Financing UK Life Sciences

Practical Law UK Articles 3-504-5704 (Approx. 10 pages)

Financing UK Life Sciences

by Paul Claydon and James Halstead, Morrison & Foerster

UK public markets

The Alternative Investment Market (AIM), the junior market of the London Stock Exchange (LSE), has traditionally positioned itself as a target destination for growing companies. It offers access to public finance in a regulatory framework which is more flexible than the main market. In the mid-2000s, AIM was flourishing. Between 2003 and 2006, the number of companies seeking AIM admission each year tripled with sums raised by initial public offerings (IPOs) rising sharply from just over GB£1 billion in 2003 to almost GB£10 billion in 2006. (As at 1 November 2010, US$1 was about GB£0.6.)

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AIM has provided the sector with over GB£2 billion since 2001. The life sciences sector attracted a disproportionately large share of the money raised on AIM, accounting for about 8% of all monies raised during the period 2001 to 2004, including notable new issuances by companies such GW Pharmaceuticals plc which raised GB£25 million in 2001 (accounting for 2% of all funds raised on AIM that year).

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The attraction of investing in life science companies at the beginning of the decade was brief, and it is clear that by the mid-2000s, when the flow of monies from the public markets into life science companies was at its height, the proportion of monies being raised by life science companies was in relative decline. Since 2005, financing has returned to about 3% of all monies raised on AIM across all sectors. The sharpest decline, however, has been observed in the number of IPOs, with only a handful of new life science companies having been brought to market. However, the return to a lower trend level may not be surprising. By reference to market capitalisation and absolute number of companies, life sciences remains reasonably steady, fluctuating around 5% of the total AIM market.

An analysis of the main market of the LSE shows a very different picture compared to AIM. Unlike AIM, where 75% of companies have a market capitalisation of less than GB£50 million, life science companies listed on the main market include big pharmaceutical companies as well as large biotechs. Invariably main market listed companies are larger and operate more mature businesses than their AIM-listed counterparts (over 80% of main market companies have a market capitalisation of over GB£50 million).

As with AIM, the main market saw a significant increase in the amount of funds raised between 2003 and 2006. The aggregate amount of equity finance raised by Main Market listed UK companies increased from just over GB£7 billion in 2003 to over GB£21 billion by 2006. When interest in the sector was at its height in the early 2000s, life science companies managed to capture 3% to 4% of monies raised on the main market, though in recent years this figure has fallen sharply to less than 0.1%. With the exception of a handful of life science companies which listed on the main market during this period (such as ReNovo, Ardana and others), the main market has proved largely inaccessible to emerging life science companies, particularly in the past few years.

So, can the UK public markets deliver the finance needed by growing companies in the UK life sciences sector? For those who believe that the volumes of money raised in the early 2000s could and should continue indefinitely, the answer is "no". Similarly, for those who would like the main market to provide finance for early stage companies the answer will likely remain "no". However, the majority of growing life science companies do not need the large amounts of capital which can only be delivered through a main market listing. Those grass root companies which drive underlying growth in the sector generally have a more modest objective of developing their product portfolio through to a point when it can realise value for their investors. In this context, the significant volume of financing accessible only through the main market may not be sought or required. For these companies, it is AIM which seems likely to remain of principal relevance, by providing the step beyond venture capital finance, but without main market listing demands.

AIM delivers less money to the life sciences sector than it has done in previous years. Although the decline in new admissions and the volume of finance raised is of concern, finance is not moving away from life sciences relative to other sectors. The life sciences boom of the mid-2000s was predominantly driven by overall growth in the AIM market as a whole. Similarly, in later years, the decline in equity investment in AIM-listed life science companies can be attributed to a general decline in the ability of AIM to provide finance for companies across all sectors.

Although in the short term some companies may be struggling to raise funds, in the medium to long term, the sector can and should hope for a return to form as the general economic climate shows signs of recovery. The rejuvenation in the IPO market announced by the LSE at the end of 2010 saw a 500% rise in LSE IPOs in 2010 compared to 2009, with AIM having raised GB£6.3 billion with a notable surge in fund raising activities towards the end of the year.

As with the mid-2000s, the expectation is that the life science sector will recover with the public markets and that life science companies will again benefit from a surge in investor confidence. Towards the end of 2010 there was an increase in life sciences funding when, during the final three months of the year, GB£63.21 million was raised by AIM-listed healthcare companies and a further GB£20.68 million was raised by healthcare companies listed on the main market (including GB£20 million announced by Oxford Biomedica plc in December, but issued at the start of January 2011).

Finance structures for public companies

Against the public market environment described above, a number of public life science companies have been considering their ability to raise further funds and many have already implemented alternative funding strategies to raise the finance required. These alternative funding strategies will continue to feature prominently in the medium term, pending further strengthening of the public markets' appetite for life science companies. Below, the main features of traditional placings and open offers are outlined, and these are contrasted with some of the available alternative financing structures.

Placings and open offers

The issue of new shares for cash is generally considered as the most common and often least complex means of raising new funds, and the bench mark against which alternative funding structures are compared.

Potential investors are invited by the company to subscribe in cash for new shares. The process is managed by a bank (referred to in this article as the broker, though multiple banks may be involved and titles may vary) on behalf of the company. The broker also typically acts as underwriter. Where an issue of shares is underwritten, any shortfall between the number of shares the company announces it will issue and the number of shares actually subscribed by investors will be taken up and subscribed by the underwriter.

The broker charges the company commission on monies raised, currently typically about 4% of the placing proceeds for listed life science companies undertaking a UK fund raising (with smaller fund raisings generally attracting a marginally higher rate of commission).

For a placing, the categories of investor approached by the company are usually restricted to institutions and other persons to whom financial promotions can be made without requiring a prospectus. The bank usually helps co-ordinate a series of "road show" presentations to select investor groups, following which the price and number of shares to be offered is determined by the company in consultation with the broker and based on indications of interest expressed by potential investors.

In addition to (or less commonly, as an alternative to) a placing to institutional investors, a company may make an open offer to its existing shareholders inviting them to subscribe for new shares at the placing price. The number of new shares offered to each shareholder is pro-rated to that shareholder's holding of shares as at a specified "record" date.

Key requirements

The key requirements include:

The directors must be authorised to issue new shares, and statutory pre-emption rights conferred under the UK Companies Act must be disapplied (except where an open offer is made in accordance with these pre-emption rights, which is uncommon). Authorisation and disapplication require shareholder approval. This may require a shareholder meeting if those authorities previously conferred (usually at the company’s last annual general meeting) are insufficient.
An admission of new shares to the main market (including through a placing only) require the company to issue a prospectus (subject to certain exceptions, including where shares issued during a 12-month period represent in aggregate less than 10% of the company's issued capital).
A placing to institutional investors (without an open offer) by an AIM-listed company does not generally require a prospectus.
More generally, an offer of shares to the public in the UK (for example, under an open offer) requires a prospectus to be issued, even if the company is only listed on AIM (subject to certain exceptions, notably article 1.2(h) of the Prospectus Directive which currently exempts fund raisings of less than EUR2.5 million over a 12-month period). (As at 1 November 2010, US$1 was about EUR0.7.)
For companies listed on the main market, nonpre-emptive share issues at a discount to market price of more than 10% requires prior shareholder approval.

Advantages

The advantages include that:

A placing is relatively straightforward, and subject to any requirement to obtain shareholder approval, can be swiftly implemented.
The company generally has no ongoing commitment or obligation specific to the subscribing investors once the fund raising has been completed (except for generally applicable laws and the rules of the public market on which the company is listed).

Disadvantages

The disadvantages include that:

The process of drafting and obtaining regulatory approval of a prospectus can be time-consuming (typically around four weeks from first submission to the regulatory authority). Further, the costs of preparing the prospectus may be disproportionately high where the funds raised are relatively modest.
If shareholder approval is required, a circular must be sent to shareholders convening a general meeting. In addition to the time taken to prepare the circular (and, for UK companies listed on the main market, its approval by the Financial Services Authority) at least 14 days clear notice of the meeting (depending on the company's articles of association) must elapse before the meeting can be held and the fund raising completed.
To attract investors it is common for newly issued shares to be offered at a discount to their current market price. The amount of discount is driven by what new investors are prepared to pay. Unsurprisingly, given the challenging markets of the last 12 months, where life science companies have successfully raised funds the discounts required by investors have been significant. For example, on 13 December 2010 Oxford Biomedica plc (listed on the main market) and ReNeuron Group plc (listed on AIM) each announced fund raisings, which were priced at discounts to the current share prices of 37.5% and 20% respectively.

PIPEs

Similarly to placings, fund raisings by way of PIPEs raise finance through the issue of new shares. Unlike a placing, where the company would market to groups of potential investors with the assistance of a broker, a PIPE is generally structured as a direct subscription for shares made by a limited number of key investors (indeed often just a single investor).

Traditionally PIPE investments have been the domain of private investment funds, aiming to take sizable stakes in listed companies and often seeking to turn around the company's fortunes. In this context, PIPEs have been synonymous with distressed finance, with large discounts to market price offered on the share subscription.

The life science sector's experience of PIPEs has been somewhat different. In addition to the traditional investment fund PIPEs, emerging life science companies have also benefited from PIPE financing provided by commercial partners.

It is not uncommon for emerging life science companies to collaborate with a commercial partner (a big pharmaceutical or larger life science company), to jointly develop or market a new product or technology. These symbiotic relationships may be cemented by the larger partner taking an equity stake in the smaller partner. This investment offers many advantages to the larger partner. Not only does it finance the continued outsourcing of product development work, but also by acquiring a significant equity stake the investor gains an ability to protect its interests from acquisition by rivals while simultaneously offering the prospect of a financial return if the investee company increases in value.

Key requirements

The company requires the same authorities to issue shares free from pre-emption rights to the investor as for placings (see above, Placings and open offers).

Advantages

The advantages include that:

Traditional PIPEs are usually swift to implement, often being a simple one-to-one negotiation.
Commercial PIPEs can reinforce underlying relationships. In some circumstances such an investment may be seen by the markets as the prelude to a full acquisition.
Commercial PIPEs may be undertaken at a lower discount (or even a premium) to the current share price than comparable placings, representing the strategic value of the equity interest to the investing company.

Disadvantages

The disadvantages include that:

Traditional PIPEs often required large discounts to market value.
Commercial PIPEs can be slow to implement if dependent on the parties concurrently entering into other more complex arrangements such as collaboration agreements.
If a commercial partner holds a significant equity stake, this may dissuade takeover offers from being made by rivals. This may negatively impact the company's market value.
Existing shareholders are not offered the opportunity to participate in the investment. This can be a sensitive issue if the discount to market price is large.

Equity drawdown facilities

For many emerging life science companies, the need to have access to capital is critical, particularly for those companies incurring the costs of product development at a time when they may have little or no significant revenue.

To help guard against an uncertain ability to raise finance on the public markets, a number of listed companies have entered into equity drawdown facilities with a broker or investor. Although the names given to these facilities may vary, a common underlying structure applies.

A typical equity drawdown facility grants the company a right to call upon the broker or investor to procure subscribers for (or to itself subscribe for) shares in the company. This right is subject to an overall limit on the financial commitment made to the company and commonly tranched, such that the amount of funding callable by the company on each drawdown is also limited. There is also usually a requirement that a minimum period of time elapses between each drawdown.

The inclusion of over allotment options may also feature in some equity drawdown facilities. Under these arrangements, where finance is called for by the company, the broker or investor can increase the size of the fund raising subject to agreed limits.

Key requirements

To use the facility, the company requires the same authorities to issue shares free from pre-emption rights to the broker or investor as for placings (see above, Placings and open offers).

Advantages

The advantages include that:

The company is not generally obliged to use the facility, and subject to the company paying a commitment fee, the facility provides a secure line of equity finance.
Where the company anticipates a significant appreciation in its share price, successive drawings under the facility may decrease the cost of capital relative to a placing on day one.

Disadvantages

The disadvantages include that:

The investor or broker usually charges a commitment fee (typically about 3%) on the aggregate amount of the available facility, which is payable whether or not the facility is used.
A commission is charged on funds raised under the facility at rates comparable to those chargeable on an ordinary placing.
The subscription price payable for shares subscribed under the facility is at a discount to market value (often expressed by reference to the lower of the then market price and the average market price over the previous ten or 20 trading days).
The investor or broker is not typically subject to an obligation to hold the acquired shares, and may seek to re-sell the shares into the market. Critics of equity drawdown facilities often note that this may result in a "death spiral" in which a cash constrained company's share price may be forced downwards by successive discounted share issues being re-sold into an illiquid market.

Swap arrangements

The value of emerging life sciences companies often depends on anticipated future performance, with investors looking for capital appreciation in the value of the company's shares as the company further develops its product portfolio. A number of investors now offer companies an ability to capture the benefit of anticipated future increases in share price by proposing that the company enter into equity swap arrangements.

The terms of the swap arrangement offered by these investors may vary, but in general all follow a similar basic structure. The investor subscribes for shares in the company, sometimes as part of a larger placing. The company and the investor then enter into a swap transaction, under which the investor agrees to make payments to the company the amount of which varies depending on the future performance of the company's share price. In exchange, the company agrees to make certain fixed income payments to the investor. The financial obligation of the company to make these payments is typically capped at the amount initially subscribed by the investor, with these subscription monies being applied to acquire collateral securing the company's obligations, such as government bonds.

Key requirements

The company requires the same authorities to issue shares free from pre-emption rights to the investor as for placings (see above, Placings and open offers).

Advantages

The advantages include that:

The company benefits from future increases in its share price. This makes swap investment arrangements particularly attractive to companies which believe they may be undervalued by the public markets.
The security which the swap arrangements offer to the investor may allow finance to be raised without heavy discounts to the current share price or the granting of security interests over the company's core assets.
Swap arrangements do not generally create a net debt obligation.

Disadvantages

The disadvantages include that:

The company does not receive a lump sum payment, but a series of payments over the period of the swap (typically between six and 18 months).
The amount of cash received by the company varies depending on its share price performance.
Typically, a minimum appreciation in the share price of the company must be achieved for the aggregate payments received by the company to match the amount subscribed for shares issued to the investor.
When entered into as part of a placing, the investor subscribing shares subject to swap arrangements generally receives the same discount (if any) to market value on the subscription price paid as that offered to other placees. Further, brokers acting on the placing will usually be paid commission on the placing shares subscribed by the swap investor.

Revenue financing

Many emerging life science companies are engaged in developing new drugs, devices or other products. Though these products may offer the prospect of substantial future returns, the revenues initially generated by these products may be modest or non-existent.

Revenue financing structures offer companies the ability to unlock future anticipated product value. Typically a single investor advances funds to the company (a portion of which may be contingent on the occurrence of future milestone events) and the company grants the investor an interest in future product revenues.

Depending on the financial objectives of the parties, the investment may be structured as either:

An asset sale, whereby the company transfers assets including the right to receive future product revenues to the investor (or a special purpose vehicle).
A debt financing, whereby the company undertakes to repay the investment from future product revenues and secures such obligation against its relevant assets.

Under either structure, the company commonly pays substantially all future revenues arising from the relevant product(s) to the investor until the structure is unwound.

When structured as an asset sale, a call option in favour of the company generally allows the structure to be unwound and the assets re-transferred to the company. The call option re-purchase price is often expressed as a multiple of the amount invested, though reduced to the extent revenue payments have been received by the investor in the interim. When unwinding a debt structure, the original investment plus a premium is generally repayable, subject to deductions in relation to product revenue payments made during the term of the investment, and on satisfaction of the debt, the investor's security interests over the company's assets will be released.

Key requirements

The product will need to be revenue generating (or at least have a credible prospect of generating revenue in the short to medium term). Revenue financing is unlikely to be suitable for companies with very early stage product candidates.

The company's product assets must be capable of being transferred to or secured in favour of the investor. Companies with restrictions over their product assets (for example, prohibitions under in-licences) may be unable to satisfy investor requirements under revenue financing structures.

Advantages

The advantages include that:

No shares are issued and consequently, existing equity investor interests are not diluted and no discount to market price is necessary to attract the investment.
The investment may be tailored to specific product(s) enabling the commercial terms to more precisely balance the costs of finance against risk.
The investment need not always be applied solely towards the secured product assets. For example, non-core products may be used to attract funds to finance other product development programmes.
The investor will generally have a good technical and commercial understanding of the product. This may be particularly important for a company which believes that the public markets undervalue its product portfolio.

Disadvantages

The disadvantages include that:

The company cannot freely dispose of the product assets until the investment is unwound.
Revenue financing can be expensive. Typically the cost to unwind the investment is a multiple of the investment received by the company.

Contributor details

Paul Claydon

Morrison & Foerster LLP

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T +44 20 7920 4021
F +44 20 7496 8521
E [email protected]
W www.mofo.com

Qualified. England and Wales, 1989

Areas of practice. Corporate finance; M&A; life sciences; technology.

Recent transactions

Advising Acambis plc on its GB£276 million takeover by Sanofi Pasteur.
Advising ReNeuron Group plc, an AIM-listed stem cell research company on its recent GB£10 million placing.
Advising the venture capital fund owners of Piramed Limited, on the sale of the company to Roche for US$184 million.
Advising UK main market listed Vernalis plc on two placings and open offers to raise GB£52.1 million.

For more details of recent transactions, publications, and so on, see full PLC Which lawyer? profile here.

James Halstead

Morrison & Foerster LLP

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T +44 20 7920 4032
F +44 20 7496 8532
E [email protected]
W www.mofo.com

Qualified. England and Wales, 2000

Areas of practice. Corporate finance; M&A; life sciences; technology.

Recent transactions

Advising CeNeS Pharmaceuticals plc on its recommended takeover by Paion.
Advising Intercytex Group plc, a stem cell company, on its IPO on AIM and subsequent fund raisings, acquisitions and disposals.
Advising the venture capital owners on the sale of Paradigm Therapeutics Limited to Takeda Pharmaceutical Co of Japan.
Advising Stem Cell Sciences plc, then listed on AIM and Australia's ASX market, on the sale of its trading subsidiaries to Nasdaq-listed StemCells, Inc.

Financing UK Life Sciences | Practical Law