May 1, 2013 (Vol. 33, No. 9)
Kevin Johnson, Ph.D. Partner Index Ventures
U.K. Found to Be Most Favorable Location for Nascent One-Product Companies
In an era of payer austerity and funding challenges, more and more biotech entrepreneurs and investors, alike, are realizing the considerable risks associated with simultaneous development of multiple assets and instead opting for a more streamlined approach that has come to be known as “asset-centricity.”
An asset-centric biotech company (ACC) is essentially a single-purpose entity focused on just one product candidate. Financing is tightly linked to achieving the next milestone, so that only the amount necessary to jump the next hurdle is put at risk.
This approach deconstructs the R&D process into a straightforward sequence of decisions influenced only by the specific merits of the project, rather than the distractions of a larger portfolio strategy.
Asset-centricity marks a return to fundamental values: it’s about finding new drugs, not necessarily on creating massive new companies.
Given this laser-like focus, little or no overhead or infrastructure is required to set up an ACC. Most if not all lab work can be outsourced, thus heightening the venture’s capital-efficiency. Having such low overhead costs allows a great deal of flexibility in terms of where the company can be located. This is important, because with a team of just, on average, between four to six people working on a project, there’s no actual need for these team members to be in the same country as one another or indeed as the company itself.
Ensuring a Return
It helps to have the whole team under one roof, of course, but that’s less important than ensuring an overall favorable return on the investment to the investors and the entrepreneurs. Based on our several years’ experience in creating, and now exiting, these asset-centric biotechs, one of the most important considerations in terms of where to locate the ACC has turned out to be tax on proceeds from the transaction, be it a share sale, an asset purchase, a phased purchase, or licensing.
Most governments are keen to promote and nurture small- and medium-sized businesses (SMBs), especially those that are technology- or knowledge-based, as they are viewed as critical drivers of economic growth. Many countries offer incentives to locate one’s company there, and some of the inducements can be very attractive indeed.
Until, that is, one takes a close look at how the exit transaction proceeds are handled. This topic gets less air time than it should: the differences between countries are really quite pronounced. The Table shows a comparison between the U.S., the U.K., the Netherlands, Switzerland, Luxembourg, and an offshore tax haven.
In this analysis, the tax haven wins, of course, but at a price. There is an absence of incentives for the ACC as it develops and wrestles with the withholding tax and anti-avoidance rules of other countries during the life of the company and on exit. In that case, few biotechs are based in tax havens and for good reason.
Of the other countries, it turns out that the U.K. is the most favorable regime, whenever there is a need to return corporate cash to investors, mainly due to the lack of dividend withholding tax and the incoming 10% “patent box” corporate tax rate. This need is always the name of the game for an ACC.
This becomes massively important in a deal structure we’re starting to see come up again and again: an “asset purchase” structure. This is where the purchaser simply buys the intellectual property (IP) and the rights to develop the asset, with the company then left behind. The company is, after all, merely a vessel for the asset and this structure is highly tax efficient for the purchaser.
The tax hit for the investors and entrepreneurs can be considerable, though, depending on which tax regime it falls under.
U.K. Is the Place to Be
The best domicile for this turns out again to be the U.K. For example, assume investors put in $50 million and obtain a $100 million exit via asset sale:
- If 50% of $50m is spent on R&D, U.K. R&D tax credits will be $6.25m.
- The ACC will have $25m of non-R&D related U.K. tax losses
- Corporate income tax liability realized will be $100m–$25m @ 10% = $7.5m
- The remaining $92.5m can be distributed to Investors without withholding tax
- The ACC only suffers net $1.25m of tax over its lifetime.
The U.K. tax system has always worked on the simple principle that dividends are paid out of profits after tax and should not be taxed further. It is not necessary to read a bilateral tax treaty or work out if a complex exemption system applies, as there is simply no rule in the U.K. tax system that imposes tax on dividends, so there is no need to worry about where a myriad of investors are located—the dividend can be paid and there is no tax to be accounted for.
No country is a panacea of course, the U.K. included. The U.K. tax system for investors and management teams who are U.K. residents still hasn’t caught up with developments for companies. Milestone deals can still be taxed up front based on the total potential proceeds, with relief if milestones fail to arrive.
Given the attrition in drug programs and uncertainty over those milestones, this is unfair. Proceeds should be taxed as they are received, not before.
Flexibility on an exit would be further enhanced if the current complex demerger and reorganization provisions were simplified to allow one-step transactions that move assets from one company to another, provided both are under common ownership. These seem pretty logical to us, and the motivation for updating the rules is that the U.K. would become the jurisdiction of choice for the best assets and the best people, regardless of where they originate from.
We are often asked, “Where’s the next Genentech coming from?” It certainly isn’t going to spring into existence just because that’s seen as a good outcome. It is, however, much more likely to happen if one country in particular becomes the aggregator of seasoned product developers and the best assets the planet has to offer.
Overall, though, we were surprised to arrive at the conclusion that the U.K. is currently the best country in which to locate an ACC. We have an international perspective and are genuinely indifferent to where these companies are located.
Another surprise was the deteriorating attractiveness of the U.S. as a place for a startup. This is inexorably tied to the macro trend from company purchase deals to asset purchase deals. Unless the exit is a share sale, for American firms the transaction losses to tax in an asset sale deal are considerable.
In a world of increasingly choosy buyers of assets, and the increasing internationalization of deals, the need to return cash to investors in multiple jurisdictions without burdensome tax levies has increased. The U.S. has always slapped a 30% withholding tax on investment returns as they leave the U.S., but this steep hit is being incurred more frequently, thus lowering the attractiveness of the U.S. market for ACCs overall.
Of course, an advocate of starting an ACC biotech in the U.S. could stand his/her ground and insist that the deal is actually just a share purchase, but this could result in there being no deal at all.
Our view is that we’d like as much flexibility as possible to make a deal work. We feel that, absent a serious shift in U.S. tax policy, these trends will continue and the U.S. will fall further behind the U.K. on the attractiveness scale for ACCs.