Development Path and Capital Structure of Belgian Biotechnology Firms Bastin Véronique Gestion Financière – ULG Séminaire de Gestion

10/06/2003Séminaire de Gestion2 Outline Objectives and motivation Objectives and motivation Firms’ investments viewed as real options Firms’ investments viewed as real options Real options in biotech firms Real options in biotech firms Interaction between development path and financing needs Interaction between development path and financing needs Empirical study: data and methodology Empirical study: data and methodology Empirical results Empirical results Conclusions and further research Conclusions and further research

10/06/2003Séminaire de Gestion3 Objectives Study interactions between investment and financing decisions Study interactions between investment and financing decisions On the investment side: identify creations and exercices of real options On the investment side: identify creations and exercices of real options On the financing side: analyze consistency of financing decisions with respect to investment pattern in real options On the financing side: analyze consistency of financing decisions with respect to investment pattern in real options Application to a specific sector: bio-industry Application to a specific sector: bio-industry

10/06/2003Séminaire de Gestion4 Why bio-industry? Specificities of the investment process: importance of R&D decisions Specificities of the investment process: importance of R&D decisions Specificities of the financing process: Specificities of the financing process: long path to profitability => important to have sufficient and adequate financing sources Better understanding of financial challenges in the bio- industry

10/06/2003Séminaire de Gestion5 Options in finance The right but not the obligation… The right but not the obligation… to buy or sell a specified asset (underlying asset)… to buy or sell a specified asset (underlying asset)… at a prespecified price (exercice price)… at a prespecified price (exercice price)… at a prespecified date or during a prespecified period in the future (maturity date) at a prespecified date or during a prespecified period in the future (maturity date) Value of options (premium):  due to asymmetry in the contract  increases with uncertainty about the future

10/06/2003Séminaire de Gestion6 Real options in corporate finance Investment projects often have strategic and operating options embedded Investment projects often have strategic and operating options embedded Underlying asset : investment opportunity Underlying asset : investment opportunity Exercice price : investment cost Exercice price : investment cost Time to maturity : time until opportunity disappears Time to maturity : time until opportunity disappears Valuation: almost like financial options (Trigeorgis, Dixit and Pindyck) Valuation: almost like financial options (Trigeorgis, Dixit and Pindyck) Strategic NPV = Standard NPV + Option premium

10/06/2003Séminaire de Gestion7 Examples of real options (1/2) Waiting-to-invest option Waiting-to-invest option Wait before investing to see if market uncertainty resolves positively Option to abandon Option to abandon Option to exit the investment project and sell off assets if market conditions decline Time-to build option (compound option) Time-to build option (compound option) Staging investment as a series of outlays => option to abandon in midstream if bad new information => option to abandon in midstream if bad new information

10/06/2003Séminaire de Gestion8 Examples of real options (2/2) Option to alter operating scale Option to alter operating scale Expand or contract the scale of production in response to changing market conditions Option to switch outputs (inputs) Option to switch outputs (inputs) Option to switch production to respond to changing demand Growth option Growth option Early investment as a perequisite to a chain of interrelated projects

10/06/2003Séminaire de Gestion9 Real options in bio-industry: related to R&D investments INVESTMENT in R&D Very uncertain Very uncertain Sequential nature Sequential nature Option to market innovative products Option to market innovative products BIOTECHNOLOGY R&D Long, high failure rates Ex : develop drugs Ex: Building up technology platforms TIME-TO-BUILD option GROWTH option

10/06/2003Séminaire de Gestion10 Implications for biotech financial management Investment projects often have multiple real options embedded Investment projects often have multiple real options embedded Need to identify creation and exercise of real options along firms’ development path Need to identify creation and exercise of real options along firms’ development path Integrate growth and time-to-build options in a scenario tree describing firms’ development path

10/06/2003Séminaire de Gestion11 Firms’ development path R&D C P R&D F CFCF R+ C+ P= C+ R+ R- C- R= C= R+ R= Stage 2: Commercialization Stage 3: Profitability Stage 1: Research & Development Failure

10/06/2003Séminaire de Gestion12 Real options along firms’ development path R&D C P R&D F CFCF R+ C+ P= C+ R+ R- C- R= C= R+ R= Time-to- build Growth

10/06/2003Séminaire de Gestion13 Real option creation and consumption along the tree « Success » : consumption of 1 stage of time-to- build option « Success » : consumption of 1 stage of time-to- build option increases total option value of assets… … BUT decreases option volatility value of assets « Failure » : consumption of 1 growth option « Failure » : consumption of 1 growth option decreases total option value of assets… … BUT increases option volatility value of assets What implications for financing policies?

10/06/2003Séminaire de Gestion14 Debt versus equity: the trade-off theory What lowers the target debt/equity ratio? What lowers the target debt/equity ratio?  Costs of financial distress  Agency costs of debt: underinvestment and asset substitution problem positively related to the volatility of future Cash Flows

10/06/2003Séminaire de Gestion15 Debt versus equity: the trade-off theory What increases the target debt/equity ratio? What increases the target debt/equity ratio?  deductibility of interest expenses : creates a tax advantage for debt over equity BUT less relevant for young biotech firms with losses H1Success: higher leverage Failure: lower leverage

10/06/2003Séminaire de Gestion16 Internal vs external financing: The pecking-order theory 1. Internal financing: retained earnings BUT often not available for biotech firms 2. External financing: a)Straight debt; private (banks) and public (bonds) b)Convertible debt c)Outside equity: private (FFF, VCs,…) and public

10/06/2003Séminaire de Gestion17 Choice of private financing vehicles (1/4) Venture Capital financing Venture Capital financing  Better monitoring of firms than outside equity  Monitoring is valuable in presence of serious information asymmetries, like for R&D intensive biotech firms H2 Failure: lower equity ownership by VCs Success: higher equity ownership by VCs

10/06/2003Séminaire de Gestion18 Choice of private financing vehicles (2/4) Debt maturity Debt maturity  Long maturities: can be better renegociated  Ability to renegociate: important source of financing flexibility  Short-term refinancing: never competitive  Need for more flexible financing when consumption of growth options H3 Failure: longer debt maturity Success: shorter debt maturity

10/06/2003Séminaire de Gestion19 Choice of private financing vehicles (3/4) Leasing Leasing  Provides immediate guarantee to the lender in case of problems  Often used when shortage of funds H4 Failure: more lease financing Success: less lease financing

10/06/2003Séminaire de Gestion20 Choice of private financing vehicles (4/4) Hybrid financing like convertible debt Hybrid financing like convertible debt  Debt with an option embedded to convert it into equity: Option-related security  Solution when debt becomes too expensive after some failures  But avoids to send a negative signal to the market (like equity) H5 Failure: more convertible financing Success: less convertible financing

10/06/2003Séminaire de Gestion21 The role of patenting Patent issue: Patent issue:  Decreases volatility value of existing options, by transforming intangible research into a more « tangible » asset  But creates an additional option to WAIT  Permits longer-term and less exigible financing devices H6A Patenting: more long-term debt H6BPatenting: more convertible debt

10/06/2003Séminaire de Gestion22 Empirical study : data Gross sample: Gross sample: 80 belgian biotech companies (2001) Cleaning: Cleaning: subsidiaries, very young firms, data availability Final sample: Final sample: 40 companies, 9 years old on average, 364 observations (year-firm) Accounting data: Accounting data:  R&D, tangible assets, revenue and profitability  Financing variables (scaled by external financing)

10/06/2003Séminaire de Gestion23 Empirical study : methodology Position observations on the tree: Position observations on the tree: Set of rules derived from accounting dummies Ex: not profitable, no increase in tangible assets and reduction in R&D investments => failure in R&D stage Group observations across nodes & branches Group observations across nodes & branches Hypotheses tests: Hypotheses tests: Test for mean differences in financial ratio evolution between « failure » and « success » observations

10/06/2003Séminaire de Gestion24 Means of capital structure ratios (whole sample & stages)

10/06/2003Séminaire de Gestion25 Means of capital structure ratios (tree branches)

10/06/2003Séminaire de Gestion26 Capital structure hypotheses tests: success vs failure (1/2) X???X??? Outcome: > < < <

10/06/2003Séminaire de Gestion27 Capital structure hypotheses tests: success vs failure (2/2)  Outcome: > > > >

10/06/2003Séminaire de Gestion28 Capital structure hypotheses tests: role of patents  Outcome:

10/06/2003Séminaire de Gestion29 Main empirical results (1/2) Most capital structure hypotheses: confirmed Most capital structure hypotheses: confirmed  Successes: harmonious decisions BUT  Failures: not always consistent with theoretical expectations Financial consequences of patenting: Financial consequences of patenting:  Good approach, use of more flexible and long-term financing

10/06/2003Séminaire de Gestion30 Main empirical results (2/2) Heavy recourse to debt financing in case of failure: Heavy recourse to debt financing in case of failure:  Lack of a well-developed equity capital market? OR/AND  Too large and easy availability of cheap debt financing? Convertible debt financing: Convertible debt financing:  Used in the right situation …  … But still very scarcely used

10/06/2003Séminaire de Gestion31 Further research Role of venture capital in financing of other types of R&D intensive firms Role of venture capital in financing of other types of R&D intensive firms Detect more accurately firms’ positioning on the scenario tree Detect more accurately firms’ positioning on the scenario tree Model dynamic capital structure evolution with real option evolution Model dynamic capital structure evolution with real option evolution