KEEPING THE FAITH.

BUILDING INVESTOR CONFIDENCE IN THE ABSENCE OF PROFITS

Managers of small emerging businesses, typically in technology or biotechnology, are confronted with the same obstacle: how can their management teams establish credibility among investors in the absence of sales revenues?

Small emerging businesses in technology and biotechnology are still in the nascent stages of developing their products and have not yet had the opportunity to sell them in the market. From an accounting point of view, this creates a fundamental problem since many performance metrics used to evaluate the strength of a management team relate to profitability. For such early stage companies, sales revenues, let alone profitability, cannot be expected.

The biotechnology sector is one exemplary industry where this problem appears to be endemic. Companies in this sector typically have a market capitalization of no less than one billion US and the lion's share of such companies have no revenues. Revenues periodically appear in the context of alliances, but such financing is both intermittent and insufficient to sustain operations.

While examining this industry will provide lessons relevant to other sectors, a few distinguishing features should be noted. The above table depicts the drug development process, from the laboratory to final marketing. Twenty per cent of drug candidates ("investigational new drugs") attain final approval by the U.S. Food and Drug Administration (FDA) following the successful completion of phase III clinical trials. For drugs that successfully clear clinical trials, the total cost exceeds 300 million over a period of eight years.

Phase I explores the safety profile of the drug by testing different doses on normal subjects. Phase II builds upon the research in phase I by testing the drug on a small patient sample. Phase III, sometimes referred to as the "pivotal" trial, determines whether the drug is actually beneficial for the disease in question. The stakes surrounding the clinical trial process place formidable barriers for early stage companies in this sector.

The pitch

The ability to sell investors on the future prospects of an early stage company is the critical determining factor in raising financing. Commensurate with this challenge, is the ability to attract and retain an investor base.

Geoff Barth and Allan Brown are two portfolio managers who run a global science and technology mutual fund through the Investors Group, with about 1.2 billion US in assets under management. While still a young fund, its first year returns were 121%. A substantial fraction of the companies they consider for investment are early stage and largely unknown to Wall Street.

Candidate early stage companies are evaluated through an assessment of technology position, management strength and strategic positioning. For each of these areas there are specific actions management can take to build confidence among investors.

Management strength

Barth and Brown pay close attention to management's performance with respect to stated milestones and targets. Consistent failure to meet such goals may require a re-examination of the company through discussions with the management team. Obviously, while management should be aggressive in setting goals, unattainable or "stretch goals" should not be communicated to an investor base, since failure may precipitate the loss of investor confidence.

"An initiative by a company that is inconsistent with the original strategy communicated to an investor is considered a 'red flag,'" says Barth, "which is followed by discussion with management and a re-examination of the company." For example, Novopharm Biotech, a company that has traditionally focused on immunotherapy for diseases like cancer, embarked on a second technology several years ago called "anti-sense." Strategically, this did not make sense for the firm since this second technology required a completely new set of core competencies that it did not possess. Since the development of "anti-sense," the firm has corrected its direction and has subsequently re-focused on immunotherapeutics.

"Management credentials for an early stage company is also essential," adds Brown. "There has to be the confidence that the executive team has both a detailed understanding of their technology, and a track record of operational experience to make it happen. The scientific advisory board or board of directors will also be scrutinized with the same criteria in mind. Senior staff members whose notable achievements have been as 'consultants' do not appear to command investor confidence."

A credible management team for execution is needed to cradle any new technology. Early stage firms can no longer defer employment of professional management staff for late stage development. Lorne Meikle, CEO of BioCatalyst Yorkton, a subsidiary of Yorkton Securities, recognizes this need and provides management expertise, up to the level of CEO, to early stage companies that cannot afford full-time professional management staff. In Meikle's business model, early stage companies outsource their management to his firm. Referred to as "management virtualization," this option is recommended for companies that are still privately held.

"A solid business plan is necessary to engage potential investors," says Meikle. Some biotechnology companies that are currently in the process of raising capital have management teams comprised entirely of scientists with no practical business experience, no demand forecasts, or any idea what their margins would be for their product. Some of these firms' criteria for the identification of comparables and competitors are also questionable. Professional management services firms like BioCatalyst Yorkton provide business plan development for such avoidable circumstances.

Alliances are another important step for early stage companies because they inherently reflect both the value of the technology and management strength. Two key factors that can kill an alliance are management incompatibility and an unrealistic valuation of technology. If a firm has an unrealistic valuation of its technology, this will present itself as an immediate and fatal obstacle for alliance formation. Weak management may also engender personality differences that can result in a failure to establish any substantive alliance (e.g. an alliance with a well-known firm in the industry). The absence of any substantive alliances for an early stage company that is public raises concerns about the company's management, technology, or both.

Leading technology

Management must recognize which of two categories its lead in technology falls into: a throughput game or a strong proprietary position. A technology is a throughput game if, despite its novelty, a new entrant can be a threat by performing a variation on the same process and on a larger scale. In this instance, patents do not easily defend the technology. A topical example of this is licensed access to genetic databases. Which category does a genetic database fall into? There are number of different ways in which DNA may be sequenced, and patents do not present a 'lock' on the only means to perform this task. Management must recognize that their technology in this example is ultimately based on throughput, since competitors can easily offer the same type of product, which may or may not have the same breadth of information.

The second technology lead is a strong proprietary position, which means that there are few viable forms of the process or product. This makes such a technology segment easier to defend by patents. In addition to patents, the company may have spent many years developing in-house capabilities to deliver the technology, which again may not easily be imitated by competitors. For example, the new class of drug technology "ant-sense" appeared for clinical use several years ago. These molecules have the ability to bind molecules with specificity that may rival the immune system (antibodies), however, this technology is intended for blocking the activity of undesirable gene messages. Despite its potential, the public domain form of this technology has not been practical in the clinic. Isis Pharmaceuticals advanced the technology by developing means to stabilize these sophisticated molecules so that when administered to patients, such constructs have a high likelihood of reaching their biological targets. Isis has a strong proprietary position in anti-sense because it has patented the few significant advancements available to overcome the shortcomings of the public domain form of this technology.

Investor Group's Barth says that once management recognizes what type of technological lead their company is based upon, they can anticipate concerns by investors pertaining to their ability to grow the market share. "One error made by management teams is to argue for the merits of their company with the mistaken or unconvincing view that their technology is proprietary in nature when, in fact, to investors it appears to rest on throughput."

In conveying competence to investors, it is important for management to refrain from a restrictive view of their competitor space. Some companies define their competitors as those working with the same disease. Others define their competitors by those that employ a similar technology, regardless of the disease conditions that currently preoccupy them. Early stage companies should define their competitive landscapes by both criteria. Assuming the company wishes to avoid a discussion of what a competitor is, it is prudent to have considered as broad a range of competitors as possible so investor concerns can be readily addressed.

A demonstration that leading scientific authorities on the company's technology are employed or have in some way affiliated themselves with the firm is also important. Scientists who, in proclamation of their expertise, refer to several hundred papers they have published in the area do not necessarily impress investors. The relevant question is "what's the highest caliber journal you have published in?"

Don MacAdam, an entrepreneur and chairman of Toronto-based AutoBranch Technologies Inc., has taken several early stage companies to the Initial Public Offering (IPO) stage, and is currently developing an early stage company, CTL Immunotherapies, in the area of cancer vaccines. The company's technological credibility in this case is conferred by the presence of Dr. Rolf Zinkernagel, a 1996 Nobel Laureate recipient in medicine for his work in immunology.

Strategic positioning: telling a good story

Good strategic positioning reflects the potential to assume a leading positioning to exploit an opportunity in the market, as well as a good fit between internal activities within the firm. "A good fit between business units or project initiatives within the company is a significant factor in the investment attractiveness of a company," says Brown.

Isis Pharmaceuticals, for example, has three different business units, all of which compliment each other in a manner that can be conveyed as a coherent story to investors. Isis started originally with anti-sense technology, molecules that intercept messages conveyed by genes. The company then introduced their small molecule drug division "Ibis," which targets a different structural aspect of such genetic messages. Thus, two different drug divisions target different components of gene messages. Depending upon the disease, one drug technology may be more effective than the other. Together, both drug divisions provide an overall view of the properties of gene messages -- which can be stored in a database -- that resulted in the creation of their third business unit, "Genetrove." Isis' business activities demonstrate a good internal fit and provide a good story that can be conveyed to potential investors, which in turn directly reflects the strength of the management team.

Reducing the product pipeline risk

In biotechnology, the pipeline refers to the various drugs a company has patents on and their respective phase in clinical trial testing. There are steps management of early stage companies can take to reduce the risk of their product pipelines in the eyes of the investor. Again, how well such risk appears to have been minimized is another reflection of the management strength.

Progenix is a company with a number of drugs in its product pipeline. Most of these drugs employ the same technology to treat different cancers -- the company's patented vaccine technology. The company's most advanced product recently failed proof of concept testing during phase 111 of the clinical trial process. Consequently, the company's stock price collapsed, losing 70% of its value. Investors not only discounted the companies lead drug, but virtually the entirety of the company's product pipeline.

Failure of the lead product was taken as a repudiation of the company's platform technology, so that all drugs undergoing testing with the same approach were dismissed by the financial community. Ensuring that the company was employing more than one technology (albeit it did have a second minor technology) could have reduced product pipeline risk in pursuing different disease states. Taking such a step can potentially make a firm more attractive to investors, inspiring confidence in management.

Unfortunately, a product pipeline that represents more than one technology can introduce new challenges. "It is important that a company maintain a coherent message it can communicate to investors," says Dr. Anthony Shincariol, CEO and president of Novopharm Biotech. Completely unrelated technologies can confuse this message. Ilex Oncology, for example, has a product pipeline dedicated to cancer but employs a number of different technologies. Their message is that they stand for cancer while reducing the risk associated with their pipeline through varied technologies.

Gardiner Smith, director of business development for Human Genome Sciences argues that project/technological diversification is necessary for early stage companies to ensure their survival, but synergies should exist between projects. "If management wants to reduce the risk associated with their companies, they should not appear to be 'pure plays' -- instead they should pursue a variety of complimentary projects."

It's a hard balance to achieve. "Companies that embark on unrelated projects to reduce the risk associated with their survival in the early stages run the risk of an incoherent investment story in approaching the financial markets," Shincariol adds. Further, in the absence of synergies between projects, it can appear that management has stretched its intellectual capital and operational effectiveness. Investor confidence can be best built by project initiatives that ideally provide synergy with current company project areas while diversifying the technology base.

From private financing to public financing: the IPO

According to MacAdam, who has lead several early stage companies to the IPO stage, a critical mistake often made by these companies is attempting an IPO prematurely. In biotechnology, the rule of thumb for drug discovery companies is that the company's lead drug candidate should be well into phase II of clinical trials.

A premature public offering can have a number of serious ramifications. It seems that when there is doubt about a technology, investors tend to undervalue the technology. If the lead drug candidate has not made significant progress in phase II clinical trials, there really is no proof of concept that speaks on behalf of the product. An IPO under such circumstances typically underestimates the value of the company.

Both Barth and Brown of the Investors Group contend that, to investors, such a premature offering can appear desperate or undisciplined, raising questions about the strength of management and the firm's. According to Novopharm's Shincariol, going public also dilutes the control of management over the direction of business development, since the investor base has expanded considerably.

The presence of venture capitalists can be enormously important in establishing the credibility of a new business that is about to go public. Sometimes venture capitalists can be left out of the picture if there is a suitable substitute. Hewlett Packard, for example, recently spun-out its instrumentation division, Agilent, through a public offering. In this case, the reputation of Hewlett Packard substituted for the backing of venture capitalists in establishing credibility among investors on behalf of the management team. However, investor confidence in management can be low (high risk) if there is an absence of any role, either by venture capitalists or a well recognized company, in supporting management in the pre-public stages of the company.

Debates about the sustainability of the new economy not withstanding, early stage companies have established themselves as an important and inexorable force. This demands a greater understanding of the skills management teams need under such circumstances to build credibility among investors to attract investment.

Dr. Jayson L. Parker

([e-mail]) is currently a portfolio analyst for the biotechnology and pharmaceutical sector. The author obtained his Ph.D. in physiology (neuroscience) and an MBA.

11 Steps to building investor confidence in nascent companies

* Be aggressive yet realistic in setting goals. Do not communicate "stretch goals" to an investor base.

* Establish management credentials. A credible management team is needed to cradle any new technology.

* Form a solid business plan to engage potential investors. Consider the use of professional management services.

* Form alliances. The absence of any substantive alliances for an early stage company that is public raises concerns about the company's management, technology, or both.

* Recognize which category your lead in technology fall into. Is it a throughput game or a strong proprietary position?

* Refrain from a restrictive view of your competitors. It's necessary to have considered as broad a range of competitors as possible (not just the ones working with the same disease), so investor concerns can be readily addressed.

* Demonstrate an affiliation of the company's technology with leading scientific authorities. This will heighten the company's technological credibility.

* Have a good story to tell. A good fit between business units or project initiatives within the company can be conveyed as a coherent story to investors, making company more attractive.

* Take the right steps to reduce the risk of product pipelines in the eyes of the investor. How well such risk appears to have been minimized is a reflection of management strength.

* Don't attempt an IPO prematurely. The rule of thumb for drug discovery companies is that the company's lead drug candidate should be well into phase II of clinical trials.

* Consider the presence of venture capitalists. Investor confidence in management can be raised if there is a presence of venture capitalists or a well recognized company supporting management in the pre-public stages of the company.