biotech - Haaretz - July 20 2011
Biotech research. Photo by Haaretz
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Big Pharma used to pour money into internal research and development departments, in the hope of finding the next blockbuster drugs. In recent years, however, many giants in the pharmaceutical industry have been slashing R&D spending.

By doing this, they have effectively outsourced their innovation needs to biotechnology startups.

This change, however, has not translated into easy money for the startups. Early-stage biotech companies often find themselves starved for cash and drugmakers are wary of paying significant amounts of money for assets that have not yet achieved clinical proof-of-concept.

It was not always so complicated. In the fledgling years of the biotech industry, before the turn of the century, it was a sellers' market. A typical biotech startup success story went something like this: at an early, preclinical stage, raise venture capital, and at early stages of clinical development, sell to a large pharmaceutical company or go public on the stock market.

Things change

Since that seemingly simple time, things changed. Many once-promising technologies failed. Additionally, the world experienced a financial crisis in 2007-2008, leading biotech venture capital to contract. On top of all that, the pharmaceutical industry consolidated, which had the double effect of limiting the number of potential acquirers and forcing venture capitalists to reserve funds for follow-on financing of portfolio companies.

The upshot was that, for about five years starting in 2008, early-stage biotech startups were forced to seek capital in an extreme buyers' market. In 2013, the market did somewhat favor discovery-stage companies, large pharmaceutical companies did ease up on merging with each other, and initial public offerings of biotech companies did surge. It is too soon to say, however, whether 2013 signaled a meaningful shift – for example, pharma merger activity is on the rise again in 2014 and it is hard to ignore the big biotech selloff in the public market earlier this year.

Indeed, overall, it is still the case that there exists a significant gap in valuation expectations between many early-stage biotech companies and their prospective licensees or acquirers.

Enter the option transactions

This reality has forced early-stage biotech companies and pharmaceutical companies to devise creative deal structures to advance their symbiotic interest in developing biomedical technology and products. By reducing some early-stage risk that licensees or acquirers would otherwise take on, these structures have enabled early fund-raising by biotech startups – even in the dark years following 2008. Prominent among these structures are the "option to license" and the "option to acquire" transactions.

In an option to license, the "licensee" pays the startup company cash for an exclusive right, but not obligation, to in-license in the future certain technologies or products of the company, based on preset terms. In a simple option to license arrangement, the licensor gets an immediate cash infusion – the premium for granting the option -- which it can apply to develop, say, a certain antibody; and the licensee will have the right to move the so-developed antibody into clinical development, at the licensee's own cost, subject to payment of milestones and royalties.

In an option to buy, the "buyer" pays the startup company cash for the exclusive right, but again not the obligation, to buy the company in the future at a predetermined price. For example, in 2012, Genentech committed $95 million over three years to finance development of Constellation Pharmaceuticals' lead assets and obtained the right to buy Constellation outright at the end of the three years on predetermined terms. An option to buy can even be finessed to lock up certain assets without requiring the startup to acquiesce to a full-on acquisition.

Spreading early-stage risk

Option deals come in many variations, but the basic trade of paying a startup a relatively small amount on the front-end to lock up, without commitment, assets that could be worth much more on the back-end remains the common feature. This means that the startup both gives up on the certainty that accompanies a deal without options and limits its exit possibilities.

Companies and their venture capital backers do see advantages in option deals. Most importantly, the startup achieves critical funding for early-stage, even pre-clinical, research and development – with non-dilutive capital, no less. The startup can also maintain some independence, at least during the option term. Also, depending on the terms of the contingent license or acquisition, the startup can retain exclusivity over its assets that do not interest the licensee or acquirer, leaving the startup free to partner with others on -- even option out – those other assets.

The back-end payment of an option deal is designed to close the gap in valuation expectancies between a startup and the licensee or acquirer. It is true that a startup and its shareholders may worry that an option deal requires them to compromise on the high valuations they could achieve without optionality if the startup were to attain value-proving milestones. Perhaps justified, perhaps not, but for a startup, the up-front liquidity can be practically invaluable.

Also worth considering is the total deal value of an exercised option transaction, which includes the payment of the option premium and the future price of the underyling assets, if successful.

Option deals spread development risk -- they push significant consideration to a later, successful stage of development. In other words, the company and its shareholders keep some of the early-stage risk. Regardless, these types of deals do solve a key challenge in the biotech world – getting funds from pharmaceutical companies to early-stage innovators. In today's market, that is critical.

The author is a partner in the law firm of Caspi & Co. in Tel Aviv, where he heads the international department, and teaches at Tel Aviv University Law School.