advantage of using an SPE is that it may permit financing that would not otherwise be possible, especially if the project held by the SPE has less risk associated with it than if it were held by the sponsor company.

A Recent Model

The number of variations in SPE structures is virtually limitless. Since business negotiations, accounting principles, tax considerations, and a variety of legal issues will affect the structuring of an SPE, no two SPEs are exactly the same. These vehicles must be tailored to meet the needs of both the sponsor company and the investors, all within a framework dictated by the specific requirements of the proposed R&D project. With that in mind, some of the basics of an SPE financing within a Canadian context are discussed below.

The SPARC transaction structure shown in Figure 1 was recently used by a public biotech company in the U.S. to fund clinical development of three of its drug candidates. In that case, the sponsor company licensed the intellectual property (IP) rights in the project to the SPARC and the investors agreed to invest up to $80 million US. In the event of a new project, the IP might be created over time and would be owned by the SPARC. In the case of an existing project, there might be a licence or a disposition of the IP rights to the SPARC. If there is a disposition, the feasibility of the structure might depend in part on whether the sponsor company has any offsetting losses to moderate the disposition’s impact. The sponsor company will derive revenue from the IP licence and the research contract. To the extent the SPARC incurs losses or generates tax credits from its operations, flow-through treatment to the investors might be required. In that case, consideration should be given to establishing the SPARC as a flow-through vehicle.

The exit strategy for investors may take a variety of forms. For example, to the extent that all assets related to the project and all liabilities and obligations in connection with the project are concentrated in the SPARC, the project may be sold by means of a sale of the shares and other outstanding securities of the SPARC. While some rollovers or non-recognition treatment may be available in certain circumstances, many exit strategies will result in a disposition by the investors, and the business terms need to take into account the resulting tax implications.

Conversely, the sponsor company will often wish to negotiate rights that allow it to reacquire the project. In some situations this might include a right to acquire some or all of the IP owned by the SPARC or to acquire the shares and other securities of the SPARC, as illustrated in Figure 1. Again, these transactions can give rise to dispositions and the resulting tax implications need to be considered.

In formulating a suitable structure and negotiating the related business arrangements, the accounting implications will be material. As a general rule, transparency is desirable from an accounting perspective and will be crucial to maintain investor confidence in the sponsor company.

If the project fails, the sponsor company may allow its right of purchase to lapse. In that case, unless the investors have a viable exit strategy they will be left with the SPARC and its IP rights in the failed project. This possibility will generally give rise to significant negotiations. As a result, usually the relationship among the sponsor company, the investors and the SPARC, as well as the rights accruing to each party, will be governed by a complex set of contractual agreements. The overall goal of the contractual agreements will be to set well-defined boundaries around the project and the rights to it, as well as to any new IP developed during the course of the ongoing R&D work.

Conclusion

One of the driving forces behind the increased use of SPEs in the U.S. biotech industry was the opportunity they provided for securing less expensive financing than could otherwise be obtained. Arguably, SPEs fell out of favour in the U.S. right around the time that even more affordable forms of financing became available. In Canada, the use of SPEs may, in certain circumstances, allow sponsor companies to raise funds that may not otherwise have been raised. Simply put, SPEs allow outside investors the ability to finance attractive projects while avoiding other risk and liabilities associated with the sponsor company, thus broadening the range of potential investors.

References

(1) Ernst & Young LLP. Beyond Borders: Global Biotechnology Report. New York, 2005.

(2) Solt, M.E. “SWORD Financing of Innovation in the Biotechnology Industry.” (1993) 22 Financial Management 173.

(3) Schiff, L., and F. Murray. “Biotechnology financing dilemmas and the role of special purpose entities” (2004) 22 Nature Biotechnology 271.

(4) Ibid.

Joseph Garcia is a partner in the Business Law Group of McCarthy Tétrault LLP (Toronto, ON) and is a member of the firm’s Life Sciences Group. Garcia practises principally in the areas of corporate finance, M&A and transactions involving the commercialization of IP assets. Garcia completed a B.Sc. in pharmacology and human biology and subsequently worked in clinical research for a major pharmaceutical company and in corporate finance with a national investment bank prior to practising law.

Jeremy Feist is an articling student with McCarthy Tétrault who has a B.Sc. in chemistry and biochemistry (combined honours).

The authors wish to thank and recognize Brent Kerr, Beth Macdonald, John Pearson and Orysia Semotiuk of McCarthy Tétrault for their thoughtful insights and assistance with this article.