Private Exchanges Emerge as an Alternative Financing Strategy

Biopharma startups have always struggled to find early-stage financing. The economy’s plunge into a severe recession in 2008 has made things even worse. The near-freeze of public markets has chilled the prospects for IPOs and dented the once-flourishing market for traditional venture capital. According to MoneyTree Report, the number of biotech VC deals fell 13.5% during Q3 2011 from the same period a year earlier to 96 even as the amount of capital raised rose to $1.1 billion from $855 million.

Small wonder, then, that biopharma startups and their worried investors are scrambling for alternatives. One such alternative that has emerged is for companies to stay private but trade their shares through private exchanges that allow them to raise capital through pre-vetted institutional networks as well as individual investors. Another key factor in the development of private exchanges has been the desire by private companies to avoid the red tape required of public companies.

“It’s hard to get IPOs off the ground in this market,” Antony Pfaffle, M.D., senior advisor for healthcare research at the investment fund Bearing Circle Capital, LP, told GEN. “By necessity, people are coming up with these new mechanisms to generate capital and to reduce costs. It’s an issue of risk assessment and risk reduction. It’s an issue of financing capacity or financing capability of the companies, and also what the industry deems to be a more efficient development pathway for these drugs that doesn’t involve spending an inordinate amount of money to get the process right the first time.”

Genesis of Private Exchanges

The exchanges capitalize on the increasing impatience of investors for returns on their money as well as their willingness to accept smaller returns given the economy. “If you can’t answer the question, ‘When do I get paid?’ with the answer ‘three to five years’ for a reasonable investment, then most people are not willing to invest,” Dr. Pfaffle pointed out. The returns, he added, have shrunk from a 3x to 5x, to somewhere above 2x.

“Most of the time, if it’s a high net worth individual, I would say that the amount of investment is $500,000 to $1 million per individual investor and $5 million to $15 million per institutional investor,” added Dr. Pfaffle.

Two notable private exchanges that have emerged in recent years are SecondMarket and SharesPost. For the third quarter of 2011, SecondMarket’s Private Company Market reported its best quarter to date, completing over $167 million in private stock transactions. During the first nine months of 2011, SecondMarket completed $435 million in private company stock transactions, a 75% year-over-year increase.

Biotech and pharmaceutical companies accounted for just 1.7% of shares that private exchange members expressed interest in purchasing and a paltrier 0.5% of shares that members sought to sell during Q3. Still, biotech, along with advertising, generated the most increased interest over the past year. Leading both in interest to buy and interest to sell were consumer web and social media companies, followed by retailing and commerce firms.

SharesPost did not respond to questions by GEN, but its website includes profiles of four biotech companies: Navigenics, Nodality, Response Scientific, and XDx. SecondMarket’s website includes profile information for the investment fund Biotechnology Value Fund L.P. as well as 44 biotechs, 243 pharma companies, and 149 companies with “therapeutics” in their names. That does not necessarily mean all those companies have traded on SecondMarket, which won’t disclose which companies are trading, usually at the companies’ request.

Workings of SecondMarket

SecondMarket was founded in 2004 by Barry Silbert, who saw a gap in the market for a centralized trading venue for shares not traded publicly. Initially focused on restricted stock, SecondMarket expanded to bankruptcy claims and fixed-income products such as auction-rate securities. When the latter market melted in 2008, SecondMarket brought holders of the suddenly illiquid securities scrambling to sell together with buyers seeking fixed assets.

Conditions that suggested the time was right for setting up SecondMarket included the rise of high-frequency trading, an increased focus by investors on quarterly earnings, and especially the decline of public markets, which has doubled the time private companies take to go public from about four to five years to as many as 10 years.

“There’s this entire gap for a growth market structure for companies with a market cap of $150 million up to less than $1 billion,” Aishwarya Iyer, a spokeswoman for SecondMarket, told GEN.

SecondMarket launched its private company market in 2009. Member companies determine when their shares will be open for trading, rather than allowing the constant trading typical of public markets. The result could be a weekly auction of shares or quarterly or annual liquidity programs. Companies can gain new investors without having to issue new shares, as when public companies raise new rounds of capital.

SecondMarket’s investors must be “accredited” as defined by the US Securities and Exchange Commission, i.e., investors with at least $200,000 in annual income or at least $1 million in assets. Most buyers are institutional investors, and the average transaction size is more than $1 million. That’s above most angel and seed rounds, so SecondMarket companies have been in business for a few years when they first use the private exchange; exactly how many depends on the company. “Generally speaking, we come in around year four, five, or six, when a company has issued shares and has a certain number of shareholders whose shares are vested,” Iyer said.

Reviving the Public Markets

“We think that the markets are not really going to come back for these smaller companies,” Iyer added, since high-volume trading and the focus on quarterly results aren’t likely to end soon.

A comeback for public markets will be more possible if several bills with that purpose emerge from Congress. The Biotechnology Industry Organization (BIO) has voiced support for three such bills:

• The Private Company Flexibility and Growth Act (H.R. 2167; S. 1824), which would expand from 500 the minimum number of shareholders, or “holders of record,” required for going public and exclude current and former employees from being counted toward that number. H.R. 2167, which raises the limit to 1,000 shareholders, has been placed on the House Calendar. S. 1824, which would raise the limit to 2,000 shareholders, was the topic of hearings by one Senate committee and its subcommittee.
• The Small Company Capital Formation Act (H.R. 1070; S. 1544) would multiply from $5 million to $50 million the maximum companies can raise to go public through SEC Regulation A, which has reduced disclosure requirements. H.R. 1070 passed the House and was the topic of hearings by one Senate committee.
• The Access to Capital for Job Creators Act (H.R. 2940; S. 1831) would allow companies undertaking private offerings to market their securities to accredited investors under SEC’s Rule 506 of Regulation D, which now bars general solicitations or advertising. H.R. 2940 passed the House and was the topic of hearings by one Senate Committee.

Removing various hurdles to going public should jumpstart the weak IPO market, especially in biopharma, where the number of first-time-public companies in the U.S. dipped to 13 last year from 16 in 2010. SecondMarket says an IPO revival won’t necessarily hurt it, more than likely because the company could still sell restricted stock from any private companies that rush to the public markets.

Even with that shift of business, SecondMarket and other private exchanges should still find growing private companies eager to raise capital by selling shares rather than take their chances in the VC market, which should continue to shrink as investors keep running away from early-stage biopharmas.