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Development Path and Capital Structure of Belgian Biotechnology Firms. Bastin Véronique Gestion Financière – ULG. Séminaire de Gestion 10-06-2003. Outline. Objectives and motivation Firms’ investments viewed as real options Real options in biotech firms

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development path and capital structure of belgian biotechnology firms

Development Path andCapital Structure ofBelgian Biotechnology Firms

Bastin Véronique

Gestion Financière – ULG

Séminaire de Gestion 10-06-2003

outline
Outline
  • Objectives and motivation
  • Firms’ investments viewed as real options
  • Real options in biotech firms
  • Interaction between development path and financing needs
  • Empirical study: data and methodology
  • Empirical results
  • Conclusions and further research

Séminaire de Gestion

objectives
Objectives
  • Study interactions between investment and financing decisions
  • 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
  • Application to a specific sector: bio-industry

Séminaire de Gestion

why bio industry
Why bio-industry?
  • Specificities of the investment process: importance of R&D decisions
  • 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

Séminaire de Gestion

options in finance
Options in finance
  • The right but not the obligation…
  • to buy or sell a specified asset (underlying asset)…
  • at a prespecified price (exercice price)…
  • 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

Séminaire de Gestion

real options in corporate finance
Real options in corporate finance
  • Investment projects often have strategic and operating options embedded
  • Underlying asset : investment opportunity
  • Exercice price : investment cost
  • Time to maturity : time until opportunity disappears
  • Valuation: almost like financial options (Trigeorgis, Dixit and Pindyck)

Strategic NPV =

Standard NPV + Option premium

Séminaire de Gestion

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

Wait before investing to see if market uncertainty resolves positively

  • Option to abandon

Option to exit the investment project and sell off assets if market conditions decline

  • Time-to build option (compound option)

Staging investment as a series of outlays

=> option to abandon in midstream if bad new information

Séminaire de Gestion

examples of real options 2 2
Examples of real options(2/2)
  • 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 production to respond to changing demand

  • Growth option

Early investment as a perequisite to a chain of interrelated projects

Séminaire de Gestion

real options in bio industry related to r d investments
INVESTMENT in R&D

Very uncertain

Sequential nature

Option to market innovative products

BIOTECHNOLOGY R&D

Long, high failure rates

Ex : develop drugs

Ex: Building up technology platforms

Real options in bio-industry: related to R&D investments

TIME-TO-BUILD option

GROWTH option

Séminaire de Gestion

implications for biotech financial management
Implications for biotech financial management
  • Investment projects often have multiple real options embedded
  • 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

Séminaire de Gestion

firms development path
Firms’ development path

Stage 3: Profitability

Stage 2: Commercialization

Stage 1:

Research & Development

P

P=

R=

R+

C+

C

C=

C+

R+

C-

R&D

R=

R+

CF

R-

C-

Failure

R&DF

R-

Séminaire de Gestion

real options along firms development path
Real options along firms’ development path

P

P=

R=

Time-to-build

R+

C+

C

C=

C+

R+

C-

R&D

R=

R+

CF

R-

C-

R&DF

Growth

R-

Séminaire de Gestion

real option creation and consumption along the tree
Real option creation and consumption along the tree
  • « 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

decreases total option value of assets…

… BUT increases option volatility value of assets

What implications for financing policies?

Séminaire de Gestion

debt versus equity the trade off theory
Debt versus equity:the trade-off theory
  • 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

Séminaire de Gestion

debt versus equity the trade off theory15
Debt versus equity:the trade-off theory
  • 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

H1 Success: higher leverage

Failure: lower leverage

Séminaire de Gestion

internal vs external financing the pecking order theory
Internal vs external financing:The pecking-order theory
  • Internal financing: retained earnings

BUT often not available for biotech firms

  • External financing:
      • Straight debt; private (banks) and public (bonds)
      • Convertible debt
      • Outside equity: private (FFF, VCs,…) and public

Séminaire de Gestion

choice of private financing vehicles 1 4
Choice of private financing vehicles (1/4)
  • 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

Séminaire de Gestion

choice of private financing vehicles 2 4
Choice of private financing vehicles (2/4)
  • 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

Séminaire de Gestion

choice of private financing vehicles 3 4
Choice of private financing vehicles (3/4)
  • 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

Séminaire de Gestion

choice of private financing vehicles 4 4
Choice of private financing vehicles (4/4)
  • 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

Séminaire de Gestion

the role of patenting
The role of patenting
  • 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

H6B Patenting: more convertible debt

Séminaire de Gestion

empirical study data
Empirical study : data
  • Gross sample:

80 belgian biotech companies (2001)

  • Cleaning:

subsidiaries, very young firms, data availability

  • Final sample:

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

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

Séminaire de Gestion

empirical study methodology
Empirical study : methodology
  • 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
  • Hypotheses tests:

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

Séminaire de Gestion

capital structure hypotheses tests success vs failure 2 2
Capital structure hypotheses tests: success vs failure (2/2)

Outcome:

>

>

>

>

Séminaire de Gestion

capital structure hypotheses tests role of patents
Capital structure hypotheses tests: role of patents

Outcome:

Séminaire de Gestion

main empirical results 1 2
Main empirical results (1/2)
  • Most capital structure hypotheses: confirmed
    • Successes: harmonious decisions

BUT

    • Failures: not always consistent with theoretical expectations
  • Financial consequences of patenting:
    • Good approach, use of more flexible and long-term financing

Séminaire de Gestion

main empirical results 2 2
Main empirical results (2/2)
  • 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:
    • Used in the right situation …
    • … But still very scarcely used

Séminaire de Gestion

further research
Further research
  • Role of venture capital in financing of other types of R&D intensive firms
  • Detect more accurately firms’ positioning on the scenario tree
  • Model dynamic capital structure evolution with real option evolution

Séminaire de Gestion

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