Stephanie S. McCann, Partner, McDermott Will & Emery03.07.19
For an entrepreneurial life sciences company, partnership with an investment firm can be a smart option for business expansion and growth. While venture capital funds offer an attractive capital boost for startups, partnering with a private equity (PE) firm can provide the additional strategic support and business collaboration necessary to take a life sciences business to the next level.
Like a venture capital investment, PE funding gives companies needed capital to launch or expand strategic initiatives such as sales and marketing or research and development (R&D) efforts. Just as importantly, collaboration with a reputable PE firm gives firms access to years of industry experience and market insights—vital assets for growth in today’s competitive deals environment.
For example, a burgeoning medical device company might be considering making acquisitions to expand its portfolio. A PE firm can help build out the company’s management team, solidify its core business, identify strategic assets for acquisition, coordinate due diligence, and negotiate the purchase documents. Few early-stage life sciences companies have the capital reserves or the right staffing to successfully tackle those tasks on their own.
Rules of Attraction
The current market is efficient, and life sciences valuations are generally high. More than valuations, however, PE firms are focused on a life sciences company’s prospects for continued growth. The most attractive targets for PE investment are companies that can support their business model regardless of market conditions. While some commentators are warning that the market is reaching the top of the bubble, PE financing will continue to be available for the right products and the right business models.
The healthcare and life sciences industry is one of the most active PE markets; as such, health and life sciences products generally are attractive for investment. PE investors are often particularly interested in products that are well reimbursed or have a consistent history of reimbursement. Similarly, products that have a stable or growing population base—and are therefore less likely to be affected by economic or regulatory change—also are good targets for PE investment.
Hot investment areas for PE investors today include tools for the lab products sector, diagnostic products and pharmaceutical outsourced services (i.e., CRO, CMO, and medical affairs). Healthcare information technology is likely to remain a highly active sector for PE investors in 2019 as adoption of digital health solutions, platforms, and therapeutics continues apace. In particular, life sciences companies that leverage machine learning and artificial intelligence in their products and services are taking a prominent spot in many PE investors’ portfolios. Such technologies enable companies to develop innovative products and services in areas like wellness that have long been investment priorities for corporations and payers alike.
Deal Execution Factors to Consider
Deal Structure
In general, the preferred purchase price structure for a life sciences PE transaction is one under which the life sciences company owners retain equity and are incentivized alongside the PE firm to grow the value of the business. Earn-out structures are generally less appealing because they can potentially cause conflict down the road—for example, in determining earn-out metrics, the way in which an earn-out will be paid, and whether the earn-out will be invested into sales and marketing or R&D. As an alternative to earn-outs, a deal could include creative solutions such as profit interests or preferred securities to maintain downside protection for the investor along with adequate upside incentive for the founders and management, while mitigating dilution to the life sciences company owners.
Use of Insurance in Transactions
Representations and warranties insurance (RWI) plays a significant role in PE transactions, offering myriad advantages on both the buy and sell side. RWI is an excellent way for a life sciences company to differentiate itself at auction, because it allows a seller to monetize close to 100 percent of the deal proceeds immediately and avoid lengthy escrows. For large-scale deals, in fact, RWI is essentially a prerequisite.
An underutilized but equally important form of insurance is patent insurance. Intellectual property (IP) litigation in the life sciences arena is frequent and severe—life sciences is one of the top three most targeted areas for IP litigation. Patent infringement claims occur two times more frequently than directors and officers liability (D&O) claims, yet D&O insurance is far more common in the life sciences field than insurance for patents.
Unlike RWI, which can be handled in the course of a deal, advance planning is required for IP insurance. Companies should obtain patent insurance well before seeking an exit, since once there is active infringement, it is too late to buy coverage. The good news is that having IP insurance in place often means earlier access to funding and better terms—and when it comes time for the transaction, quicker, better exits, because having patent insurance means that a third-party insurer has already conducted substantial due diligence of the asset.
While patent insurance is of course an extra expense, for emerging and small life sciences companies, it is usually worth it. For a controversy between $10 million and $25 million, for example, the average cost of a trial is $3.5 million, according to the American Intellectual Property Law Association. The bigger the amount at stake, the higher the trial costs. IP insurance coverage can be customized to a company’s needs, and can include patent trolls, enforcement actions, and unintentional infringement.
Escrow Agency Services
While RWI is frequently used in PE transactions and shifts the indemnification risk from the seller to the insurer, RWI may not completely eliminate the need for an escrow arrangement. In these instances, the amount of escrowed funds may be reduced, but escrow services will usually be a prerequisite to closing. Selecting an escrow agency with robust experience in the life sciences space will ensure the transaction is not held up unnecessarily.
Conclusion
The benefits of partnership with a PE investor extend beyond the capital infusion. PE investors with broad deal experience can offer the management support, business know-how, and deep industry relationships to help an early-stage life sciences company achieve scale and take its place in the industry as a robust and savvy market player. In this moment of rapid market transformation and disruption, a carefully planned and well-structured PE investment can help a company maximize its potential and seize the opportunity to thrive.
Stephanie S. McCann is a partner at McDermott Will & Emery. McCann focuses her practice on corporate finance. She represents private equity groups, commercial lending institutions, and major public and private companies in connection with the structuring, negotiation, and documentation of secured and unsecured financing transactions, including senior, mezzanine and subordinated debt transactions, acquisition financings, loan workouts and restructurings. McCann is a current member of McDermott’s Executive and Management committees.
Like a venture capital investment, PE funding gives companies needed capital to launch or expand strategic initiatives such as sales and marketing or research and development (R&D) efforts. Just as importantly, collaboration with a reputable PE firm gives firms access to years of industry experience and market insights—vital assets for growth in today’s competitive deals environment.
For example, a burgeoning medical device company might be considering making acquisitions to expand its portfolio. A PE firm can help build out the company’s management team, solidify its core business, identify strategic assets for acquisition, coordinate due diligence, and negotiate the purchase documents. Few early-stage life sciences companies have the capital reserves or the right staffing to successfully tackle those tasks on their own.
Rules of Attraction
The current market is efficient, and life sciences valuations are generally high. More than valuations, however, PE firms are focused on a life sciences company’s prospects for continued growth. The most attractive targets for PE investment are companies that can support their business model regardless of market conditions. While some commentators are warning that the market is reaching the top of the bubble, PE financing will continue to be available for the right products and the right business models.
The healthcare and life sciences industry is one of the most active PE markets; as such, health and life sciences products generally are attractive for investment. PE investors are often particularly interested in products that are well reimbursed or have a consistent history of reimbursement. Similarly, products that have a stable or growing population base—and are therefore less likely to be affected by economic or regulatory change—also are good targets for PE investment.
Hot investment areas for PE investors today include tools for the lab products sector, diagnostic products and pharmaceutical outsourced services (i.e., CRO, CMO, and medical affairs). Healthcare information technology is likely to remain a highly active sector for PE investors in 2019 as adoption of digital health solutions, platforms, and therapeutics continues apace. In particular, life sciences companies that leverage machine learning and artificial intelligence in their products and services are taking a prominent spot in many PE investors’ portfolios. Such technologies enable companies to develop innovative products and services in areas like wellness that have long been investment priorities for corporations and payers alike.
Deal Execution Factors to Consider
Deal Structure
In general, the preferred purchase price structure for a life sciences PE transaction is one under which the life sciences company owners retain equity and are incentivized alongside the PE firm to grow the value of the business. Earn-out structures are generally less appealing because they can potentially cause conflict down the road—for example, in determining earn-out metrics, the way in which an earn-out will be paid, and whether the earn-out will be invested into sales and marketing or R&D. As an alternative to earn-outs, a deal could include creative solutions such as profit interests or preferred securities to maintain downside protection for the investor along with adequate upside incentive for the founders and management, while mitigating dilution to the life sciences company owners.
Use of Insurance in Transactions
Representations and warranties insurance (RWI) plays a significant role in PE transactions, offering myriad advantages on both the buy and sell side. RWI is an excellent way for a life sciences company to differentiate itself at auction, because it allows a seller to monetize close to 100 percent of the deal proceeds immediately and avoid lengthy escrows. For large-scale deals, in fact, RWI is essentially a prerequisite.
An underutilized but equally important form of insurance is patent insurance. Intellectual property (IP) litigation in the life sciences arena is frequent and severe—life sciences is one of the top three most targeted areas for IP litigation. Patent infringement claims occur two times more frequently than directors and officers liability (D&O) claims, yet D&O insurance is far more common in the life sciences field than insurance for patents.
Unlike RWI, which can be handled in the course of a deal, advance planning is required for IP insurance. Companies should obtain patent insurance well before seeking an exit, since once there is active infringement, it is too late to buy coverage. The good news is that having IP insurance in place often means earlier access to funding and better terms—and when it comes time for the transaction, quicker, better exits, because having patent insurance means that a third-party insurer has already conducted substantial due diligence of the asset.
While patent insurance is of course an extra expense, for emerging and small life sciences companies, it is usually worth it. For a controversy between $10 million and $25 million, for example, the average cost of a trial is $3.5 million, according to the American Intellectual Property Law Association. The bigger the amount at stake, the higher the trial costs. IP insurance coverage can be customized to a company’s needs, and can include patent trolls, enforcement actions, and unintentional infringement.
Escrow Agency Services
While RWI is frequently used in PE transactions and shifts the indemnification risk from the seller to the insurer, RWI may not completely eliminate the need for an escrow arrangement. In these instances, the amount of escrowed funds may be reduced, but escrow services will usually be a prerequisite to closing. Selecting an escrow agency with robust experience in the life sciences space will ensure the transaction is not held up unnecessarily.
Conclusion
The benefits of partnership with a PE investor extend beyond the capital infusion. PE investors with broad deal experience can offer the management support, business know-how, and deep industry relationships to help an early-stage life sciences company achieve scale and take its place in the industry as a robust and savvy market player. In this moment of rapid market transformation and disruption, a carefully planned and well-structured PE investment can help a company maximize its potential and seize the opportunity to thrive.
Stephanie S. McCann is a partner at McDermott Will & Emery. McCann focuses her practice on corporate finance. She represents private equity groups, commercial lending institutions, and major public and private companies in connection with the structuring, negotiation, and documentation of secured and unsecured financing transactions, including senior, mezzanine and subordinated debt transactions, acquisition financings, loan workouts and restructurings. McCann is a current member of McDermott’s Executive and Management committees.
