Genzyme Corporation: Financing Strategy

Financing Strategy Planning for an entire program of investments and financing (rather than isolated transactions) How does the nature of the business and the investments condition the types of financing instruments used? The role of options in investment and financing (Note: slides and spreadsheet available at www2.bc.edu/~taggartr)

Genzyme Businesses, 1992 (Exh. 3) 1.Biotherapeutics Heavy R&D 2.Diagnostic Products Some sales, some R&D 3.Diagnostic Services All services sales 4.Pharmaceuticals and Fine Chemicals All product sales

Genzyme Financing History 1981: Venture Capital (Round 1) –$3 mill – Oak Inv. Partners 1983: Venture Capital (Round 2) –$3 mil – Oak – Termeer hired 1985: Venture Capital (Round 3) 1986: IPO –2.8 mil $10 (net $21.5 mil) 1987: GCP Units –Net $8.65 mil 1989: GDP Units and SEO –$30.5 mil from units –SEO: $34.1 mil 1990: Neozyme I Units –$43.5 mil 1991: SEO and 6.75% Convertibles –SEO: $136.5 mil –Converts: $97.25 mil

Financing Growth Options Pharmaceutical Company Partnership Straight Debt –Why would Genzyme have difficulty raising straight debt? Ordinary Equity –What problems does equity financing pose for a company that relies heavily on R&D? –Why does Termeer pledge no proceeds from equity offerings spent on R&D? Securities with Attached Options –Can anything be gained by attaching options to ordinary securities (isn’t whole = sum of parts)?

A Brief Digression on Options Not obligationcallputunderlying asset An option is the right to buy (sell) a specified asset at a specified price on (or before) a specified date strike (exercise) priceEuropean (American) maturity (expiration) date

Payoff Diagram: Buying a Call with Exercise Price E on a Stock Payoff at Expiration S T - E E Stock price at Expiration (S T )

Payoff Diagram: Buying a Put with Exercise Price E on a Stock Payoff at Expiration E E - S T E Stock price at Expiration (S T )

Options Associated with Corporate Investment R&D expenditures or marketing research can create options to make future investments –Genzyme can be thought of as a portfolio of existing businesses plus growth options An investment can be undertaken immediately but the firm also has the option to postpone it to a future date

Financing Instruments with Attached Options Corporations often issue securities with options attached: Callable bonds (issuer has the right to buy the bonds back at a prespecified price) Puttable bonds (holder has the right to sell the bonds back to the issuer) Pay-in-Kind (PIK) bonds (issuer has the right to sell more bonds to holder in lieu of paying coupons in cash) Convertible bonds (holder has the right to convert the bonds into a prespecified number of shares; issuer has the right to buy the bonds back at a prespecified price)

Decomposing Puttable and Callable Bonds Payoff Buy Bond Payoff Buy Put Payoff Puttable Bond + = Value of Option-Free Bond (VOF) E VOF E VOF Payoff Buy Bond Payoff Sell Call Payoff Callable Bond + E VOF = Value of Option-Free Bond (VOF) EVOF

Genzyme Convertible Issue (Oct. 1991) 10-year, 6.75% bonds convertible into common stock at option of holder –Convertible at $  each bond convertible into 1000/ = shares –Stock price at issue = $35 bonds callable at option of issuer –First call date 10/93 (if GENZ sells at 150% of conversion price in previous 45 days) –Initial call price = % of par (call price declines thereafter Payoff Call option on stock EStock Price Payoff Callable Bond E VOF

When Are Convertibles a Good Idea? Bondholder suspicion of firm’s creditworthiness Bondholders nervous about shareholders’ ability to undermine their position Investor disagreement over firm’s true value –High uncertainty  higher option value

Ceredase Financing R& D fees (8.65 mil), overhead Potential Potential warrant buyout exercise losses sale of units (8.65 mil) GCP Partnership Investors Genzyme

GCP Units 4/87 – 5/871/1/898/31/918/31/94 Units soldE = 18.15E = 20.15warrants ($50,000)expire

How Can Place a Value on the Warrants? The Black – Scholes Call Option Pricing Model S = current stock price E = exercise price R F = risk-free rate (continuous compounding)  2 = variance (per year) of stock price return T = time (years) to option expiration N(d) = probability of value ≤ d (std. normal distribution)

Warrant Valuation S = $14.50 E = $18.15 (4-yr warrants) or $20.15 (7-yr warrants) T = 4 yrs (or 7 yrs)  =.70 (Exh. 5) R F : 5-yr govt bond rate = 8.52% (Exh. 8). Continuously compounded equivalent can be found from:

Valuation of Partnership Interests Warrants worth ~ $10 per underlying share Each warrant written on 1500 shares, so each unit’s warrants worth ~ $15,000 Investors pay $50,000 per unit, so each partnership interest worth about $35,000 After the fact each of 200 partnership interests bought out by Genzyme in February, 1990 (~ 2.5 yrs) for total of $20.8 mil ($104,000 per interest)

After-the-Fact Partnership Rate of Return