Unfortunately for biotechnology companies, their products have long development timelines and are perceived to be a high-risk investment. Our current environment of high inflation and high interest rates is a double whammy with direct implications for asset (and company) valuations. If you are still keen to invest in smaller biotech companies that make up the life-blood of future treatments then there are aspects to be aware of, so hard-earned capital can both support human health and generate an acceptable ROI.
Biotech valuation during inflation
To start, we use the SPDR S&P Biotech ETF (XBI) as a surrogate to capture the aggregate value of biotechnology companies. This index includes many non-revenue generating companies compared to the big pharma-oriented iShares Biotechnology ETF (IBB). Larger pharmaceutical companies are more likely to be commercial-stage and revenue generating from pharmaceutical sales, the prices of which typically increase with inflation (other factors remaining constant). Likewise, big pharma tends to in-license rights to drugs from mid and small-size biopharma companies, who are compensated in the form of lump sum payments (not always inflation-protected) and royalties (inflation-protected). This means a big portion of revenue for small and mid-stage non-commercial biotechs may not be protected from inflation. Finally, big pharma companies are more diversified than smaller biotechs and inherently less risky. When capital is expensive, you look for less risky ways to park your money, like blue chip companies and government-backed bonds.
As consequence of high inflation and high interest rates in the United States, the XBI ETF is on its longest losing streak in the last ten years. After years of covid-fueled growth in the industry, biotech is facing our biggest extinction event since the financial crisis:
Figure 1. XBI ETF Performance Last 10 Years
This piece was written to support the decisions of leaders and investors within the biotech space, including how to prioritize your limited resources against headwinds a small biotech company may face. We must be willing to invest biotech companies backed by great science. Therefore, tread carefully if a biotechnology company has the following attributes:
1. Long development timeline to monetizing events
A preclinical-stage or early clinical stage company may be more deeply discounted compared to companies closer to exit or revenue generation. Similarly, clinical-stage companies with high patient recruitment targets, diseases with longitudinal endpoints, and otherwise complex trials may have to spend extra time gathering and analyzing data needed for the next regulatory milestone. This means more overhead expense. Time has extra value today due to a number of reasons, as described below, but it all boils down to cost-of-capital. A weighted cost of capital during the 2010's was around 2% versus the 4-5% return now available for less risky 2, 5 and 10-year treasures. The US federal reserve is compensating investors by increasing the coupon rate to match or exceed inflation. How can we convince investors to risk their investment on a company with a 10% likelihood of success to approval when you can buy safe, government-backed bonds?
What to do: Stakeholders of these companies may want to look for ways to lower patient recruitment thresholds, like Orphan drug indications, or invest in programs that are closer to major readouts. A Phase 2a proof-of-concept readout, for example, represents a catalyst for additional investment or acquisition. Try recruiting patients at community clinics rather than larger medical centers, which tend to recruit more slowly. If your product as a novel MOA, then a positive readout from a competitor for a later-stage program (and different indication) may have a similar effect. Lastly, clinical trials can be considered with biomarkers embedded in the protocol that may amenable to an accelerated approval pathway to shorten the clinical development timeline.
2. Expensive R&D and overhead
Year over year, expenses are increasing faster than during times of lower inflation. The speed of which are likely faster than when executives first pitched their long-range operating plan (LROP) to the board and got it approved. An expensive business is one with high cost of goods treatments, such as cell and gene therapies, and with large internal research teams working on multiple research-stage and preclinical programs. Clinical-stage companies with multi-site trials at prestigious medical centers have very high expenses. Breaking this down, over a 2-4 period for a Phase 1 clinical trial, necessary laboratory equipment (durables inflation), supplies (consumables inflation), clinical research organizations (services inflation), and new hires (wage inflation) may go up 20-25% versus 5-10% during the same time span in the 2010s. This is detrimental to your net present value (NPV) and requires companies to raise even more expensive money.
What to do: Look for ways to reduce overhead by operating with smaller, lean teams. Typically, an outsourced model is more modular and flexible, and despite being subject to services inflation, can be dialed back quicker and cheaper than a reduction in force. If leadership develops a reputation for executing with limited resources, then they are more likely to set themselves apart when expenses need to be kept in check. Likewise, look for ways to reduce research expense when it is not backed by non-dilutive capital, such as from grants or collaborations. Last, companies that have outsourced operations from the US can see benefits in three ways: geographies with less inflation, stronger USD, and incentive tax credits (i.e. Australia and Canada).
3. Little cash on balance sheet
We all agree it is always better to have more cash in your pocket. However, having less cash in your pocket makes raising money that much more painful when dilutive events are coupled with low valuations. As mentioned, a higher cost of capital flows directly into your NPV model which can often result in a negative enterprise value. A sufficient cash balance supports a capital-intensive biotech until programs are de-risked and/or external financial conditions improve. You may not be able to dilute yourself into bankruptcy directly, but you will be in a difficult spot if you discourage future investment by ensuring shareholder's positions get less valuable with every raise. Even full-rachet anti-dilution protections have their limits. If a company does not have the runway to reach the next inflation point and leadership is not willing to make major sacrifices to the budget or otherwise pivot, the company may not have the buffer required to survive this high inflation/high rates mass extinction event.
What to do: Review cash flow and balance sheet statements to calculate runway. Identify other assets the company may sell to support a lead program, such as a legacy business and/or rights to non-core cash flows. Review management notes in 10-Qs and 10-Ks for organizational changes including layoffs and other cost cutting measures, such as deprioritizing non-core research programs, to gauge leadership’s willingness to extend runway. A non-revenue generating company needs enough runway to make it to the next major inflection point, usually at least 18-24 months for a clinical-stage company. On a side note, I believe too much money sitting in the bank is also not adding value. This is a topic for another day and a good problem to have in today’s environment (think acquisitions).
4. Single-asset pipeline
Contrary to the above, you may wonder if a biotech can cut back too much in order to survive. Cutting research and/or clinical pipeline down to a single program may not be the best solution, even if it saves money. This goes back to the philosophy that it is better to have at least one back-up. For instance, a platform approach entails multiple shots on goal and when licensing a technology package, IP may exemplify a series of compounds. Although investors appreciate cost cutting measures, there is a point where perceived risk increases to become more of a consideration than runway. In an overall “risk-off” environment investors impart a higher discount rate on a single-asset company, leading to a lower valuation and less potential investment. High-risk companies target low-success rate indications: urology, gastroenterology and endocrine indicated drugs all have success rates lower than 50% for Phase 1 to Phase 2. Likewise, drugs with novel or unprecedented mechanisms of action have higher discount rates applied to them.
What to do: Focus on how to diversify your pipeline, by mechanism, stage, and indication. Prioritize programs with active co-development partnerships. Run multiple clinical trials that have a quicker time to inflection than a large-scale clinical trials for a single asset. Any single failure in Phase 3 can break a company. If you have no choice but to advance a single asset, review your historical chance of success by phase and indication. For example, sub-indications within hematology and metabolic are the most likely to succeed at each phase from Phase 1 to approval. Finally, look for precedented mechanisms that relate to a clear clinical pathology. Reformulations of approved drugs--505 (b)(2) pathways--carry the least perceived risk of development failure.
5. High debt to equity ratio
When a biotech company can no longer raise money through equity they must finance with debt. This includes convertible notes, warrants, and/or to a less extent, asset-backed debt. In a high interest rate environment, debt can carry rates of 8% or higher. By increasing debt liability, your debt-to-equity ratio can have negative consequences for future investment. On the other hand, inexpensive fixed debt financed during times of low inflation and low interest rates can be a great thing. Larger companies require debt to invest in growth to obtain market share and fuel future earnings. The challenge for small biotech companies is that they are typically financed through equity. In a high inflation environment, interest rates rise and valuations decrease, leading to lower shareholder equity. Warrant coverage and convertible debt with a high coupon rate protects new investors from decreasing equity valuations. Unfortunately, this can lead to poisonous cap tables and negative shareholder equity, and possible delisting from exchanges if the company is public.
What to do: Your cap table is the blueprint of the financial foundation of a business. Biotechs tend to thrive on higher equity valuation in low interest rate environments. When risks increase, investment requires high warrant coverage, convertible debt, or other discounts. Public investors wait until the next fundraise or until the warrants expire to avoid dilution. As a result, biotech companies must raise as much cash as they can when they are able to in order to support pipelines through their next infection points and beyond. Leadership may consider awarding equity to employees and service providers in lieu of cash. In general, biotechs should avoid carrying debt on their balance sheets and aim to control expenses rather than raise expensive capital in a high interest rate environment.
What does this all mean for valuation?
High-risk products with long development timelines are instrumental to improving healthcare worldwide. As development of drugs, medical devices, and diagnostics becomes more efficient through technological advancement, it will always be hindered by duration of treatment response and the regulatory process. Our current environment of high inflation and high interest rates is a double whammy with direct implications for asset (and hence company) valuations. As seen below, biotech valuations are inversely related to core inflation and to a less degree, interest rates:
Figure 2. 10-Year Performance of XBI Vs. Fed Funds Rate, 5-Year Treasury Yield and Core CPI
Our industry experienced unprecedented growth in a low interest environment since the financial crisis and is going through a necessary contraction phase. Many biotech companies that survive will grow and endure for years to come. By recognizing the five pitfalls outlined above, a biotech leader or investor can plan out a path toward efficient capital preservation to maximize the impact of life saving science while providing a return-on-investment shareholders.
XBI Price at Time of Publication = $73.66/share
Author's Disclosure: I/we own shares directly in XBI and indirectly through its holdings. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.