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
Interaction between development path and
financing needs
Empirical study: data and methodology
Empirical results
Conclusions and further research
10/06/2003
Séminaire de Gestion
2
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
10/06/2003
Séminaire de Gestion
3
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 bioindustry
10/06/2003
Séminaire de Gestion
4
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
10/06/2003
Séminaire de Gestion
5
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
10/06/2003
Séminaire de Gestion
6
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
10/06/2003
Séminaire de Gestion
7
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
10/06/2003
Séminaire de Gestion
8
Real options in bio-industry:
related to R&D investments
INVESTMENT in R&D
 Very uncertain
 Sequential nature
BIOTECHNOLOGY R&D
 Long, high failure rates
 Ex : develop drugs
TIME-TO-BUILD option

Option to market
innovative products

Ex: Building up
technology platforms
GROWTH option
10/06/2003
Séminaire de Gestion
9
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
10/06/2003
Séminaire de Gestion
10
Firms’ development path
Stage 2:
Commercialization
Stage 1:
Research &
Development
P
R=
R+
R+
P=
C+
C
R&D
Stage 3:
Profitability
C=
C+
C-
R=
R+
R-
CF
C-
Failure
R&D
10/06/2003
F
RSéminaire de Gestion
11
Real options along firms’
development path
P
R=
Time-tobuild
R+
C+
C
R+
R&D
10/06/2003
C=
C+
C-
R=
R+
R-
Growth
P=
R&D
F
CF
C-
RSéminaire de Gestion
12
Real option creation and
consumption along the tree

« Success » : consumption of 1 stage of time-tobuild 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?
10/06/2003
Séminaire de Gestion
13
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
10/06/2003
Séminaire de Gestion
14
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
10/06/2003
Success: higher leverage
Failure: lower leverage
Séminaire de Gestion
15
Internal vs external financing:
The pecking-order theory
1.
Internal financing: retained earnings
BUT often not available for biotech firms
2.
External financing:
a) Straight debt; private (banks) and
public (bonds)
b) Convertible debt
c) Outside equity: private (FFF, VCs,…)
and public
10/06/2003
Séminaire de Gestion
16
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
10/06/2003
Failure: lower equity ownership by VCs
Success: higher equity ownership by VCs
Séminaire de Gestion
17
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
10/06/2003
Failure: longer debt maturity
Success: shorter debt maturity
Séminaire de Gestion
18
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
10/06/2003
Failure: more lease financing
Success: less lease financing
Séminaire de Gestion
19
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
10/06/2003
Failure: more convertible financing
Success: less convertible financing
Séminaire de Gestion
20
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
H6B
10/06/2003
Patenting: more long-term debt
Patenting: more convertible debt
Séminaire de Gestion
21
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)
10/06/2003
Séminaire de Gestion
22
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
10/06/2003
Séminaire de Gestion
23
Means of capital structure
ratios (whole sample & stages)
Stage2: Commercialization
109
Stage3:
Profitability
122
Number of obs.
EQUITY_R:
364
Stage1:
R&D
133
0,689
0,717
0,732 *
0,621 ***
1) Capital_R
0,595
0,619
0,603
0,562
2) Share premium_R
0,064
0,056
0,105 ***
0,035 **
3) Invest grant_R
0,031
0,042 *
0,024
0,025
LEVERAGE_R:
0,311
0,283
0,268 *
0,379 ***
1) Long term_R
0,192
0,190
0,164
0,219
2) 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
LEASE_R
0,028
VCPERC
0,041
Variable
10/06/2003
Sample
0,007
0,002
0,017 **
0,032
0,036
0,040
0,055
0,028
0,001
Séminaire de Gestion
24
Means of capital structure
ratios (tree branches)
Variable
BR-
BR=
BR+
BC-
BC=
BC+
BP
BU
Number of obs.
26
64
73
7
36
21
61
76
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
0,054
0,038
0,063
0,160
0,104
0,091
3) Invest grant_R 0,046
0,044
0,023
0,010
0,021
0,012
LEVERAGE_R:
0,338
0,257
0,269
0,210
0,266
1) Long term_R
0,227
0,192
0,183
0,175
2) LT due_R
0,035
0,030
0,037
3) Short term_R
0,075
0,035 ***
0,049 **
2) Share pr_R
0,087
0,024
0,038
0,461 **
0,410 ***
0,295
0,165
0,210
0,245 **
0,156
0,027
0,038
0,072 **
0,050
0,033
0,009
0,063
0,179 ***
0,115 **
0,106 *
CONV_R
0,004
0,001
0,002
0,000
0,018 *** 0,000
LEASE_R
0,010
0,019
0,016
0,032
0,046
VCPERC
0,038
0,052
0,045
0,040
0,080 **
10/06/2003
0,023 **
Séminaire de Gestion
0,065 **
0,029
0,003
0,000
0,037
0,028
0,017
0,032
25
Capital structure hypotheses
tests: success vs failure (1/2)
BR-+BC-+BC= BR=+BR++BC+
BP
BU
(failures)
(successes)
H1: dependent variable = D LEVERAGE_R t
0,063 ***
0,025 *
0,015
-0,015
(0,022)
(0,014)
(0,023)
(0,019)
H2: dependent variable = D VCPERC t
0,001
0,006
-0,006
0,002
(0,013)
(0,008)
(0,014)
(0,011)
H3A: dependent variable = D (STD/LEVERAGE) t
-0,024
0,014
-0,022
0,079 **
(0,044)
(0,028)
(0,048)
(0,038)
H3B: dependent variable = D (MTD/LEVERAGE) t
-0,010
0,031
0,070 *
0,002
(0,037)
(0,023)
(0,040)
(0,032)
10/06/2003
failures vs
successes
Outcome:
>
3,080 *
X
<
0,183
?
<
0,757
?
<
1,247
?
Séminaire de Gestion
26
Capital structure hypotheses
tests: success vs failure (2/2)
BR-+BC-+BC= BR=+BR++BC+
BP
BU
(failures)
(successes)
H3C: dependent variable = D (LTD/LEVERAGE) t
0,063 **
-0,002
-0,002
-0,007
(0,024)
(0,015)
(0,026)
(0,021)
H3D: dependent variable = D MATURITY t
0,190
-0,127
-0,120
-0,104
(0,164)
(0,107)
(0,190)
(0,146)
H4: dependent variable = D LEASE_R t
0,013 *
0,001
0,000
-0,001
(0,007)
(0,004)
(0,008)
(0,006)
H5: dependent variable = D CONV_R t
0,010 *
0,001
0,003
-0,010 **
(0,006)
(0,004)
(0,006)
(0,005)
10/06/2003
failures vs
successes
Outcome:
>
7,610 ***

>
3,728 *

>
2,902 *

>
2,524

Séminaire de Gestion
27
Capital structure hypotheses
tests: role of patents
Constant
PATENT
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)
10/06/2003
Séminaire de Gestion
Outcome:


28
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


10/06/2003
Séminaire de Gestion
29
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


10/06/2003
Séminaire de Gestion
30
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
10/06/2003
Séminaire de Gestion
31