SWORD financing of innovation in the biotechnology industry - includes appendix - stock warrant off-balance-sheet research and development - Corporate Investments Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Michael E. Solt

This paper analyzes a financing arrangement known as stock warrant off-balance-sheet research and development ("SWORD") that has been used recently in the biotechnology industry. A SWORD, as the industry calls this arrangement, consists of a set of contracts that defines both the relationships among the parties to a SWORD and the property rights accruing to each party. The primary objective of this paper is to show how a SWORD can promote innovation in a manner not possible when more conventional financing arrangements are used. Since a SWORD is designed to facilitate R&D, the various contracts are described first. Next, the rationale for considering a SWORD to be a form of (off-balance-sheet) project financing is provided. Then, a comparison with conventional capital budgeting is used to show how a SWORD provides flexibility in making investment and financing decisions that can enable a biotech firm to engage in R&D that otherwise might not be undertaken. However, as carefully crafted as a SWORD is, with the intent to balance the interests of all parties, it cannot eliminate the favorable informational asymmetry possessed by biotech managers. This asymmetry is shown below to confound the interpretation of the benefits of a SWORD. Another objective of this paper is to examine the stock market effects of the first SWORD announcements to determine whether investors have responded positively or negatively to this arrangement.

Innovation is important to biotech firms because it provides the competitive edge necessary for survival. However, uncertainty about the commercial viability and regulatory approval of new products and technologies makes innovation a very risky undertaking. Also, conventional internal financing of innovation is generally not possible because biotech firms tend to be small with meager profits and few cash resources. Total assets average $3.5 million for the smallest firms in the 1989 Ernst and Young biotech survey (60% of the respondents) and $13.1 million for the "midsize" firms (22% of the respondents). Only 15% of the firms report positive cash flow from operations in 1989, and 38% indicate that cash on hand will support current spending levels for less than 12 months. Biotech firms are forced to turn to external sources for considerable amounts of funds for innovation: on average, biotech firms plan to raise $55 million by the end of the decade in new external financing.(1)

Financing pressures have often led biotech firms to perform contract research for the larger, better-financed pharmaceutical companies. However, proprietary control over any developed products or technologies is transferred to the pharmaceutical sponsor, who then brings the products to market. Even though such an arrangement solves the funding problem, it can be a barrier that keeps the biotech firm from developing its own manufacturing and marketing capabilities. The biotech firm could be successful in innovation yet still be relegated to the role of a research house. Understandably, biotech managers report that R&D funding is the most crucial business issue they face.(2)

Since 1988, several biotech firms have used a SWORD to set up a new, separate organization: (i) that owns the property rights to the R&D; (ii) whose financial statements have no impact on those of the biotech parent; and (iii) whose financing comes from a public units offering. Each unit consists of one share of the new venture common stock that can be called by the parent, and one warrant to purchase one share of common stock of the parent firm.(3) In essence, each biotech firm has created its own research sponsor and has retained the option to buy out this sponsor by calling the new venture common stock.(4)

Since the new venture funds are not commingled with assets in place, the parent's existing shareholders avoid dilution of value if the innovation fails; a failed equity-financed R&D project could lead to substantial dilution. However, because new investors are less informed about the R&D than the biotech managers and possibly face adverse selection, they are unlikely to participate without a signal about the value of the R&D. The warrants signal that the existing shareholders are willing to share the value of the parent's assets in place even if the innovation fails. This signal is costly because the warrants also lead to equity dilution if exercised. Nevertheless, as shown below, a SWORD produces less dilution than does conventional capital budgeting.

Perhaps the ultimate test of the SWORD arrangement is that presented by the stock market. While the small sample examined here is not statistically reliable, it does provide an opportunity to measure a SWORD's usefulness. The stock market reaction generally is positive for each SWORD, allaying fears that the potential for adverse selection renders the SWORD valueless. This positive reaction is consistent with that found by Chan, Martin, and Kensinger |3~, who provide similar evidence for the R&D decisions of high-technology firms, and McConnell and Muscarella |8~, who document positive announcement effects for unexpected increases in capital expenditure decisions. Thus, issuing equity is not always an indication of the adverse selection problem identified by Myers and Majluf |11~. Even in the Myers and Majluf framework |11, p. 194~, large returns from a highly successful investment benefit both current and new shareholders. Asquith and Mullins |1~, echoed by Smith |13, p. 7~, state that a positive stock price effect is consistent with a favorable information effect associated with an investment by the firm. The findings of Masulis and Korwar |7~ and Mikkelson and Partch |9~ regarding capital expenditures provide some support for such a positive information effect.(5) In light of the findings of these other studies, the interpretation offered here for the positive announcement effects is that a SWORD is a viable technique for financing valuable biotech R&D.