NATURE BIOTECHNOLOGY ADVANCE ONLINE PUBLICATION 1

BUI LDI NG A BUSI NESS

small upfront price for an option to license or
buy the company. Increasingly, biotech start-
ups must approach and plan for exits based
on monetizing each asset separately and col-
lecting payments from different partners over
a longer time horizon.
This shift to structured acquisitions
impacts the economic returns for a startups
core constituencies. The founders (and often
the original licensing institution), manage-
ment, employees and investors will all hold
an equity interest in the venture and will
participate to varying degrees in the sale or
license of the technology assets. Upon exit,
the biotech startup will attempt to receive
maximum value for each asset, technology
or product in its portfolio. For a structured
deal, the initial or upfront payment will be
distributed to its equity holders based on an
agreed set of established priorities (called
liquidation preferences) and residual shar-
ing percentages (based on stock ownership).
The contingent payments, if any, will follow
this payout waterfall. Investors are likely
to get their initial amounts back first plus
an increased return, then all stockholders
(including option holders, if their options
are in the money) will share in the remain-
ing proceeds. Increasingly, the value to inves-
tors and management equity holders hinges
upon the value of the contingent payments,
as well as what other value can be obtained
for assets that might not be the focus of the
primary deal.
Returns must also be viewed on an after-tax
basis. With a corporate entity, for an asset sale
or licensing transaction, not a sale of the entire
entity, there is tax paid at two levels: upon the
receipt of payments (generally to the extent of
a profit) by the corporate entity at corporate
tax rates, and at the stockholder level upon
a distribution of those funds to its equity
holders (generally as a dividend). Certain
pass-through tax entities, like limited liability
more virtual, having a small group of employ-
ees in a lab-less facility with R&D outsourced.
The companies typically develop only one or
two candidates at a time, and most of the
other promising assets and opportunities are
left to languish or kept on life support.
These factors have created a reliance on the
structured acquisition for the exit of many
biotech and life science startups. Buyers in
these acquisitions will typically make a sub-
stantial portion of the purchase price con-
tingent on the success of later-stage clinical
and commercial development. The payments
are commonly referred to as earn-out pay-
ments. For example, Cubist Pharmaceuticals
acquisition of Calixa Therapeutics in 2009
had an upfront payment of only $92.5 mil-
lion, whereas up to $310 million was payable
upon achievement of certain development,
regulatory and commercial milestones.
Another example is Eli Lillys purchase of
Alnara Pharmaceuticals in July 2010, with
$180 million upfront and up to $200 mil-
lion in future milestones. In a less common
variation of the structured transaction, a
buyer, usually a public company, will issue
contingent value rights (CVRs) to the sellers
stockholders, such as in the 2011 acquisition
of Genzyme by Sanofi. These CVRs may be
publicly traded and are essentially earn-out-
type payment rights typically tied to clinical
and commercialization milestones.
Complicating matters, many of the buyers
in these structured transactions do not want
to purchase the entire company, and they
may seek to license only a single product or
a portion of the technology in exchange for
upfront, milestone and royalty payments.
The company being acquired must stay in
existence and may even have certain R&D
responsibilities it must perform during the
license period. Finally, many of the risk-
averse pharmaceutical and emerging public
biotech companies may seek to pay only a
I
n biotechs early years, there was a typi-
cal formula for exit in which a startup
attracted venture capital investment before
any meaningful preclinical development,
then either went public in an initial public
offering (IPO) or was sold to a large pharma-
ceutical company (for cash or stock) in the
earliest stages of clinical development. These
startups were built with broad product pipe-
lines and extensive personnel and lab facili-
ties to manage and progress these programs.
Employees were often attracted and retained
by the promise of upside in the form of stock
options.
As the biotech industry has matured,
expectations have changed, and capital
investments are more difficult to access.
Public markets are not available until prod-
ucts have reached later clinical-stage devel-
opment or even product approval. Also, the
pharmaceutical industry has consolidated,
leaving fewer purchasers. The emerging pub-
lic biotech sector has smaller, more aggressive
players but limited cash resources.
This article will suggest ways to prepare for
this new reality.
The new exits
Because the public markets are more dis-
cerning for biotechs now, private investors
are looking to participate at later stages of
development. Those investors that do look
at earlier-stage companies are seeking to fund
only the most advanced product candidates
and hope to keep the burn rate of each com-
pany as low as possible.
This has caused biotech startups that
emerged in the late 2000s to be generally
Planning for the exit
Kenneth E Eheman Jr
As the biotech industry has matured, the exit process has evolved. Entrepreneurs need to build todays companies
based on the new exit paradigm.
Kenneth E. Eheman Jr. is a partner at
Wyrick Robbins Yates & Ponton LLP,
Raleigh, North Carolina, USA.
e-mail: keheman@wyrick.com
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2 ADVANCE ONLINE PUBLICATION NATURE BIOTECHNOLOGY
BUI LDI NG A BUSI NESS
out by an amount equal to the value of a
share of common stock at closing. The gain
on these stock options (that is, the difference
between the fair market value of the stock
and the exercise price) will most typically
be taxed at the higher ordinary income rates
instead of the favored long-term capital gains
rates because the option is typically extended
so close to the transaction that capital gains
holding periods have been satisfied. In addi-
tion, in deals with significant contingent
future payments (such as milestone pay-
ments), because the upfront payment will
barely cover the liquidation preference, often
there may be no or little actual proceeds allo-
cated to common stock at the time of closing.
Because options will terminate at closing if
not exercised, the optionee will have to pay
cash to exercise the option without assurance
of a future return. Compounding this prob-
lem, the value of a share of common stock at
exercise must take into account the expected
value of the future contingent payments
(even though such proceeds may never be
received), resulting in a substantially higher
tax burden at closing that in some cases may
even exceed the proceeds being received by
the optionee for the purchased stock. The
licensing transaction does not allow for opti-
mal outcomes for stock options, either. In a
license transaction, vesting may not be trig-
gered, and the options may not be exercisable,
leaving participation for optionees in transac-
tion proceeds uncertain. Even if the options
can be exercised, they would be subject to
all the same tax limitations and issues above
with respect to contingent consideration in
an acquisition context.
Noncore assets. In an outright acquisition,
buyers will typically purchase the entire com-
pany of the seller and thus acquire all of the
assets of the company, including all product
candidates and research programs at all stages.
A buyer may be interested in the entire spec-
trum of a sellers development products, par-
ticularly when the development products relate
to a core platform technology. In many other
situations, however, a buyer will be focused on
one, or perhaps two, clinical-stage products,
and many of the other development products
or research programs, particularly the early
stage products, will receive little or no value
from the buyer, although such assets may have
potential future value.
Exit by license. Many biotech startups will be
built upon one or more technologies that are
licensed from a university or other research
institution. Those licenses will often be set up
to cover the linear exit patterns of either IPO,
Issues with new exits
Even the more virtual companies of today typi-
cally complete multiple rounds of preferred stock
financing. Venture funds seek to deploy invest-
ments that mature in five to seven years, ideally
in an exit whereby the proceeds can be realized
and distributed to the investors at closing. These
requirements can drive a company to an earlier-
than-optimal exit and result in structures that
do not optimize the potential value of any less-
developed technologies. Transaction structures
and outcomes need to balance the interests of
the venture investors against the interests of
the stockholders, who may be willing to take a
longer-term approach. Thus, corporate form and
structural components of a biotech startup must
allow for and preserve opportunities for a broad
variety of transactions.
Stock options. In a typical acquisition, each
stock option will be either exercised or cashed
companies (LLCs), limited partnerships (LPs)
and S-corporations (S-corps), can be advanta-
geous because they are taxed only at the equity
holder level. In addition, LLCs and LPs are
much more flexible than corporations with
respect to governance and investor returns.
However, these structures are rare due to ven-
ture fund restrictions on investing in pass-
through entities. For an entity sale transaction,
like a stock sale or merger, tax is paid only at
the stockholder level, typically as capital gains.
Optimizing outcomes for the biotech entity
involves attempting to avoid double levels of
taxation at the corporate level while trying to
make as much of a return to stockholders as
possible in order to take advantage of the cur-
rent favorable tax rate imposed on such gains
(as compared to ordinary income). As we will
see, the corporate structure and employee
equity can impact those tax-adjusted returns
dramatically.
Box 1 Structure in-licenses for flexibility
The typical license from a university or research institution will be delivered by virtue of
a standard form license. Many seemingly benign provisions (or omissions in some cases)
can prevent the biotech startup from maximizing its opportunities and can limit flexibility
in deal structures. In addition, many institutions are adding in new provisions designed
to recapture value for the institution, which can work to limit the startups alternatives for
developing and commercializing the technology. The following issues can be addressed at
the founding stage of the company when the technology is originally licensed:
Assignability or sublicense. It is critical that the license be assignable to an affiliate of
the licensee or to an acquirer of the licensee without the consent of the licensor and that
sublicenses will not require approval of the institution. In addition, assignments and
sublicenses to an affiliate of the licensee should not trigger sublicense fees.
Milestones for multiple products or indications. Ideally, milestone payments should only
apply to the first product that achieves the milestone and for only the first indication, not
all products for all indications. Development for follow-on products and indications should
not be burdened by the same economics as the lead program.
Claw-back provisions. Increasingly, licenses are requiring the licensee to diligently pursue
development of all products in all areas, and provide for claw-back provisions for products
and, in some cases, indications that are not being pursued. These provisions should be
resisted, or at least limited, as some of the areas that are not being pursued diligently
currently could be subsequently developed after the primary exit.
Equity issuance and/or dilution provisions. Many research institution licenses to startups
will include an initial grant of equity that will cover ongoing financing dilution protection.
These provisions, in addition to diluting the founders and management teams in a manner
disproportionate to the research institution, can confound attempts to restructure the
company into a multiple-entity structure. In addition, many research institutions for tax
reasons are prohibited from holding equity in pass-through tax entities, such as limited
liability companies, limited partnerships and S-corporations. Given the complications
with issuing equity to research institutions, one solution to this problem is to provide for
a one-time limited contractual company exit fee in lieu of equity. This exit fee would be
determined and payable to universities at the time the company exits.
Sublicense fees. Option fees, milestones and direct research payments are typically
targeted for specific development costs. Startups need to ensure that these types of
development payments do not trigger compensation to the research institution. Only
payments received that are not burdened by a reciprocal performance obligation should
trigger payment to the licensing institution.
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NATURE BIOTECHNOLOGY ADVANCE ONLINE PUBLICATION 3
BUI LDI NG A BUSI NESS
Biotech companies should consider using
restricted stock for management as well. As
the company progresses and more rounds of
financing are raised, typically the value for
common stock does not increase dramatically
given the increasing senior liquidation prefer-
ences that build on top of each new round of
financing and the relatively minor upticks in
value that occur from round to round until exit.
Many venture-backed companies routinely get
common stock appraisals for accounting and
tax purposes that result in relatively low com-
mon stock values. In those situations, manage-
ment could be either granted restricted stock
(resulting in taxable income for the value of the
stock) or sold such stock, each of which would
involve some cash outlay (taxes or purchase
price). In addition to the potential for capital
gains treatment, by using restricted stock, the
outlined valuation problems associated with
exercising options in a contingent value deal
are avoided. The holder of restricted stock
would ride out the contingent waterfall of pro-
ceeds without paying full option exercise prices
and resulting taxes on an estimated fair market
value of the stock. In other words, stakeholders
are taxed only on what they actually receive (at
capital gain rates) instead of on what they might
receive (at ordinary tax rates).
Summary
Todays biotech startup needs to prepare
for a multitude of potential exit scenarios.
Flexibility is fundamental to preserving
optionality. Too often the issues related to
such alternatives are not addressed until an
exit event is soon to occur and it is too late to
take steps to optimize the outcome for stake-
holders. Any biotech startup should review
before formation and in its early stages its
corporate structure, management equity and
key licensing documents to ensure maximum
flexibility for a future potential exit.
add some incremental operational complex-
ity, and they are not right for every company;
however, any company that has multiple
products or technologies in development,
particularly if they are unrelated, should at
least consider well in advance of its initial exit
opportunity whether such a structure might
be advisable.
You can also use restricted stock when-
ever possible. The optimal method for equity
planning would involve the use of restricted
stock purchases or restricted stock grants in
lieu of options. For these vehicles, the recipi-
ent either receives stock outright or purchases
the stock, in some cases by paying for the
stock with a note. This stock can have vest-
ing limitations just like stock options. These
instruments must be held for more than one
year prior to the closing of an exit event to
obtain capital gains treatment. Restricted
stock is often issued to the founders of the
company upon formation, because the value
or price of founders stock is very low.
outright acquisition or a straight sublicense
to a drug company partner. In a variable exit
scenario, the license may not provide option-
ality for all the different scenarios and thus
might impede the realization of certain types
of exits. Licenses may include assignment
limitations, burdensome royalty and mile-
stone provisions, claw-back provisions on
lagging products, and limiting equity grants.
Rules of engagement
Youll need flexibility in everything you do,
starting with how you in-license your found-
ing technology (Box 1) and continuing with
the rest of your early stage activities correctly.
You might want to retain the opportunity to
realize value on products or programs that
are not of interest or have limited value to a
buyer. A seller can spin out those assets to a
new entity at the time of the primary acquisi-
tion, but that will usually be a taxable trans-
action that can result in additional tax to the
seller and sellers stockholders at the time of
the spin-out and at an appreciated value of
those noncore assets. You might, as a seller
with foresight, instead spin those assets out
much earlier in the companys history, when
those assets may have low or nominal value,
or even place these assets into separate enti-
ties from the outset, avoiding the taxation that
can result by waiting until the time of the exit.
These assets then can be separately financed,
developed, or sold and/or licensed before or
after the acquisition. You could set up a hold-
ing company structure of parent-childrelated
entities or create separate standalone entities
in a brother-sister structure (Fig. 1).
By placing programs and/or products into
different companies, a startup could aim to
exit each program separately, potentially
obtaining capital gains treatment with only
a single level of taxation, while also leaving
open the opportunity to separately realize
value on the other technology. Venture capi-
tal funds have become more open minded
to the benefits of pass-through entities, and
these structures have evolved to accommo-
date fund restrictions. These structures do
Holding company structure
Brother-sister structure
Stockholder
group
Program/product 1
new company
Stockholder
group
Program/product 2
new company
Equity holder
group
Holding company
LLC/LP
Program/
product 1 subcompany
Program/
product 2 subcompany
Figure 1 Alternative spin-out structures.
For more content on bioentrepreneurism,
visit our Trade Secrets blog.
http://blogs.nature.com/trade_secrets/
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