development path and capital structure of belgian biotechnology firms bastin véronique gestion...

Development Path andCapital Structure of

Belgian Biotechnology Firms

Bastin Véronique

Gestion Financière – ULG

Séminaire de Gestion 10-06-2003

10/06/2003 Séminaire de Gestion 2

Outline Objectives and motivationObjectives and motivation Firms’ investments viewed as real optionsFirms’ investments viewed as real options Real options in biotech firmsReal options in biotech firms Interaction between development path Interaction between development path

and financing needsand financing needs Empirical study: data and methodologyEmpirical study: data and methodology Empirical resultsEmpirical results Conclusions and further researchConclusions and further research


Objectives

Study interactions between investment Study interactions between investment and financing decisionsand financing decisions

On the investment side:On the investment side: identify creations identify creations and exercices of real optionsand exercices of real options

On the financing side:On the financing side: analyze consistency analyze consistency of financing decisions with respect to of financing decisions with respect to investment pattern in real optionsinvestment pattern in real options

Application to a specific sector: bio-Application to a specific sector: bio-industryindustry


Why bio-industry?

Specificities of the investment process:Specificities of the investment process: importance of R&D decisionsimportance of R&D decisions

Specificities of the financing process:Specificities of the financing process:

long path to profitability => important long path to profitability => important to have sufficient and adequate to have sufficient and adequate financing sourcesfinancing sources

Better understanding of financial challenges in the bio-

industry


Options in finance

The The rightright but not the but not the obligationobligation…… to buy or sell a specified asset (to buy or sell a specified asset (underlying underlying

assetasset)…)… at a prespecified price (at a prespecified price (exercice priceexercice price)…)… at a prespecified date or during a prespecified at a prespecified date or during a prespecified

period in the future (period in the future (maturity datematurity date))

Value of options (Value of options (premiumpremium):): due to asymmetry in the contractdue to asymmetry in the contract increases with uncertainty about the futureincreases with uncertainty about the future


Real options in corporate finance Investment projects often have Investment projects often have strategic strategic

and operating optionsand operating options embedded embedded Underlying assetUnderlying asset : investment opportunity : investment opportunity Exercice priceExercice price : investment cost : investment cost Time to maturityTime to maturity : time until opportunity : time until opportunity

disappearsdisappears ValuationValuation: almost like financial options : almost like financial options

(Trigeorgis, Dixit and Pindyck)(Trigeorgis, Dixit and Pindyck)

Strategic NPV =Standard NPV + Option premium


Examples of real options (1/2) Waiting-to-invest optionWaiting-to-invest option

Wait before investing to see if market Wait before investing to see if market uncertainty resolves positivelyuncertainty resolves positively

Option to abandonOption to abandonOption to exit the investment project and Option to exit the investment project and

sell off assets if market conditions declinesell off assets if market conditions decline Time-to build option (compound option)Time-to build option (compound option)

Staging investment as a series of outlaysStaging investment as a series of outlays => option to abandon in midstream if => option to abandon in midstream if

bad new informationbad new information


Examples of real options (2/2) Option to alter operating scaleOption to alter operating scale

Expand or contract the scale of production Expand or contract the scale of production in response to changing market in response to changing market conditionsconditions

Option to switch outputs (inputs)Option to switch outputs (inputs)

Option to switch production to respond to Option to switch production to respond to changing demandchanging demand

Growth optionGrowth option

Early investment as a perequisite to a Early investment as a perequisite to a chain of interrelated projectschain of interrelated projects


Real options in bio-industry: related to R&D investmentsINVESTMENT in R&DINVESTMENT in R&D Very uncertainVery uncertain Sequential natureSequential nature

Option to market Option to market innovative innovative productsproducts

BIOTECHNOLOGY R&DBIOTECHNOLOGY R&D Long, high failure Long, high failure

ratesrates Ex : develop drugsEx : develop drugs

Ex: Building up Ex: Building up technology technology platformsplatforms

TIME-TO-BUILD option

GROWTH option


Implications for biotech financial management Investment projects often have Investment projects often have multiplemultiple

real options embeddedreal options embedded Need to identify Need to identify creationcreation and and exerciseexercise

of real options along firms’ development of real options along firms’ development pathpath

Integrate growth and time-to-build options in a scenario tree describing

firms’ development path


Firms’ development path

R&D

C

P

R&DF

CF

R+

C+

P=

C+

R+

R-

R-

C-

C-

R=

C=

R+

R=

Stage 2: Commercialization

Stage 3: Profitability

Stage 1:Research &

Development

Failure


Real options along firms’ development path

R&D

C

P

R&DF

CF

R+

C+

P=

C+

R+

R-

R-

C-

C-

R=

C=

R+

R=Time-

to-build

Growth


Real option creation and consumption along the tree

« Success » : consumption of 1 stage of « Success » : consumption of 1 stage of time-to-build optiontime-to-build option

increases total option value of assets…increases total option value of assets…

… … BUT decreases option volatility value of BUT decreases option volatility value of assetsassets

« Failure » : consumption of 1 growth option« Failure » : consumption of 1 growth optiondecreases total option value of assets…decreases total option value of assets…

… … BUT increases option volatility value of BUT increases option volatility value of assetsassetsWhat implications for financing policies?


Debt versus equity:the trade-off theory

What lowers the target debt/equity ratio?What lowers the target debt/equity ratio?

Costs of financial distressCosts of financial distress Agency costs of debt: underinvestment Agency costs of debt: underinvestment

and asset substitution problemand asset substitution problem

positively related to the volatility of positively related to the volatility of future Cash Flowsfuture Cash Flows


Debt versus equity:the trade-off theory

What increases the target debt/equity What increases the target debt/equity

ratio?ratio? deductibility of interest expenses : deductibility of interest expenses :

creates a tax advantage for debt over creates a tax advantage for debt over equityequity

BUT less relevant for young biotech BUT less relevant for young biotech firms with lossesfirms with lossesH1 Success: higher leverage

Failure: lower leverage


Internal vs external financing:The pecking-order theory1.1. Internal financing:Internal financing: retained earnings retained earnings

BUT often not available for biotech BUT often not available for biotech firmsfirms

2.2. External financingExternal financing::a)a) Straight debt; private (banks) and Straight debt; private (banks) and

public (bonds)public (bonds)b)b) Convertible debtConvertible debtc)c) Outside equity: private (FFF, VCs,…) Outside equity: private (FFF, VCs,…)

and publicand public


Choice of private financing vehicles (1/4) Venture Capital financingVenture Capital financing

Better monitoring of firms than Better monitoring of firms than outside equityoutside equity

Monitoring is valuable in presence of Monitoring is valuable in presence of serious information asymmetries, serious information asymmetries, like like for R&D intensive biotech firmsfor R&D intensive biotech firms

H2 Failure: lower equity ownership by VCs Success: higher equity ownership by VCs


Choice of private financing vehicles (2/4) Debt maturityDebt maturity

Long maturities: can be better renegociatedLong maturities: can be better renegociated Ability to renegociate: important source of Ability to renegociate: important source of

financing flexibilityfinancing flexibility Short-term refinancing: never competitiveShort-term refinancing: never competitive Need for more flexible financing when Need for more flexible financing when

consumption of growth optionsconsumption of growth options

H3 Failure: longer debt maturity Success: shorter debt maturity


Choice of private financing vehicles (3/4) LeasingLeasing

Provides immediate guarantee to the Provides immediate guarantee to the lender in case of problemslender in case of problems

Often used when shortage of fundsOften used when shortage of funds

H4 Failure: more lease financing Success: less lease financing


Choice of private financing vehicles (4/4) Hybrid financing like convertible debtHybrid financing like convertible debt

Debt with an option embedded to Debt with an option embedded to convert it into equity: convert it into equity: Option-related Option-related securitysecurity

Solution when debt becomes too Solution when debt becomes too expensive after some failuresexpensive after some failures

But avoids to send a negative signal to But avoids to send a negative signal to the market (like equity)the market (like equity)H5 Failure: more convertible financing

Success: less convertible financing


The role of patenting Patent issue:Patent issue:

Decreases volatility value of existing Decreases volatility value of existing options, by transforming intangible options, by transforming intangible research into a more « tangible » research into a more « tangible » assetasset

But creates an additional option to But creates an additional option to WAITWAIT

Permits longer-term and less exigible Permits longer-term and less exigible financing devicesfinancing devicesH6A Patenting: more long-term debt H6B Patenting: more convertible debt


Empirical study : data Gross sample:Gross sample:

80 belgian biotech companies (2001) 80 belgian biotech companies (2001) Cleaning:Cleaning:

subsidiaries, very young firms, data availabilitysubsidiaries, very young firms, data availability Final sample:Final sample:

40 companies, 9 years old on average, 364 40 companies, 9 years old on average, 364 observations (year-firm)observations (year-firm)

Accounting data:Accounting data: R&D, tangible assets, revenue and profitabilityR&D, tangible assets, revenue and profitability Financing variables (scaled by external financing)Financing variables (scaled by external financing)


Empirical study : methodology Position observations on the tree:Position observations on the tree:

Set of rules derived from accounting Set of rules derived from accounting dummiesdummies

Ex:Ex: not profitable, no increase in tangible not profitable, no increase in tangible assets and reduction in R&D investmentsassets and reduction in R&D investments=> failure in R&D stage=> failure in R&D stage

Group observationsGroup observations across nodes & branches across nodes & branches Hypotheses tests:Hypotheses tests:

Test for mean differences in financial ratio Test for mean differences in financial ratio evolution between « failure » and evolution between « failure » and « success » observations« success » observations


Means of capital structure ratios (whole sample &

stages)

Variable

Number of obs.EQUITY_R: 0,689 0,717 0,732 * 0,621 ***1) Capital_R 0,595 0,619 0,603 0,5622) Share premium_R 0,064 0,056 0,105 *** 0,035 **3) Invest grant_R 0,031 0,042 * 0,024 0,025LEVERAGE_R: 0,311 0,283 0,268 * 0,379 ***1) Long term_R 0,192 0,190 0,164 0,2192) LT due_R 0,039 0,031 * 0,035 0,052 **3) Short term_R 0,079 0,062 * 0,070 0,107 **CONV_R 0,003 0,001 0,007 0,002LEASE_R 0,028 0,017 ** 0,032 0,036VCPERC 0,041 0,040 0,055 0,028

109 122

Sample Stage1:R&D

Stage2: Com-mercialization

Stage3:Profitability

364 133


Means of capital structure ratios (tree branches)

Variable

Number of obs.

EQUITY_R: 0,662 0,743 0,731 0,790 0,734 0,539 ** 0,590 *** 0,705

1) Capital_R 0,562 0,661 * 0,645 0,620 0,608 0,436 ** 0,543 0,580

2) Share pr_R 0,054 0,038 0,063 0,160 0,104 0,091 0,023 ** 0,087

3) Invest grant_R 0,046 0,044 0,023 0,010 0,021 0,012 0,024 0,038

LEVERAGE_R: 0,338 0,257 0,269 0,210 0,266 0,461 ** 0,410 *** 0,295

1) Long term_R 0,227 0,192 0,183 0,175 0,165 0,210 0,245 ** 0,156

2) LT due_R 0,035 0,030 0,037 0,027 0,038 0,072 ** 0,050 0,033

3) Short term_R 0,075 0,035 *** 0,049 ** 0,009 0,063 0,179 *** 0,115 ** 0,106 *

CONV_R 0,004 0,001 0,002 0,000 0,018 *** 0,000 0,003 0,000

LEASE_R 0,010 0,019 0,016 0,032 0,046 0,065 ** 0,037 0,028

VCPERC 0,038 0,052 0,045 0,040 0,080 ** 0,029 0,017 0,032

26 64 73 7 36 21 61

BUBR-

76

BC- BC=BR= BR+ BC+ BP


Capital structure hypotheses tests: success

vs failure (1/2)

X

?

?

?

Outcome:

H1: dependent variable = LEVERAGE_R t

0,063 *** 0,025 * 0,015 -0,015 3,080 *(0,022) (0,014) (0,023) (0,019)

H2: dependent variable = VCPERC t

0,001 0,006 -0,006 0,002 0,183(0,013) (0,008) (0,014) (0,011)

H3A: dependent variable = (STD/LEVERAGE) t

-0,024 0,014 -0,022 0,079 ** 0,757(0,044) (0,028) (0,048) (0,038)

H3B: dependent variable = (MTD/LEVERAGE) t

-0,010 0,031 0,070 * 0,002 1,247(0,037) (0,023) (0,040) (0,032)

BU failures vs successes

BR-+BC-+BC=

(failures)

BR=+BR++BC+

(successes)BP

>

<

<

<


Capital structure hypotheses tests: success

vs failure (2/2)

Outcome:

H3C: dependent variable = (LTD/LEVERAGE) t

0,063 ** -0,002 -0,002 -0,007 7,610 ***(0,024) (0,015) (0,026) (0,021)

H3D: dependent variable = MATURITY t

0,190 -0,127 -0,120 -0,104 3,728 *(0,164) (0,107) (0,190) (0,146)

H4: dependent variable = LEASE_R t

0,013 * 0,001 0,000 -0,001 2,902 *(0,007) (0,004) (0,008) (0,006)

H5: dependent variable = CONV_R t

0,010 * 0,001 0,003 -0,010 ** 2,524(0,006) (0,004) (0,006) (0,005)

failures vs successes

BR-+BC-+BC=

(failures)

BR=+BR++BC+

(successes)BP BU

>

>

>

>


Capital structure hypotheses tests: role of

patents

Outcome:H6A: dependent variable = LTDTOT_R t

0,159 *** 0,088 ***(0,015) (0,024)

H6B: dependent variable = CONV_R t

0,000 0,008 **(0,002) (0,003)

Constant PATENT


Main empirical results (1/2)

Most capital structure hypotheses: Most capital structure hypotheses:

confirmedconfirmed Successes: harmonious decisionsSuccesses: harmonious decisions

BUTBUT Failures: not always consistent with Failures: not always consistent with

theoretical expectationstheoretical expectations Financial consequences of patenting:Financial consequences of patenting:

Good approach, use of more flexible and Good approach, use of more flexible and long-term financinglong-term financing


Main empirical results (2/2)

Heavy recourse to debt financing in case of Heavy recourse to debt financing in case of failure:failure: Lack of a well-developed equity capital Lack of a well-developed equity capital

market?market?OR/ANDOR/AND Too large and easy availability of cheap Too large and easy availability of cheap

debt financing?debt financing? Convertible debt financing:Convertible debt financing:

Used in the right situation …Used in the right situation … … … But still very scarcely usedBut still very scarcely used


Further research

Role of venture capital in financing of Role of venture capital in financing of other types of R&D intensive firmsother types of R&D intensive firms

Detect more accurately firms’ Detect more accurately firms’ positioning on the scenario treepositioning on the scenario tree

Model dynamic capital structure Model dynamic capital structure evolution with real option evolutionevolution with real option evolution

development path and capital structure of belgian biotechnology firms bastin véronique gestion...

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