services: Valuation
Industries: Life Science

Similar to the challenges we discussed in mid-2022 facing growth-stage technology companies, life science companies are facing a complex matrix of economic and financial challenges that are impacting valuations. This is especially true of those companies in the early stages and with a long horizon to operating profit. Many of the macro risks have been heavily discussed and include stubbornly high inflation, rapid increases in baseline interest rates by the Federal Reserve, and a dramatic slowing of the IPO and SPAC capital markets relative to the high pace of activity in 2021. Given the market challenges, the Nasdaq Biotech Index finished in 2022 down 10.1%, with the last quarter of 2022 rallying to save the index and overall life science space from larger declines. The impact on earlier-stage life science companies, where cash flows may be projected many years in the future, has been more pronounced as higher expected rates of return discount future earnings more heavily. Accordingly, the venture deal count slowed in 2022, and some life science companies find in this inflationary landscape that they may be trading below cash.

For emerging companies, this environment makes for a challenging landscape to navigate, and therefore, valuation becomes particularly complicated. Private life science companies are having to be more creative when raising capital, with convertible notes offering a potential bridge with discounts embedded in a future round, rather than having to apply a potentially lower sticker price right now. Additionally, with the resources already on the balance sheet, like consumer product companies, life science companies should also be intimately dialed into their cost structures to maximize efficiencies during this period of a higher cost of capital. There are several paths these companies can explore to operate efficiently and maximize valuation.

Take advantage of legislative developments

Emerging companies in the life science sector should be taking full advantage of research and development (R&D) tax credits. These are available as a payroll tax deduction for early-stage companies because many of these companies are not yet profitable, and therefore, are not paying federal taxes. Certain credits, such as these for emerging companies, may offer a dollar-for-dollar offset to payroll tax liability and help keep cash in the door. It is important to develop proper procedures and document the applicable expenses to maximize applicable credits and efficiency, while minimizing risk.

Innovate with funding sources and alternative financing options

Creative funding and nuanced structures can provide a bridge over rough waters in a challenging financing environment. In today’s climate, many life science companies fall short on debt funding because they do not have the income to cover traditional debt interest payments. As such, companies have gravitated to hybrid securities, such as convertible notes that, at some point, are eligible to be converted into equity, typically at a discount. These convertible notes are more prevalent in times and spaces like these, where priced deal volume may be slower, and investors seek both the protection and embedded discount in the note structure. In some cases, companies can add warrant features as an incentive to these notes. In an impaired valuation environment, receiving warrants with a lower future exercise price creates an upside for investors and serves as a further incentive for growth-oriented creative funding options.

For public companies, a shelf registration is an option for fundraising, where the company can pre-register securities with the U.S. Securities and Exchange Commission (SEC) in order to issue new shares to the public in the future. While this saves time and money due to fewer filing requirements, this option, similar to the issuance of convertible notes, requires sufficient accounting and compliance guidance to navigate the tax implications and financial reporting requirements.

Gain an economy of scale by considering business combinations

In the current inflationary landscape, a business combination strategy may present opportunities for life science companies to gain an economy of scale. For example, two companies — each with one or two platforms — have cost structures in place to support these platforms. Combining these platforms results in the potential for cost savings and an optimized cost structure, and ultimately, may make for a stronger and more valuable company that is built for growth as the economy settles.

There are additional opportunities in today’s environment. This includes larger companies funding opportunistic deals, where they are purchasing smaller companies at a discount (often desirable for the sell-side company as well, depending on the funding situation). Another is “spin-out” deals, where companies separate the financials of a piece of their multi-platform business (e.g., one of three therapeutics in development) for sale to refine their platform and operating structure.

Consider outsourcing to save people costs

For any company, and certainly not limited to life science companies, the expense associated with qualified people is substantial. In leaner times such as these, consider deploying a smaller in-house team and leveraging external service providers, such as outsourced accounting or human resources. This often is both easier to manage and more cost effective than employing a full-service team in-house.

Given today’s market environment and economic crosscurrents, it is important that life science companies be realistic about their position in the marketplace. They need to continue making strong strategic and tactical decisions to prepare for the next wave of success that will come when the winds shift again.

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