Life science companies that have plunged into the IPO waters over the past few years have likely found the temperature, at best, tepid. Rather than being warmly embraced by the public markets, as was the case in the not too distant past, the reception new issues are more recently getting often amounts to little more than the cold shoulder.
And the numbers seem to bear this out. Since January 2005, 34 new life science issues have come to market through initial public offerings24 in 2005 and 10 through April this year. Of the total, 26 IPOs were biopharmaceutical issues with seven medical device IPOs and one diagnostic deal.
Virtually from the start of the going-public process, most of these issues have come up short by one measure or another.
As has been the case in recent years, the vast majority initially filed with public market valuations anticipated to be $300 million or more, an apparent necessity to attract the attention of the larger institutional portfolio managers whose fund size often precludes investment in smaller, less liquid companies.
This seems particularly true among biopharmaceutical issues where the S-1 filings for 23 of the 26 issues to debut since January 2005 have projected market capitalizations crossing the $300-million threshold. Such often inflated valuation expectations are rapidly corrected when these deals ultimately priceif they even get public. Of the 34 life science companies, only six have actually achieved the targeted $300-million valuation, and only five of them were biopharmaceutical deals.
Consequently, the funds that companies access through an IPO often fall far short of expectations. Companies that have gone public since 2005 have, on average, raised little more than 60% of their initial funding targets, with the gap between amount anticipated and amount realized only increasing year-over-year. Also, certain companies commit to completing the IPO despite raising less than 25% of initial funding targets. Under no circumstances can these companies’ venture investors consider these IPOs as exits.
These newly public companies often fair no better after the IPO, as their valuations continue to be challenged in the secondary markets. Of the 34 new life science issues, nearly 50% are currently trading below their IPO price.
This trend seems to suggest that many companies are willing to endure the going-public gaunlet regardless of the coststhat despite a far-from-ideal IPO scenario, being public in whatever form is more desireable than remaining private. And in certain cases a going-public event has provided these companies funds to remain in operation that otherwise would not have been available. And so companies seemingly have embraced the IPO track in the hopes that future pastures as a public company are greener.
Current activity involving reverse merger transactions in many ways provides an interesting parallel to current IPO activity and seems to further this notion.
The specifics of reverse merger transactions often vary widely and may take different forms. Yet common to all reverse mergers is a private target merging with public acquiror for operating control of the combined company and majority equity ownership. While some deals involve a significant cash component, many such transactions are coupled with a financing event.
Any number of reverse mergers take place, involving unlisted, often pink sheet companies with few reporting requirements. These types of deals are justifiably viewed with disdain. In contrast, the transactions considered here involve reporting companies that list on the OTC Bulletin Board if not on one of the major exchanges.
In light of the apparent dislocation created by current capital market trends, reverse mergers have seemingly gained increased legitimacy and credibility as a means to go public. Interestingly, since the beginning of 2005, 21 life science companies became public through reverse mergers, with activity accelerating over the period. In the first four months of 2006 alone, nine reverse mergers were completed with others in the pipeline. The capital accessed through the more visible of these reverse-merger transactions often exceeded the average amount raised through a traditional IPOs.
Among the more visible reverse mergers announced this year have been MicroMet’s merge with CancerVax, providing MicroMet with a NASDAQ national market listing and $50 million in cash; Cyclacel’s merger with Xcyte, giving Cyclacel $19 million in cash and a NASDAQ national market listing, with Cyclacel then bringing in an additional $45 million through a subsequent private placement; and most recently, Infinity Pharmaceutical’s announced merger with Discovery Partners Intenational, a transaction that brings as much as $75 million to Infinity, in addition to providing Infinity a public company listing.
And while these deals may be viewed as outliers, that respected companies with sophisticated venture investors are increasingly using reverse mergers to effect go-public transactions seems to suggest the strategy is perhaps gaining more mainstream support.
Why would this be so?
The Argument Against-Forcing a Square Peg into a Round Hole
The arguments against going public through a reverse merger are numerous and well supported through historical experience. The fundamental issue is whether the company attempting to go public through a reverse merger is a viable public company. Good companies can always get public holds conventional wisdom, though perhaps on less than ideal terms. A company that must resort to a reverse merger is merely fighting the inevitable.
Practical transaction-related considerations also bring into question the value of the approach. As these deals may involve the de facto acquiror paying a significant premium to the cash value of the target or purchasing unrelated assets of limited value, the issue of unwarranted dilution inevitably arises. Moreover, absent other benefits, in particular access to financial resources that otherwise might not be available, being public is likely a net negative as a company’s public status can severely restrict its operating dexterity and the regulatory burdens, including Sarbanes-Oxley compliance, can be onerous.
Reverse mergers also face the challenge of competing against the well-established conventional IPO process, as well as the investment banking industry that supports it. Without the structure provided by an organized underwriting effort, company shares often do not find their way to the more sophisticated institutional investors that have a greater appreciation for the science and the value of a longer-term perspective.
The predominant holders of the stock are likely retail investors, notoriously fickle and quick to sell, or hedge funds that often look to leverage a trading prowess for near-term gainsneither an ideal buy and hold investor. In addition, the company is unlikely to attract the support of the sell-side research analysts, dedicated champions willing to promote the story and give it the continued visibility necessary to rise above the noise. Nor is the organized market-making an effort for the issue, likely to be as robust, making the stock’s liquidity much more uncertain.
An argument in support of the reverse merger may be constructed that is likely as compelling as the argument against. External circumstances can often be as influential, if not more so, in dictating the likelihood of a conventional IPO closing than the particulars of an issue itself. So in and of itself, the inability to access the public markets may have little to do with the specific investment merits of a particular company.
The Shape of Things to Come?
Moreover, aside from a sale of the company on less than favorable terms or an outright dissolution, what then are these companies’ alternatives? Current venture investors often have limited resources and little patience to fund long-in-the-tooth investments for any amount of time, and even if a new lead investor is to step in, likely the terms would be unattractive.
Perhaps most importantly, the pool of investors in private life science companies is relatively limited, with 40 or so venture groups leading the majority of deals. On the other hand, investors in public equities are much more plentiful, particularly given the seemingly ubiquitous presence of hedge funds.
The inherent quality of the investor, while important, also becomes a secondary consideration at a certain point. So while all else is equal, longer-term portfolio managers might be preferable to hedge-fund investors, immediate funding requirements take priority regardless of source. Also, positive clinical data will likely result in a more favorable rebalancing of investor composition in any event. These perspectives suggest that reverse mergers may warrant some level of consideration. Moreover, advances in telecommunication and information technology have likely enhanced reverse mergers’ practical utility.
Where once the ability to effect the rapid distribution of information to a wide investor audience was a core differentiating advantage of the brokerage houses, electronic distribution via the Internet has, to a great extent, leveled the distribution playing field. The emergence of the ECNs (electronic communication networks) as the dominant market-making platform has likewise reduced the influence and importance of specific market makers. And the liquidity of many, if not most new issues, regardless of route taken, is far from ideal.
These changes, coupled with the appearance of independent research boutiques, suggest that the activities, once strictly the domain of the investment banks, can now be accessed through other means. Similarly, if discrete IPO-related activities can now be accessed through alternate sources, what is preventing the emergence of viable alternates to the overall process?
Direct Public Offerings
A more pragmatic and perhaps more regulatory-efficient means of arriving at many of the same benefits as a reverse merger transaction may be the use of a direct public offering, also known as a DPO or self-underwritten offering. To raise money through this structure, the issuing company would first file a Act registration statement with the SEC.
As a consequence of that filing, upon the registration statement becoming effective, that company becomes a reporting public company. Importantly, however, until that company has more than $10 million in assets and 500 shareholders, it is considered a 15D public company, whose reporting requirements are limited to an annual audited 10K, three unaudited 10Qs, and 8Ks as appropriate, as opposed to a 12G fully reporting company whose reporting requirements are much more onerous.
In addition to the reporting requirements of a 15D company, a 12G company must also conform to proxy rules and tender-offer rules and comply with Patriot Act, Section 16 insider trading rules, and Sarbanes-Oxley, making sure that all filings are complete and up-to-date.
Given that a shareholder base of more than 500 shareholders may take some time to evolve, 15D status is likely to be sufficient for many companies for quite a while. At a future point when the asset and shareholder limits of 15D become cumbersome, the issuer can then voluntarily convert to 12G status.
To enable the newly public company’s shares to trade in the secondary market, the company must first file Form 211 under Rule 15c(2)-11 with the NASD. Trading in 15D reporting companies is restricted to the OTC bulletin board. Status as a fully reporting 12G company is required to trade on the NASDAQ Small Cap or National Market, the American Stock Exchange, or the New York Stock Exchange.
While many investors, including many of the more established mutual funds, are restricted from buying bulletin-board stocks, many others, including many hedge funds, are quite active in bulletin-board stocks. Should a company choose to move its listing to a more established market, it can readily do so, provided specific listing requirements are met.
A direct public offering clearly requires a significant commitment from the issuer, much more so than a conventional, investment-bank led IPO. Avoiding the 7% spread typical of IPOs though, may more than compensate an issuer for the added burden.
The time required to complete a DPO, typically from three to six months, compares favorably to the time likely required to complete a reverse merger. Another advantage over a reverse merger is avoiding being boxed in by inherited regulatory encumbrances, such as 12G reporting status, that may be unnecessary.
Likely, the greater challenge to a potential DPO candidate is the issuing company’s ability to construct a successful plan of distribution. Companies often have neither the relationships with investors nor the market savvy to place the securities, though more sophisticated managements may not find this a challenge. While regulations prohibit use of a third-party placement agent, certain outside advisors, may be helpful in facilitating investor introductions.