Australian biotechnology stocks have suffered from unfair association with the dotcom boom and bust, but David Sparling and Michael Vitale* provide a new study to show that this sector is alive and well.
Australian biotechnology do perceptions and reality meet?
Australian biotechnology stocks have suffered from unfair association with the dotcom boom and bust, but David Sparling and Michael Vitale* provide a new study to show that this sector is alive and well.
This working paper reports preliminary results from a study of recently listed Australian biotechnology companies. The analysis compares these companies to a sample of American biotech companies, and to a sample of Australian non-biotech companies, listing during 1998-2002.
Research indicates that the Australian biotech sector is not "tech wreck II – the sequel" – at least not yet. Shares in the recently listed biotechs significantly outperformed those of US biotechs, Australian non-biotech IPOs, and the Australian stock market as a whole. Many of the young biotechs have products on or near the market, and most have formed alliances with American or European companies. On the other hand, roughly half of them are short of cash, with poor prospects for raising more. In this sense the firms may be said to have gone public "too early". However, for many a public listing was the only means of survival.
The lack of scale and liquidity, particularly when compared to American biotechs, suggests they will have to compete differently and perhaps in different markets.
Surprisingly, research also found that the young biotechs are almost entirely concentrated in human health, despite Australia's legacy of success in various areas of agriculture.
The research does not seek to predict the future for any individual company, but overall leads to a cautiously optimistic view of the biotechnology sector as a whole.
'Biotechnology companies, are there any left?" was a neighbour's reaction to hearing that we were studying Australian biotech firms. Not everyone thinks the biotechnology industry is gone, but the perception is definitely of an industry in deep trouble, without the funds or the people needed to survive.
In a recent analysis, US venture capitalist Michael Greenberg characterised the Australian biotechnology sector as lacking the financing, resources, experience, and management to be successful in a global context.
He also stated that Australians celebrate their successes too much and pay too little attention to their failures, thereby presenting a reassuring but unrealistic outlook for the future. While these are harsh criticisms, Australian policy makers and business leaders ignore them at their peril. Widely held perceptions often shape policy and investment decisions as much as facts do.
Ask Australian investors about the performance of biotechnology shares and most will lump them in with the dotcom meltdown. When talking to investment professionals and industry managers, one frequently hears the questions, "Did the Australian firms go to the market too early? Were their technologies too far from the market and their value propositions undeveloped?"
There are also veiled suggestions that some managers took firms to the markets in part because "mum and dad" investors were more gullible than hard-nosed venture capitalists.
The perceptions change when you move into the public sector – there you hear about the strength of Australian science, the cost-competitiveness of Australian research, and that start-ups are the surest route to economic prosperity.
There is a widely held view that the main funding gap for Australian biotechnology firms is finding pre-seed funding to help get start-ups out of universities, research institutions and CSIRO. You also hear that while there are local shortages of managers, there are trained Australian managers abroad ready to leap at the chance to come back.
So perceptions range from the gloomy "Isn't it dead yet?" to a rosy, and possibly equally unrealistic, optimism. With innovation and economic renewal at the top of the public agenda, this disparate aggregation of perceptions is influencing public policy, as well as private investment, today.
Policy and investment will, in turn, determine the structure, direction, and ultimate success of the Australian biotechnology sector.
While perceptions are powerful forces, we believe that facts form a stronger platform for policy and investment decisions. Our intention in this paper is to fill in some of the facts for one important segment of the Australian biotechnology industry, the group of 24 firms that went public on the ASX in the period 1998 to 2002.
These firms all survived the fragile period between university laboratory and IPO and managed to convince investors to entrust their capital to the development of their new biotechnologies.
We examined 24 biotechnology IPOs on the Australian Stock Exchange during the period 1998-2002, the most active period ever for biotech listings. We examined the companies and their technologies at IPO, the degree to which they have achieved their financial and technological objectives, and how the firms changed their business models and positioned themselves to weather the current funding drought.
The analysis took two routes. First, we examined the document trail for each firm, from IPO prospectus to recent news and financial statements. Since biotechnology firms compete for funds with non-biotech companies on the ASX and with international firms, we compared the results for our sample with those from a random sample of 48 of the 422 ASX non-biotech IPOs during the same 1998-2002 period.
The non-biotech sample was in the same annual proportion as the biotech IPOs, reducing concerns over the effects of time from IPO to the present. We also compared the biotech IPOs with US biotech IPOs over the same period. However, numbers only tell part of the story, so in the second phase of the study we conducted in-depth interviews with the managers leading the Australian biotech IPO companies.
The results shed some light on the challenges and successes in the sector and may provide guidance for biotechnology managers and directors. They may also help reshape perceptions and policies related to the industry to assist it achieve its maximum potential.
All twenty-four firms in the study operate in the human health arena, although one also works in the plant and animal industry. Fifteen were classified by primary activity as drug discovery/genomics, three diagnostic, three medical systems/device firms and one primarily chemical.
The firms operate in the middle area of the drug discovery or technology development process illustrated below. In almost every case the technologies originated in an academic institution, medical research institute, or CSIRO, represented by the circle on the left.
The business models of the firms tended to involve adding value by further developing of the technologies, as represented in the middle area, before passing them on to large pharmaceutical or technology firms represented on the right, which take the technologies to the market.
Prior to IPO, the firms relied on a combination of government funding, venture capital, research and development syndicates, and university support. Ten firms reported receiving an average of just over $5 million from either angel or venture capital investors.
Two firms received major investments from R&D syndicates of $8.8 million and $18 million respectively. The other half of the firms received much less support with average investments under $500,000, often from founders or industry partners. It is worthy of note that a single company made small investments in three of the firms, who used that money to develop both a technology and a business plan that could be taken to IPO.
The firms also received significant government support before IPO and after. Many of the firms were supported and protected within universities for up to several years before moving to their own premises. Seven of the companies have received START grants totalling $13.7 million, ranging from $245,000 to $4.9 million. Other programs, for example Biotechnology Innovation Fund (BIF) grants, have been used less frequently and with lower funding rates. All firms took advantage of the R&D tax credit system.
One of the concerns with technology-based firms is that the technology and the scientists behind it will exercise too much influence over the direction of the business. This may be true at the time of start-up, but by IPO the boards of the young biotechs emphasised a business background, as illustrated in Table 1.
The mixture of science and business backgrounds in the management and boards of the biotechnology IPO firms has changed somewhat since IPO, again as illustrated in Table 1. While both management and boards have been relatively stable, there has been a trend toward stronger business backgrounds among the CEOs and non-executive directors.
Understandably, the boards of these relatively small companies still exhibit a very strong Australian composition. However, in our discussions with managers it was obvious that the firms had been and were continuing to strengthen the international content of their boards by adding directors with overseas biotechnology or pharmaceutical experience.
None of the firms reported any difficulty in finding qualified and willing board members, and all were able to hire or contract all the scientific staff they could afford. There is, however, a reported shortage of experienced senior managers.
In America and Europe, large pharmaceutical and consumer product firms are the breeding ground for start-up biotech managers. There are no such Australian-owned firms, and the overseas presence in Australia is generally limited to a sales organisation that takes its lead from overseas.
Thus there is relatively little opportunity for managers to gain experience at developing a major new product or managing a brand. Bringing experienced expatriate Australians home is difficult given the difference in salaries and the unfavourable exchange rate, although firms continue to try. (On the other hand, overseas firms also stalk good Australian managers, particularly those sent abroad to open an offshore office or establish a sales force.) Without doubt the passage of time will lead to a larger pool of experienced managers, but if the sector expands apace then the situation will not improve.
Asked the reasons for doing an initial public offering when they did, all managers cited market conditions as the main motivation. Favourable market conditions and public interest in new technology created a readiness by ASX investors to embrace biotechnology IPOs.
In almost every case, however, the decision was also motivated by the difficulty or even perceived impossibility of raising funds from venture capital firms or other private sources.
Faced with a public market willing to fund new companies and venture capitalists unwilling to do so, managers took the only route available to raise the funds they needed. In more than one instance the IPO decision was also pushed by shareholders looking for an exit strategy; venture capital firms, universities, and sometimes inventors who saw the IPO as a chance to capture value and gain liquidity.
The wave of biotechnology IPOs exhibited a small lag compared to the overall pattern of IPOs on the ASX, as shown in Figure 2.
Both the amount raised and market capitalisation after IPO were related to the date of the IPO and reflect the general characteristics of the market at the time, as shown in Figure 3. The obvious outlier is 2002 when one firm listed at a significant valuation.
One of the common perceptions in the industry is that biotechnology firms went to IPO too soon in their development, driven by an inability to secure venture capital funding.
While the scarcity of venture funding did encourage the IPOs, we found that the average age (from incorporation to IPO) of firms at IPO for Australian biotech companies was 6.5 years compared to 4.7 for the non-biotech sample firms and approximately 5.9 for US biotechs.
Interestingly, age was not a good predictor of firm performance either at IPO or after. Age at IPO was not significantly related to the market value of the firm at IPO, the amount raised, most recent six months earnings, or share price performance from IPO to present. Even revenue at IPO was not significantly correlated related to the amount raised.
Although they may have been older, Australian biotechs were significantly under-resourced compared to their American counterparts (Table 2). They received neither large infusions of cash nor large valuations at IPO. Although they compare favourably with other ASX IPOs, their value and funding are less than 10 percent of those of the US firms. The obvious implication is that Australian firms have to manage differently and possibly compete in different ways.
Disclosures at IPO:
What did firms tell investors?
Biotechnology investment involves inherent risks, somewhat mitigated by strong intellectual property, value propositions, and management teams. We assessed firms at IPO and what they told potential investors about their position and future.
The value of biotechnology firms rests in the knowledge embedded in their products and people. One indicator of a firm's ability to capture value from that knowledge is the patents it holds or licenses in. Seventeen of the firms held or licensed existing patents while four had patents pending. For three firms there was no indication of existing or pending patents.
The business models identified in the IPO prospectus for these firms reflect both the small size of the firms and the significant resources needed to take a biotechnology product through regulatory approval to an end product.
All firms with a major or minor emphasis on drug discovery and development had a strategy of adding value to initial discovery research and then licensing the technology to a large pharmaceutical partner. Only the six firms in the diagnostic or devices businesses planned to take products through to the market. Two others planned to in-license promising pharmaceuticals from other firms.
In order to provide a return to shareholders, biotechnology firms must be able to:
• Develop technology,
• Secure market acceptance and marketing capabilities for the technology, and
• Capture the value of the technology through intellectual property rights.
For potential investors, assessing a firm's ability to achieve these is difficult. Australian biotechnology firms addressed this uncertainty to differing degrees in their prospectuses. Many of the firms employed outside specialists to assess their technologies, the market and value of the firm or of lead products, and the intellectual property position, as illustrated in Table 3 below.
Sixteen provided an overall market and technology valuation report, and fourteen provided a dollar value for the firm or its lead product(s). Valuations reported ranged from $25.2-90 million and averaged $44.1 million. Except for one outlier at 6.4, the ratio of estimated valuation to IPO market capitalisation ranged from .52 to 2.07.
Usually, but not always, firms that provided technology valuations also provided IP reports. Seven firms provided technology reports by experts in the field, designed to provide the reader with more knowledge about the status of the technology. Three firms provided no outside assessments and two others provided only IP reports.
Forecasting future revenue for a new biotechnology product is particularly challenging. The uncertainty around future revenues is apparent in the information provided to prospective investors. Twelve companies either had sales at IPO or projected reaching the market within two years, but only half of those gave actual forecasts of revenue. All firms had a much better handle on R&D spending, and 18 of 23 provided projected R&D spending for the first two years after IPO, projecting spending just under $6 million on average.
Biotechnology firms tend to be built on a promise of undeveloped science and unproven technologies. This means that in most cases they must plan for several years of losses before becoming profitable, generating revenues either through the sale or licensing of their technologies or through actual product sales.
An examination of funds raised relative to R&D spending for the first two years reveals that 15 of the 18 firms with R&D projections raised more than enough to cover R&D. Two firms raised about half of projected spend and one firm only raised 18 percent. When operating expenses are added two more firms drop below 99 percent of projected expenses.
Thus six of the 18 firms reporting expenses would require positive earnings or an additional round of funding within two years to carry out the plans specified in their prospectuses. These firms are at higher risk than those with better coverage, and the recent downturn has affected the returns experienced by their shareholders as will be discussed later.
The companies have definitely progressed since their IPOs but are not yet economic powerhouses. On average they employ 32 people, had 2002 revenues of $5.6 million, and a 2002 loss of $4 million. The firms spend an average of almost $4 million per year on research and development – about 75 percent of their average revenue.
Since much of the R&D spending goes to organisations external to the firms, their employment impact is understated. By comparison the ASX sample firms on average employ 162 people, had $35 million in revenue, and made $3.7 million in profits. Only three of the firms reported any R&D spending at all, and only one reported more than $250,000.
Business models have undergone a significant shift from IPO to present. At IPO, many firms had quite broad value propositions. Companies typically cited developments in several areas with numerous projects at varying stages of their life cycles. The current funding drought has forced many these firms to redefine their business models. With cash reserves depleting and no easy way to raise more, managers have shifted their focus, moving revenue generation activities to the forefront.
In some cases, this has meant providing services and products to other biotechnology firms. The products ranged from reagent to recombinant proteins and the services from production to consulting. In other cases, firms have generated revenue through early licensing or sale of their leading technologies. For many managers it was a necessary, but not the preferred development path.
The inherently risky nature of early stage biotechnology development means that there will be technology failures. It was apparent that while managers recognised the risk, their planning did not always include adequate strategies for coping with failure. "We planned [only] for success," stated one manager.
Technology failures caught some companies by surprise. The sample included several cases of such failures. The impact on the firms varied depending on the technology portfolio and capital structure of the firm. In two instances, the companies were built on single technologies and failures were catastrophic.
These two companies exited biotechnology and entered entirely new lines of business, employing the remaining capital in their firms to make the change. In other cases the impacts were less severe but the managers went through agonising periods redefining the company and its businesses.
Although raising additional funding is challenging, some firms have been successful in doing so, with seven firms having follow on financing in 2000, three in 2001, and four in 2002. In addition, the cash flow of the firms improved in the latter half of 2002. On average their revenues have increased more than expenses and their losses have decreased, as shown in Table 4.
One of the concerns with biotechnology firms and their long development timeframes is that they will run out of cash before their products begin to produce significant revenue. We tested the firms' ability to cover future expenses from cash plus investments using the following formula:
Number of years' expense coverage = (Annualised revenue + cash + investments)
divided by annualised expenses
It is apparent from the results in Table 5 that the overall cash position of firms deteriorated in the second half of last year. The number of firms with less than one year's coverage has risen, and now represents more than 60 percent of the firms.
Shareholder returns and cash flow projections
Earlier we predicted that firms raising less than two years' projected expenses would be at higher risk than those raising more. Examining shareholder returns reveals that the shareholders of those riskier firms have fared marginally worse on average than those investing in firms raising more (Table 6).
An interesting result was that the firms that offered no projections for revenue or expenses performed much better than average. Of five firms not reporting, three were huge successes with share price increases of 1220 percent, 428 and 305 percent. The non-reporting firms far outpaced the others. Although the five firms did not offer financial projections, three did provide independent valuations of their firms, created using a discounted cash flow method.
Table 6. Shareholder returns and IPO cash flow projections
Total shareholder returns from IPO to March 2003
There appears to be a general pessimism and dissatisfaction about the performance of biotechnology firms on the ASX and a sentiment that biotechnology IPOs have been a failure overall.
To test this perception we compared the share performance of biotechnology IPO firms to that of a sample of ASX IPOs for firms in other sectors. The sample of 48 non-biotechnology IPOs was randomly selected from the entire population of IPOs on the ASX in the period 1998-2002. The sample was matched to the biotechnology firm IPOs in terms of the proportion of the sample occurring in each year to reduce the effect of time since IPO. Share price changes from IPO to 7 March 2003 are compared.
While many biotechnology IPOs have fared poorly, overall the biotechnology IPOs significantly outperformed the sample of the general IPO population. The return for shares of the biotechnology firms in our sample was 65.6 percent compared to -38 percent for the general IPO sample. Even removing the one outlier with a return exceeding 1200 percent still leaves the return for biotech IPO stocks at 15.4 percent.
We also compared this to a random sample of 92 NASDAQ biotechnology IPOs and the average share price change for that sample was -46.2 percent. Only three of the NASDAQ IPOs exhibited positive returns, and two of those were achieved by firms that were acquired in 2000 and 2001.
The crash of biotechnology stocks, and the (incorrect) perception of their close association with information technology stocks, has meant that there is currently virtually no opportunity for Australian biotechnology firms to raise money in the public markets.
Finding additional funding is a concern for most of the senior managers we spoke to. The consensus was that there would be some reorganisation of the sector as firms run out of cash. However, the managers did feel that there were great opportunities in Australia in terms of the science. They also were unanimous that no firm could make it by focusing on the Australian market alone.
To be truly successful, Australian biotechnology firms need to think globally, sourcing the best technologies and capabilities in the world, targeting large foreign markets, and partnering with international firms.
Managers were relatively uniform in their split views of government. All liked receiving grants and felt that the grants had contributed to their success and image. In many cases grants had been instrumental in securing additional industry funding. On the other hand, all managers stated that government policies and programs should not drive strategy.
Business opportunities had to stand on their own merit. Grants might make implementation easier but should not change the initial decision. They also wanted as little interference in their on-going operations as possible.
There is little doubt that the comparatively easy access to cash up to 2002 resulted in a number of firms becoming public before they were perfectly ready, either from a corporate or a technology perspective.
Equally, there are firms successfully meeting customer needs today that might not have survived under other market conditions. Their IPOs provided the resources that managers needed to advance both the technologies and the business models.
For some firms, going public was a major, and somewhat traumatic, event. Systems, processes, and procedures all had to change, and more importantly senior managers had to change as well. The transparency and equity required of a public firm did not always come easily.
For other firms, those that we would describe as having been "born public", the IPO was an exciting but not difficult event, representing the achievement of another expected milestone in the corporate plan. These firms had intended from the start to become public, and had adopted the systems and behaviours of a public company very early on.
The jury is still out on how many of the 1998-2002 IPO firms will survive to become significant industry players. As we look around the industry we seem firms that have exited, others which have changed their business models in response to technological delays or failures, and some which have never veered from their initial plan, thanks to a combination of technological success, good partnerships, good management, and at least a bit of good luck.
* David Sparling and Michael Vitale are from the Australian Graduate School of Management UNSW. This paper was presented at the AICD National Conference in Canberra
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