In my last post, I wrote about shelf registration filings among small cap biotech companies. I defined a small cap biotech company as one engaged in drug development with a market capitalization of less than $1 billion. Often referred to by their SEC form designation, S-3, shelf registrations are prospectuses that allow companies to issue securities at any time within three years of the date of filing. Data from the past four years, specifically second quarter of 2010 to second quarter 2012, revealed that approximately 1/3 of US small cap biotechs use S-3 shelf registrations. Of those, however, around 80% of shelf-filing companies subsequently employ them, i.e., sell securities and raise additional capital, though the timing and the size of the first financing varies considerably. Thus, a company’s decision to put a shelf in place does indeed foreshadow a likely future financing, usually within six months.

I gathered a lot of extra data in conducting that analysis. Several readers put forth follow-up questions, which I address here. My database includes new shelf filings as recently as the end of Q2 2012, so many of the S-3s under consideration are still active. I should note that in the two months since I last wrote, numerous public companies have raised money by drawing upon securities registered in their S-3s. January 2013 was a particularly robust month for fundraising in the biotech sector. I’ve updated my data to account for the recent financings through January 2013.

@biotechbaumer asked, “Would be interested to know how stock trades post S3 filing until the financing event(s) occurs.” 

Similarly, John Dyer of advisory firm Aquilo Partners asked, “What’s the normalized stock price reaction (filing + one day, + 5 days) to a shelf filer?” and “What is the normalized return of shelf users from filing?”

These are great questions, as they address both the market’s initial reaction to a shelf filing and the ability of an S-3 filing company to raise money at higher prices.

Looking first at short-term price movements, I examined the percentage change in share price one day after the S-3 was filed. For the 268 new S-3 filing made between Q2 2008 and Q2012, the average change was -1.5%, but there was wide range of -24.3% to +34.3%. The majority of 1 day price changes were negative; specifically, ~67% of S-3 filers experienced share price decreases the day following their shelf filing. The full distribution is shown in Figure 1.

Figure 1

Of course, one day stock movements can be strongly influenced by overall market conditions on the same day. To account for this potential confound, I looked at the concordance between the one day stock movement for the S-3 filer and the one day movement of the NASDAQ Biotech Index (NBI). In the scatter plot blot below (Figure 2), when I plotted the percent change in S-3 filer stock price one day after filing versus percent change of the NBI that  same day. The data are pretty noisy, but I think it’s fair to say that the relationship between the two price movements is weak, which indicates that when the markets are up, the S-3 filer stock price is not necessarily up, as well. Further, if one creates a 2×2 matrix of price movements, it’s clear that even on days when the NBI is up, stock prices of S-3 filers are mostly down. Rarely is the converse true.

Figure 2

As I wrote previously, S-3s provide a mechanism to sell securities opportunistically. The hope, of course, is that if S-3 filers sell securities, they do so at a higher price to minimize shareholder dilution. How often do companies that finance off the shelf do so at a price above where before the shelf was filed?

Of the 268 S-3 filings, 215 companies subsequently raised money. Slightly less than have half, or 94/215 (~44%), raised subsequent money at share prices higher than the share price at the time of the S-3 filing.  The range in share prices at the first financing varied dramatically, however. As can be seen in the plot in Figure 3, the range was -91.4% to +1,467%, the average change was +13.6%, but the mean was much lower at -8.7%, indicating the effect of positive outliers. Indeed, price decreases are limited to 100%, but share increases are theoretically limitless.

Figure 3

Lastly, @colinmagowan asked, “Did you track lead asset stage and disease, or say # of therapies in clinical trials when S-3 filed?”

I can see where the questioner is coming from; drug development costs vary by therapeutic areas. Thus, companies working in these areas may need to file larger shelves for more money. Further, the capital markets tend to value later stage assets more highly, as they are presumably closer to market. Late stage clinical trials cost more, too, so perhaps shelf filers and shelf size are related to stage of development.

I needed to go back and do some additional work for this question. To avoid the subjectivity of categorizing companies’ therapeutic area, I simply used the classification scheme put forth in each quarterly and yearly roundup issue of BioCentury. I realize that many readers do not have access to this industry publication, but suffice it to say that in these summary issues, the editors of BioCentury sort the majority of public biotech companies by therapeutic focus area. In Figure 4 are the data of S-3 filers, sorted by BioCentury classification, on shelf size and “implied dilution,” or the ratio of shelf size to market cap at filing. There may be hints of differences among companies focused on cardiovascular (CV) and pulmonary (Pulm.) regarding use of S-3s, but the sample sizes (Ns) are somewhat small in those categories. Otherwise, across therapeutic areas, it appears that implied dilution is in the 60-80% range on a shelf size of $50-$75 million dollars. (Recall that I define implied dilution as the ration of shelf size to market cap at the time of filing. The implied dilution is therefore a measure of the dilution that current shareholders would experience if all of the securities in the shelf were issued.)

Figure 4

So, putting it all together, I’d say the takeaways are:

1. The immediate market sentiment to the filing of an S-3 statement tends to be slightly negative, as suggested by 1 day stock movements in the context of broader market movements. That said, the price changes are usually less than 10%, which a long-term investor can generally accept.
2. Whether the S-3 filing company subsequently raises capital at higher prices is not predictable; roughly half of them do, half of them don’t, with wide variations in between. Clearly, companies thrive or struggle based on their unique prospects. Another reason to do your due diligence.
3. Therapeutic area doesn’t seem to impact S-3 shelf size. However, this conclusion is based on small Ns in some cases and the categorization of companies by therapeutic area is difficult, as lead programs may change, they might be based on platform technology that is broadly-applicable, etc.

Adam Bristol

Access to capital is essential for development-stage biotechs, yet the capital markets for public and private biotech companies are notoriously fragile. For private companies, venture investing in the life sciences has recovered from a rough patch in the ’08-’09 span to the robust financing environment in last year and a half. In the public markets, IPOs haven’t fully rebounded to historical levels, but follow-on financings and debt deals have been brisk as the biotech sector has performed extraordinarily well in 2012. Indeed, the NASDQ biotech index is up ~35% YTD at the end of the third quarter.

Public biotech companies have a mechanism, a shelf registration statement (or S-3, as it is known in SEC terminology), to register securities in advance of their issuance. The securities are “put on the shelf,” generally speaking, allowing them to be sold at any point within the 3-year lifespan of the shelf registration statement. One would think that having an active shelf registration on file is a must-half for public biotechs; they exist in a topsy-turvy macroeconomic environment compounded by the highs and lows of product development. Allowing them to raise money opportunistically and take advantage of strong capital markets or simply strong interest in their stock should be a good thing.

However, this is not the typical view. The filing of a shelf registration statement is often met with derision, and considered a bad omen that shareholder dilution is around the corner. If you follow any of the biotech stock watchers on Twitter, you know what I mean. My sense is that complaints arise primarily for three reasons:

1. Investors seek to avoid dilution, and the issuance of new shares via draw downs from a shelf dilutes existing shareholders.
2. Filing of an S-3 shelf registration signals to the market that a financing is forthcoming, thus creating an overhang on the stock, depressing its performance. In other words, why should big institutions buy shares in the open market if they can simply wait and buy in an upcoming follow-on financing?
3. An active shelf is like a credit line for management that can be tapped at their discretion, so incentives are not fully aligned with shareholders if shelves are utilized haphazardly.

I don’t like dilution either, and I don’t like the artificial feel to the market cap increases that result from the issuance of more shares. But is there empirical support to the notion that S-3 filings predict subsequent financings? Is filing an S-3 a reflection of management and corporate strategy or a fact of life for R&D stage biotechs?

To address these questions, I looked at new shelf registration statements filed between Q2 2008 and Q2 2012 by US-based small cap biotech companies devoted to new drug discovery and drug development. I defined “small cap” as less than $1 billion, as this captures the vast majority of pre-commercial companies. I restricted the list to drug discovery and development companies because a) their value is largely “technology value” — the value ascribed to their development programs above the cash balance, and b) their cost of capital is heavily influenced by the perceived value of their technology.

During this period, I tallied 269 new shelf registration statements by 180 companies (some companies filed more than one, a replacement to an existing shelf that was either depleted or not). By my calculation, there are approximately 340 US-listed, small cap drug development companies in the sub-$1 billion range, so around 50% of these utilize shelf registration statements. Filing S-3s are not a universal capital-raising strategy.

But S-3 filers are a diverse group, with market caps at filing of between $11 million and $840 million. Further, the size of the shelf (that is, the total amount of capital that can be raised by the securities contained in the shelf) varied as well, though there was a slight trend for larger market cap companies to file larger S-3s. Of course, shareholders are interested in “implied dilution,” or the dilution that would occur if the entire shelf was drawn down. As expected, the implied dilution, or the ratio of the shelf size to market cap at filing, tends to be larger for small companies, but as shown in the figure (click to enlarge), there are some significant outliers. I assume that shelf size is related to the cost-intensiveness of future development plans, but perhaps I’m giving management too much credit. 

Is an S-3 filing a harbinger of a near-term financing? The data say: Yes. Of the 269 shelves, 207 (77%) have raised money. Of those 244 S-3s filed before January 1, 2012, that number rises to 82% (199 of 244). If one excludes those companies that were acquired with an active shelf in place (e.g., ISTA, ANDS, INHX, CLDA, ISPH, ADLR, MITI, PRX, PPCO), the number is closer to 85%.

The average time to the first financing was 207 days, with a median of 240 days. The magnitude of the first drawdown covered the full range, from 1% of the shelf to the full 100%. As shown in the figure, the majority of the first financings raised 50% or less of the full shelf value.

Taken together, the data around S-3s in recent years, a period of economic hardship, indicate that:

1. Only about half of small cap therapeutics companies file shelf registrations
2. For those that do, the overwhelming majority utilize them, usually in about 6 months
3. The first drawn down is usually 50% of the shelf or less, which could give shareholders an estimate of the extent of dilution at a first raise.

Of course, as I noted above, raising money is a necessity for biotech, so noting here that they do, via the shelf mechanism, is somewhat self-evident; if a company files a shelf, why not use it? More important is when and how.  Ideally, shelves are utilized at opportunities when share price is high. Remember that S-3 remain active for three years, so market cap at the time of shelf drawn downs is perhaps a more important metric than market cap at the time of filing. If share price rises (and so market cap) during that time, the implied dilution would decrease.  These are questions to explore in future posts.

I should note that, in the process of compiling these data, I put together a fairly extensive spreadsheet with numerous metrics related to S-3 filers, such as stock performance, extent of insider holdings, estimated runway at the time of filing/draw-down, share price at first raise, etc. If any readers are interested in a particular question, please let me know in the comments below or via direct message on Twitter and I’ll see if I can address it with my database.

Adam Bristol

In a series of posts we introduced the Leverage Startup and how non-dilutive sources of capital can be used to accelerate the commercialization of academic biotech projects.  In this post we discuss the use and sources of non-dilutive financing in biotech startups.

We define non-dilutive funding as financing that does not require the sale of your company’s shares, and hence does not cause dilution of the existing shareholders.  The use of non-dilutive funds as a component of your financing strategy is important and has many benefits.  First, non-dilutive funds can provide critical cash to support your company’s development.  Second, because non-dilutive funds do not require the sale of the company’s voting equity, it allows founding teams and existing shareholders to retain company ownership and control.  Third, as many non-dilutive funding sources require approval from expert stakeholders with deep domain knowledge like funding agencies, important validation of the team and technology can be provided for future customers, partners, and equity investors.

The following gives an overview of non-dilutive sources.

Government research grants. (for example: NIH).  Certain research focused government grants include companies as eligible awardees.  The National Institute of Health (NIH) is a good example, where companies can compete for R01 and R21 grants alongside traditional University applicants. These government research grants typically fund basic research or its commercial translation, with the required stage of development clearly outlined in the call for proposals. Such monies typically fund salary and consumables, but limit their contribution of overhead or other non-research activities.

Government industry grants (for example: SBIR, NRC IRAP).  With the aim of enabling the commercialization of cutting edge technologies, various governments have established industry specific grant programs.  These grants typically emphasize the commercialization of research and the application often requires a strong market argument for the future product.  These grants usually fund commercialization activities rather than basic research and sometimes can be partially used to support the filing of intellectual property, conducing a market analysis, and other business development actives.  Many of these funds require the company involved to provide matching funds in the form of in kind (i.e. additional salary support) or cash, and to demonstrate that the business will provide a conduit for commercialization.

Foundations (for example: Gates, CF, Ellison, Lou Gehrigs, X Prize).  Foundations are becoming an increasingly important driver of biotechnology innovation. Foundations are typically focused on improving the health of individuals inflicted with a specific disease, for example the Cystic Fibrosis Foundation, and are primarily funded by donors with a connection to the ailment.  To increase the research being conducted for the given indication as well as the effectiveness of that research, Foundations are taking a very pro-active approach to funding R&D.  For companies, this can represent a significant opportunity to obtain R&D funds to push forward a technology that can impact a given disease. In addition, Foundations also provide a conduit to clinical expertise as well as potential access to patients and stakeholders, giving a program a larger chance of translational success.  There are also new initiatives specifically focused on biotechnology entrepreneurship.  For instance, Breakout Labs, an initiative from the Thiel Foundation, has been set-up to bridge the gap between early-stage research and venture capital-ready technologies.

Industry partnerships.  Industry partnerships are the life blood for pre-revenue biotech firms. Typically, partnerships involve a transfer of technology from a small biotech to a large company in return for cash and/or co-development rights.  These partnerships can involve significant sums of upfront and downstream cash flows and often represent the first major validation of the technology by an established pharma or large biotechnology company. Although these funds usually do not involve an equity stake in the selling company, such transactions usually involve a license or option-to-license of the selling firms intellectual property.  It is important to keep such licenses non-exclusive or narrowly-exclusive such that the startup remains positioned for long term growth.

Venture Debt (for example: Silicon Valley Bank). Venture debt is a useful tool in Biotech financing.  For example, debt can be utilized to extend the runway of an existing financing round to allow the company reach critical proof-of-concept achievements prior to follow on investments.  A financing round is usually required before accessing Venture Debt, and the lenders are anticipating that the company will raise another financing round or other capital injection to receive their payback.  Lastly, as with all debt, there is insolvency risk associated with it and careful consideration is required before taking such funds.

Revenue (for example: contract research, early product release).  Building a company on the back of a successful revenue stream is an ideal financing approach, however this can be challenging for nascent ventures.  For biotech firms will little to no regulatory involvement (i.e. tools companies, certain medical devices, industrial applications, etc.), establishing customers to use and test early prototype products is feasible and recommended.  For firms with significantly more regulatory barriers (i.e. therapeutic, diagnostic, etc.) revenue can sometimes be generated through auxiliary products or services, for example contract research or consulting.  In these cases however, the founding team needs to be diligent to not be distracted from the ultimate product goal of the firm and needs to weight the value of these funds over the delays it will create in achieving overall long-term goals.

Although non-dilutive sources are a great way to finance an early stage biotech, it should be noted that they are not “free” and can have important implications and associated costs.  For instance, certain funding agencies require that the invested cash be returned if the company is acquired by a foreign company, that they receive a multiple of their investment upon commercial success, or that they have certain rights to the IP.  Additionally, non-dilutive funds are typically allocated to a given project, rather than to the company at large.  As such non-dilutive funds are more ridged to business pivots that require a change in a said project, and do not fund other business development and overhead of running your business. A combination of dilutive and non-dilutive financing is often the strongest mix for early biotech.

Thanks to Euan Ramsay  & Mike Koeris for edits and input on the post.  This post was originally posted on BiotechStart.org.  Please provide any insights you may have to the use of non-dilutive funds, and sources of non-dilutive funds in countries outside of North America.

James Taylor