The Biotech Cash Paradox

Traditional financial theory states that the capital structure of a company should be independent of the value of the underlying assets of the company. Intuitively this makes sense in that the business doesn’t change if the company raises equity, convertible, or debt capital. The assets still have the same fundamental technical, regulatory, and commercial risks. Why then do biotech companies’ valuations change so drastically when a company raises money? The proverbial fundraising overhang has been known to weigh on a stock before the anticipating financing occurs. The current investors are anticipating the dilution but don’t know how much dilution will occur and at what price. This depresses the stock price to levels below where it would normally trade.

After a financing is announced (follow-on, PIPE, or convertible bond), the stock immediately drops and likely continues to drop until the financing closes. If the company is waiting for this money, and the money would allow them to continue their clinical development, why then would the stock drop? Well… clearly biotech hedge funds are shorting the stock into the offering in the hopes of getting some allocation to cover their short position at a lower price. Sometimes the price falls too much and management pulls the plug on the offering as what happened with a biotech company I took on the road several years back. This causes some pain for these short sellers as inevitably the stock usually recovers. The company is also worse off since they wasted time, money, and most importantly, they don’t have the money they needed. This begs the question of if there is a better way for a public company to raise money (to be discussed in a future post). Yet I digress.

After the offering closes, the stock price often recovers to the pre-offering price. Since the financing overhang is released, the stock now has the potential to appreciate. Why then is cash so important for maintaining or growing your valuation and why do stocks with low cash balances suffer? Clearly the amount of cash you have is a strategic asset since biotech is so capital intensive. Perhaps investors should ask other questions instead of how many months of cash you have or how big is your burn. How do you plan to finance through approval or through your next major value inflection point? How do you plan to pay for your earlier programs? Which program do you plan to license to fund the rest of your pipeline are more relevant strategic questions which would focus the investor less on immediate cash than on strategically how do you plan to succeed.