Investing in Life Science Companies 3:30 to 4:30



From PLI’s Course Handbook

Advanced Venture Capital 2008

#15818

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14

INvesting in life science companies

Barbara Kosacz

Cooley Godward Kronish LLP

Nader Mousavi

Wilmer Cutler Pickering Hale and Dorr LLP

PLI – Advanced Venture Capital 2008

Barbara Kosacz, Cooley Godward Kronish, LLP

Nader Mousavi, WilmerHale

Investing in Life Science Companies

1. Life Sciences Industry-Driven Venture Investment Terms and Considerations

a. Tranched Deals. Biotech companies have an insatiable need for capital. This means that in addition to technical risk, any biotech company also faces considerable financing risk. Given this, many investment rounds (which may be as much as $60M or more), even at Series A, are tranched, with subsequent tranches made at designated milestones. Several issues arise here:

i. Pre$ valuation is often, but not always the same for each tranche

1. highly dilutive to option pool/founders, so may want to pre-agree on increases to the option pool as each tranche is closed

ii. Milestones are often not crisply defined (i.e., Phase IIa clinical trial successfully completed) and vest discretion as to whether they have been met in either the:

1. Board as a whole, or specified members of the board

a. avoid this, as it creates fiduciary duties issues due to conflicting role as investor and board member

2. Certain shareholders, i.e., some % of the new investors

3. Make sure the milestone is within management’s control and does not depend upon a board decision to achieve the milestone – for example, completing a trial and obtaining data is within management’s sphere of influence, but starting the next trial may depend upon having sufficient capital and not just clinical data to continue development

4. Make each milestone independent of each other. If multiple sub-milestones need to be met to get the tranche, determine ahead of time the outcome for an individual milestone being met as opposed to the investors concluding the tranche was not triggered since multiple submilestones had to have been achieved

iii. The tranche is always a “put” and almost never a “call.”

1. Although structured in theory as a right of the company to call the investment if the milestone is met, since the investor determines in reality if it was met, rarely is this operational

2. Typically, even if milestone is not met, investors will demand the right to put the cash in the company

a. issues around whether the put right is on a per investor basis or there is a drag-along for all investors once a certain threshold determines to invest

b. in this situation, warrant coverage is often requested since the BOD is asserting that the milestone was not met

3. Note this often will come into play immediately prior to an acquisition, where investors will insist on putting into the company any outstanding tranches, causing immediate option pool/common dilution

a. Given Section 409A concerns around option pricing, Company will need to find other ways to “make whole” employees in the face of such a last minute investment, such as cash bonus plans

b. Pre and Post Money Valuation. Given poor valuations now for several years in the IPO market and need for large financing rounds, investors are extremely sensitive to post-money valuation of a biotech company, given that often the cost to get to that point (i.e., two lead product candidates in the clinic, or a lead at later than Phase II trials) is nearly $100M. Issues here are:

i. founders/management push for higher pre$ to guard against dilution, only to discover their IPO is a down round – the best way to guard against dilution is to continue to have a role at the company and be at the table for subsequent financings. The Premoney for life sciences companies are not large enough to compensate for highly dilutive financings.

ii. the auto-convert thresholds can be highly negotiated for the last-in money

iii. where higher valuations are pushed for (often due to high post money of prior round), investors in new round often push for a full ratchet on anti-dilution price protection. Company can manage through this somewhat by:

1. limiting the time period in which the ratchet is effective

2. tying the elimination of the full ratchet to some milestone event, such as the closing of a corporate partnering transaction with an upfront fee of at least $xx (where the last money in is hoping to be last money pre-IPO)

iv. Focus should be on creating long term value as opposed to paper valuations in the short term – complicated cap structures hamper the company’s ability to raise capital going forward. Keep it simple.

c. M&A Becoming a More Common Exit.

i. Acquisitions, in particular for cash, have markedly increased in this sector, causing investors and management to address M&A related issues much earlier in the Company’s life. Issues here are:

1. More management teams are putting into place change of control plans for their protection at very early stage

2. Given liquidation preference of preferred holders, management more anxious about that outcome, want to put into place plans that make management “indifferent” to an IPO vs. M&A exit

ii. Given focus on M&A exit, many investors negotiate hard for a participation right in a liquidation, which only further disincentives management to work toward that outcome

d. Financing Spin Out Companies

i. Many start-ups are actually spin outs of programs/employees/assets from big pharma or big biotech, in exchange for an equity stake in the Newco. These present some unusual issues in the venture financing context:

1. The company spinning out the assets (sponsoring company) typically will look to get no more than 19.9% of the equity of Newco due to desire not to consolidate losses BUT will push hard for unrealistic pre$ so as not to be unduly diluted and given its perceived value of the assets.

a. May result in an deal that cannot be financed – let the market set the price or be reasonable to affect a transaction as quickly as possible

b. May likely result in a downround at Series B if any slip up in Newco’s execution of its operating plan/achievement of milestones

2. The sponsoring company will almost never put in additional cash, but if given preferred rights pari passu with venture investors, will still get price-protection anti-dilution protection in a down round, with no obligation to “re up” cash. Possible ways to address this are:

a. Set up a separate series of watered down preferred for the sponsoring company without anti-dilution rights (can also make this non-voting, potentially)

b. provide a pay to play provision where failure to invest results in either loss of price protection anti-dilution or conversion to common stock

c. cash is not the same as asset value – sponsor could put in a little cash as a symbolic gesture to obtain the full set of preferred rights

e. Protective Provisions

i. Given the importance of corporate partnering deals as a means of non-dilutive financing, some investors may insist that they have shareholder approval rights regarding licensing/partnering transactions

1. this is cumbersome and creates real logistical problems for the Company in completing time-sensitive transactions

2. these also can often be overly broadly drafted, if insisted upon by investors. Focus the approval on transactions involving the lead compound, for example

ii. Another variant of this is the insistence on approval of the company’s operating plan by either:

1. a majority of the board, provided the lead investor board representative approves (which creates fiduciary duty/conflict issues, see above), or

2. a shareholder approval by new investors

iii. Investors need to establish provisions that give the company flexibility to create a valuable entity as the science progresses/changes over time, which may not be what was originally envisioned during the financing – empower management to be successful.

2. University (and Other Foundational) In-Licenses

a. Basic Structures for University Transactions

i. Patent Licenses (existing rights)

1. University patent licenses are typically limited to identified patent families (excluding CIPs with new subject matter) and/or identified inventions.

2. Consider seeking rights to dominated improvements by same inventors; Universities won’t offer it, but often will agree to it. Typically, this access would be for a specific period of time—e.g. 3 years.

3. However, you generally should not expect a University license to include rights to:

a. New inventions that are not dominated by licensed patents

b. Improvements by other inventors or laboratories, even if in same field or relating to same target/compound.

ii. Sponsored Research / Consulting (new inventions)

1. To obtain rights to such new inventions and improvements, consider the following options:

a. Sponsor research by key researchers or lab

i. Obtain at minimum an exclusive option for an exclusive license to the results

ii. If sponsored research is coupled with an existing license, seek to have results of research automatically licensed under same economic terms so as to avoid double-dipping by University

b. Engage researchers as consultant, however, before doing so, be sure to:

i. Comply with University IP policies. IP policies of Universities generally provide that any IP generated using University facilities or resources is owned by the University. To obtain ownership of consultant results, must ensure all work is done at company, on company-time and without University resources. Note: UC requires specific clause subordinating consulting terms to UC IP policy.

ii. Comply with University conflicts-of-interest policies and procedures. Some Universities require pre-approval of consulting engagements to confirm engagement will not bias academic integrity/research.

c. Seek notice of new inventions, even if not covered by the license, by requiring University to disclose to licensee relevant inventions (e.g. by inventor and field) reported to its Tech Transfer office, thereby ensuring that the licensee has a “seat at the table” to obtain rights to new inventions.

b. Financial Provisions. Financial consideration to the University/licensor may include one or more of the following: royalties on net sales, royalties on sublicensing income, milestones, equity, maintenance or minimum annual royalties, and upfront fees. We will focus on royalties and sublicensing income:

i. Royalties on Net Sales.

1. Confirm royalty burden is economically viable given market and anticipated margins.

2. Confirm the Net Sales definition is based on amounts actually collected, or else, if based on amounts billed, at least contains a deduction for bad debt (and other customary deductions).

3. Consider royalty stacking issues and whether third party patents are likely to be required, particularly if the patent landscape in the target market is crowded. Failure to include this provision can result in an economically unviable royalty burden if third party rights are required.

a. A typical royalty stacking provision would provide that licensee may deduct up to 50% of royalties payable to a third party for patents required to make or sell the licensed product, subject to a floor of 50% in any given quarter.

4. If the end product might be a combination of different products (e.g., more than a single active ingredient), some of which are not covered by the licensed patents, confirm that an appropriate “combination products” provision is included. This provision ensures that royalties from sales of the combined product are paid only on the portion that is covered by the licensed patents.

ii. Royalties on Sublicensing Income.

1. Sublicense income is generally comprised of amounts received by the licensee from its sublicensee on account of the grant of the sublicense, including royalties, upfront fees, milestones, and other amounts (discussed below).

2. Royalties on sublicensing income are critical terms in any foundational license, particularly where the company’s market strategy may involve partnering or collaborations.

3. There are two basic models for royalties on sublicensing income:

a. Percentage of Sublicense Income. This is a model whereby the licensee is obligated to pay the licensor a defined percentage of amounts it receives from its sublicensees, whether in the form of milestones, royalties, upfront fees or otherwise. This model enables the licensee to negotiate economic terms freely with its sublicensees, knowing that it will have to pay a defined portion of what it receives to the University/licensor. Typical percentages are between 10-25%, but percentages can start as high as 50% (cf. point 3(b) below).

b. Pass-through royalties: This is a model whereby the licensor is entitled to a fixed and predetermined royalty percentage for sales of licensed products by any sublicensee. In such cases, the licensee is required to pay the licensor/University a fixed percentage of sublicensee sales, regardless of the royalty rate paid by the sublicense to the licensee. Universities are increasingly moving towards this model.

i. Example: University grants a license to Company A with a pass-through royalty on sublicensee sales of 5%. Company A grants a sublicense to Company B with a royalty rate of 6%. University is entitled to 5%, and Company A is entitled to 1%, of sublicensee’s sales. If Company B were not willing to pay at least 5%, Company A would have no economic incentive to grant the sublicense (in which case, typically it would seek to renegotiate with the University).

c. Practice Tips:

i. Which model is more favorable to the licensee?

1. Economically, it depends on the relative rates.

a. Example: If licensee is required to pay 50% of sublicensee income to licensor, and licensee obtains a 10% royalty from its sublicensee on sublicensee sales, licensee is effectively paying University 5% of sublicensee sales.

b. In this case, a pass-through royalty of less than 5% would be economically more favorable to licensee. Any pass-through royalty in excess of 5% would make the sublicense income provision more economically favorable.

2. Practically, the sublicense income provision offers greater flexibility to the licensee and downside protection in case royalty rates from sublicensees are ultimately lower than expected. Companies generally cannot anticipate sublicensee royalty rates with precision, especially in the early stages. In the sublicense income model, licensees pay a portion of what they receive from sublicensees, and so can never be “underwater”. In the pass-through model, a licensee pays a fixed rate on sublicensee sales, and essentially gambles that it will be able to obtain higher, or preferably substantially higher, rate.

ii. To guarantee the best rate, you may want to seek an option for licensee to pay the lesser of these two amounts.

iii. In most cases, licenses are hybrids of these two models. Be sure that the University/licensor is not double-dipping. If a pass-through royalty is included, then the sublicense income provision should exclude income received by licensee based on sublicensee sales.

4. Sublicense Income (Model 1). Since partnering, co-promotion and collaboration deals so often involve multiple financial components (R&D funding, equity investments, up front fees, milestones, royalties, etc.), it is critical that the sublicense income provision be tailored, as follows:

a. Be sure that the sublicense income provision captures only income (whether upfront fees, milestones, royalties or otherwise) received by licensee that is attributable or allocable to the grant of the sublicense.

b. Confirm that the percentage of sublicense income payable by the licensee to the University/licensor declines over time, so as to take into account the R&D contributions of licensee.

c. Confirm that sublicense income does not include, and therefore licensee does not have to pay University/licensor a percentage of, the following:

i. The fair market value of equity securities of licensee sold by licensee to sublicensee (typically a premium would be captured as part of sublicensee income).

ii. R&D funding and patent cost reimbursements by sublicensee to licensee (typically subject to cost-based constraints, e.g., cost plus x% or a maximum FTE rate).

iii. Loans by sublicensee to licensee (except to the extent forgiven, in which case they may be captured as sublicense income).

iv. If there is a pass-through royalty provision, exclude amounts payable by sublicensee based on net sales.

v. Although often overlooked, profit-sharing based on sales of products should be excluded, particularly if profit-share or co-promotion transactions are a possibility for the licensee (otherwise the entire profit share of the company may be deemed sublicense income).

5. Equity.

a. In spin-outs or foundational licenses to early stage companies, Universities will typically accept, or sometimes actively seek, equity as a form of consideration.

b. Universities have policies regarding the circumstances in which they may accept equity, the amount of the equity they may obtain and the allocation of equity among inventors and the University.

i. For example, UC’s equity policy generally prohibits UC from accepting more than 10% share ownership in any licensee. For a copy of the full UC equity policy, please see:

ii. Many Universities (such as Stanford) have policies that require them to sell their stock immediately upon IPO.

iii. University conflict of interest policies typically prohibit the University or University researchers from holding an equity interest in companies that are conducting clinical trials for their products at the University (or require special approval for retaining such holdings).

c. Universities are typically satisfied with common stock.

d. In pre-Series A companies, Universities will typically seek anti-dilution protection sufficient to maintain their % share ownership through the completion of the Series A round. Watch out for poorly drafted commitments to maintain University’s ownership share through either some dollar amount raised, or whether such level is tied to pre or post institutional rounds of investment.

c. Other Diligence Issues.

i. IP/Field: Should cover current and future business plan of company.

ii. License Grant: In addition to the exclusive right of licensee to make, use, offer for sale, import and sell, should include right to sublicense without consent of licensor. Note that Universities, as a matter of policy, retain rights for academic and research purposes in all fields (including the field that is exclusively licensed), and there is a recent trend among Universities to reserve such rights also for other non-profit and governmental institutions.

iii. Term: License should last until the last licensed patent expires. Watch out for term licenses that expire after defined number of years (more typical in IT than life sciences).

iv. Termination: Licensor should not have any termination rights except for material breach by licensee (and possibly insolvency). Ideal if any sublicense granted by Licensee survives any termination of the underlying license to Licensee.

v. Diligence Obligations: Verify that company has met both its general “commercially reasonable efforts” obligation and particularly its specific, objective diligence milestones. Failure to have done so will generally give the Licensor a right to terminate the license (or, in some cases, convert it to non-exclusive). If company’s satisfaction of milestones cannot be verified, consider seeking a confirmation from the University Tech Transfer office that the license is in good standing.

vi. Patent Enforcement: Confirm licensee has the first right of enforcement for infringement of exclusively licensed patents and the right to retain proceeds from actions that it initiates. Many Universities will ask for first right of enforcement, but many (including Stanford) are willing to concede it in the right circumstances.

vii. Assignment. Confirm licensee has a right to assign the agreement upon a change of control, and that there is no right of the University/licensor to terminate or trigger a payment upon a change of control.

3. Partnering / Collaborations

a. Context. At the time of the Series A or other early rounds, biotech company will generally not have any significant collaborations in place. However, as the company grows, collaborations with Pharma or big biotech often become an essential component of the company’s strategy both to fund its operations and to obtain the resources to develop and commercialize its technologies or products based on its technologies.

b. Model. Typical model is the biotech company is exclusively licensing rights to Pharma or big biotech, in exchange for upfront fees (or shares of profits), royalties, milestones, maintenance fees and/or equity investments. Transactions range from outright licenses in which the biotech company plays little role in further development to strategic alliances in which the parties closely collaborate on the development and commercialization of the technology. Collaborations will allocate rights and responsibilities between the parties for development, clinical trials, regulatory, manufacturing, supply, promotion and commercialization. These agreements are complex and this outline is intended only to highlight selected issues.

c. Stage of Development. Terms, both legal and financial, will vary significantly depending on the subject matter of collaboration. Collaborations may range from early stage (e.g., target discovery and validation, and/or high-throughput screening for validated targets) to development stage (e.g., pre-IND to Phase I) to later stage (e.g., Phase II or III). Early stage deals generally involve biotech companies licensing platform or discovery tools/technologies to Pharma; later stage deals generally involve biotech companies licensing identified compounds to Pharma. Variations on this theme include collaborations centered around formulation or other technologies as well.

d. Threshold Considerations. The company’s future and prospects depend not just on the strength and success of the collaboration, but also on the rights that the company retains or rights that revert to the company for targets/candidates that do not advance in development under the collaboration. Therefore, evaluate what portion of the company’s technology/IP base has been exclusively licensed to Pharma, the scope of its retained rights, and company’s reversionary rights if Pharma fails to develop. Questions to consider in particular include:

i. Has the company exclusively licensed to Pharma substantially all rights to its technology/IP? Has the company retained rights to any significant IP in commercially viable fields and/or significant territories?

ii. Does Pharma have rights of first negotiation (ROFN) or rights of first refusal (ROFR) for future products or technologies of company? If so, would these terms allow company to practically exploit other alternatives?

iii. Do Pharma’s diligence obligations include objective, binding milestones, or just a general obligation to use commercially reasonable efforts? If the latter, would the terms allow Pharma to shelve the development of the licensed product, without losing its exclusive rights? This is common pitfall in these agreements and a material issue to the company.

iv. If the collaboration involves target discovery/validation, screening of potential drug candidates, or development of more than one candidate, do rights to such targets/candidates revert fully to company if Pharma does not proceed with development within defined timeframes or following objective milestones/ processes?

e. Financial Provisions:

i. Upfront Fees. Perhaps the most desirable form of financial return for a company is an upfront license fee that the company is free to invest in the collaboration or use to fund other projects or operations.

ii. Equity. While equity investments involve dilution to existing stockholders, companies often seek an equity investment as part of the collaboration to obtain additional unrestricted funding for its operations. However, note a few potential traps:

1. If Pharma has acquired equity in the company, confirm that Pharma’s rights as a stockholder do not include the right to block additional financings or the sale of the company.

2. If Pharma has acquired a board seat or observer rights, confirm that company has right to withhold competitive information and hold meetings without Pharma present.

iii. R&D Funding. Typically included as part of a development budget and must be invested by company in the collaboration.

iv. Milestones.

1. Confirm that milestones are crisply defined.

2. Consider whether milestones apply on a product-by-product basis, or would also apply for each indication. Ensure that if Pharma has rights to develop multiple products, milestones correspond and are not limited to a single product.

3. Consider whether geographically-based milestones would capture value generated by Pharma in other territories. Worldwide rights should come with development and commercialization milestones that are also worldwide, or at minimum cover major market countries.

4. Consider effects of failed leads on milestones, and whether Pharma should be able to credit previously paid milestones for replacement of lead product.

v. Royalties / Sublicensing Income.

1. Royalty obligations should apply to all products that Pharma is licensed to make and sell under company’s IP, whether sole or joint.

2. If Pharma insists on a royalty stacking provision, seek to ensure that Pharma may only offset a portion of patent royalties required for practice of licensed rights. Pharma will seek broad offset rights, sometimes even without a floor.

3. If Pharma has a right to sublicense (which is common, particularly in worldwide deals), royalty provisions should correspond and capture value generated by Pharma through sublicensing (including co-promotion) and have some basic protections for the company (i.e., regarding terms and termination of sublicense).

4. For any collaboration that includes co-development, confirm that Pharma must pay royalties on products covered by collaboration IP and joint IP, and not just company sole IP. Pharma will often push for reduced royalties or even no royalties on collaboration IP and joint IP, but that can result in Pharma being enabled with new products using company’s technology on which the company receives little or even no consideration.

f. Other Selected Diligence Issues:

i. Freedom to operate: Does the company have FTO as to its current and anticipated activities, including rights necessary to manufacture its products? To avoid later surprises, recommendation is to invest upfront in IP analysis of quality of company patent portfolio and any third party blocking patents. Lack of actual third party claims at the time of investment does not mean that no third party blocking rights exist. Typically assertions will begin only once a company is successful in the marketplace and on the eve of significant transactions and events, such as M&A and IPOs.

ii. In-Licenses: Virtually all biotech companies are founded or rely on certain key in-licenses. These present a number of key issues:

1. Does company have the right to sublicense without licensor approval under each relevant sublicense? Are such sublicenses subject to any terms or conditions that may preclude or impair the sublicense?

2. What are the ongoing royalty and other financial obligations of company?

3. Does the license contain a “pass-through” royalty applicable to sublicensee sales? If so, is this royalty burden low enough to allow the company to obtain a financial return on royalties from sublicensing?

4. Has the company paid all amounts due to its licensors given collaboration funding and payments received to date?

5. Is the sublicense income provision appropriately limited to amounts received from sublicensees that are attributable to the sublicense? Does the sublicense income provision have appropriate exclusions and limitations? For details, please see 2(b)(ii)(4) above.

6. Please see 2(c) above for Other Diligence Issues.

iii. Intellectual Property Ownership / License Grants.

1. Typically ownership should follow inventorship, and rights will be exchanged through licensing provisions, so focus is on the nature and scope of IP captured by exclusive licenses and the scope of those licenses.

2. Be sure that exclusive licenses granted by company would not capture IP of its acquirers. This would typically happen through an IP definition that includes IP of the company at its Affiliates. Too often, acquirers are not excluded, which can be a major issue or even deal-killer in a M&A context.

3. Consider what company IP is “captured” by license grants. Preferable to limit license grants only to relevant background IP and IP generated in collaboration. Avoid granting licenses under all IP owned or controlled by company during term of collaboration agreement, which may result in a windfall to Pharma.

4. Confirm what rights survive a termination of the agreement, whether for a party’s breach, regulatory, or other reasons. Ensure that, if company terminates for Pharma’s breach, Pharma grants-back to company all rights needed to carry-forward the development and commercialize the product (for which Pharma will sometimes insist on a royalty back to them).

iv. Steering Committee.

1. Consider risks of deadlock. Mediation and arbitration involve delays and costs, and arbitration of business decisions (e.g., budgets or development plans) is not generally appropriate.

2. Deadlock can be resolved by allocating ultimate control on deadlocked issues to a single party. However, avoid the “blank check” risk, whereby Pharma has sole rights (whether directly or indirectly through resolution of deadlock) to impose financial obligations on company, e.g., by approval of new development plans or budgets.

v. Exclusivity: Be sure that exclusivity or non-competition provisions that bind company would not extend (via the definition of Affiliates or otherwise) to bind acquirers of company. This type of provision can scuttle a potential M&A deal.

vi. Assignment / Change of Control. Does Pharma have a right to terminate the collaboration agreement upon a change of control? Typically, Pharma will at minimum want such a right for changes of control involving other large Pharma. In such cases, consider the effect of termination and whether it includes licenses by Pharma to company for rights necessary to continue the development/project.

vii. HSR. Be aware that HSR notification applies to license agreements that meet the applicable size of parties and size of transaction tests. Valuation will be limited to U.S. rights, and will include present value of fixed and contingent payments, including equity, but excluding R&D funding.

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