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Sandy Weinberg, PhD, is an associate professor of healthcare management at Clayton State University
Biodefense start-up companies have an abundance of options when seeking funding.
The development of a biodefense vaccine or a related product generally requires a significant investment, often in excess of $50 million.1 These funds are used for discovery, preclinical and clinical testing, development of a manufacturing process, and development and submission of the required regulatory-support documents. The funding process often begins with a grant-funded research project at a not-for-profit organization, such as a university, research center, or similar institution. If that research is successful, the resulting discovery must be transplanted to the commercial world for refinement, testing, regulatory approval, production, and distribution. Two general pathways are possible: Either the not-for-profit organization licenses the new product to an established company, or more commonly, the researchers or their colleagues form a spin-off company and eventually license the now refined and commercialized product to a production firm. This article deals with the sources of funding for that spin-off company.
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Traditional entrepreneurial advice suggests turning to the "four Fs" of bootstrap funding: founders, friends, family, and fools.2 "Founders" refers to the scientists and technicians who are launching the company; "friends" and "family" refer to their personal contacts; and "fools" refers to risk takers hoping for short-term tax advantages and long-term payoffs.
Sandy Weinberg, PhD
Because the founders are usually university faculty or professional researchers, they often lack the prerequisites of entrepreneurs, who are willing to "bet the farm" on an idea. Academic founders are not typically motivated by money; they generally choose their careers for the psychological paybacks of involvement in science, a collegial atmosphere, job security, and status, rather than for economic gain. They are risk minimizers or risk averse, in part because of their scientific training and in part because of their choice of a secure career. Finally, and perhaps most importantly, they tend to be realists, aware of the downside of entrepreneurial investment, and familiar with the oft-quoted but poorly documented claim that nine out of 10 new businesses fail. (The reality is that most new businesses are underfunded and poorly planned; moreover, many are spontaneous "street corner" businesses not intended to survive more than a season.)
Thus, founders tend to be a weak source of funding for a biodefense spin-off company. Similarly, founders are unlikely to recruit friends and family as investors in business ventures they view as highly speculative. Most founders and their friends and family are, not inappropriately, unwilling to risk a downside loss or resulting debt in building a new business.
The likelihood of recruiting fools is more complex, but equally grim. As used here, fools are not foolish or ignorant, nor are they wild risk takers. Principled entrepreneurs do not recruit the foolish or the ignorant for two reasons: First, doing so is unethical, and second, no one wants a true fool as an advisor, partner, or board member. The word fools in the alliterative saying refers to persons whose motivation is rational but may not be obvious to outsiders. This non-obvious motive may involve a tax advantage: the desire to write off losses from an unprofitable venture against gains from a profitable one. In such a case, an S corporation may be appealing.
Under the United States tax code, a corporation may be registered as an S corporation (S-corp) or as a C corporation (C-corp). A C-corp is typically a full corporation, with officers, stockholders, and not insignificantly, a degree of liability protection for its investors. (If you buy a share in General Motors—a C-corp—you need not worry that a car owner will sue you if the brakes fail.)
An S corporation, on the other hand, is designed to help launch new businesses. If profitable, the S-corp pays more tax than a C-corp, and retained earnings, used to fuel business growth, are taxed to S-corp stockholders. However, the losses of an S-corp, which are more likely in the start-up phase, also pass to the stockholders, who can use those losses to offset tax liabilities. Most new companies begin as S corporations, then convert to C corporation status once profitability is achieved.
S-corp status is unlikely to be appropriate for biodefense spin-offs for two reasons. First, the likelihood of high liability, in case the product develops problems, makes the protection of C-corp status more desirable. Second, S-corp status requires that all stockholders be individuals. Because the typical spin-off has a mandatory contractual license to provide part of its stock to a parent university, it cannot qualify as an S-corp.
As mentioned above, fools are knowledgeable investors with non-obvious motives, and one of those motives may be a desire to benefit from the tax advantages of an S corporation. Faced with paying taxes on a profitable venture, the fool may wisely opt to obtain shares in a high speculative venture. The foolish choice makes sense because the losses of a speculative S-corp investment may cancel out the taxable profits from another investment; thus, the wise fool will readily pick up high-risk start-up shares rather than pay the Internal Revenue Service. US tax laws, thus, encourage investment and help provide capital to start-up companies.
However, a biodefense spin-off company typically has a high liability potential and a mandatory contractual licensing agreement that disqualifies it from S-corp status. Therefore, it is unlikely to attract a knowledgeable fool as an investor. The biodefense spin-off must look beyond the four Fs when seeking funding.
Fortunately, three factors offset the loss of four F funding for biodefense start-up companies. First, the companies probably benefited from pre-stage grant funding. Second, they are likely to be working on products that are in the public interest. Third, they are typically farther along in the product development process and in the market definition process than are other, more traditional start-ups. These three factors result in substantial advantages for spin-off companies attempting to secure initial and growth funding.
As a spin-off, a new biodefense company is probably beginning with a patented or developed product initially funded by grants. The organization, therefore, starts without the product development debt that hamstrings many new organizations. Even a new local pizza restaurant must experiment with the right mix of cheese, sauce, crust, and toppings. For a spin-off, that research and development phase has been independently funded before founding.
Because the product is in the public interest, the biodefense company has a greater likelihood of government and foundation assistance than other companies might have. For example, the US military or the US government may pre-fund future orders or provide grant funding for a company in the biodefense arena.3
Finally, the reality of a market made up of civilian or military authorities makes the spin-off an attractive investment for a biomedical corporation; indeed, the appeal is far beyond that available to most new businesses. Many major biomedical companies are actively looking for new developments; others are more passive but are open to discussions. And the model of funding product development by investing in independent spin-offs is well established in the biomedical industry.
Given these advantages, biodefense spin-off companies have multiple funding options beyond the "four Fs" mentioned above. These options include: government grants, foundation grants, investors, pre-sales funding, loans, and other sources, such as licensing agreements. Spin-off companies can maximize funding success by pursuing a combination of the sources discussed below.
Although grants can be complex, and attached strings can consume a portion of funds and result in multiple frustrations, grants carry two main advantages: No equity is sacrificed, and no debt is incurred.
Federal grants are the most publicized source of funding, and they involve the largest pool of money. That pool was estimated at $5 billion in 2004, and since then, it has grown even larger. Most funds are distributed through Project BioShield, which was signed into law in 2004 with the goal of providing new tools to improve medical countermeasures against chemical, biological, radiological, and nuclear attacks. Project BioShield is charged with expediting research and development by the National Institutes of Health (NIH) on medical countermeasures, based on the most promising recent scientific discoveries. Proposals for funding from the US military may be directed through a number of programs; the Defense Advanced Research Projects Agency (DARPA) is probably the best starting point for a biodefense spin-off seeking funding.
The Department of Homeland Security (DHS) is funding some projects, particularly in biodetection and treatment. Some DHS funds pass to individual states, which may be additional sources of grants (see below).
The first step in identifying and applying for any federal grant is generally a conversation with the company's local member of the US Senate or US House of Representatives. This representative is likely to have a paid aide responsible for helping companies cope with governmental complexities. Companies outside the US can gain access by partnering with a US company.
Grants made by an individual US state typically go to companies in that state and provide jobs for the state's residents. Many states have established their own programs to promote the research and development of biodefense products. They also may be distributing federal money, such DHS grants. The best starting point for a company seeking a state grant is usually a congressional representative or senator.
Some state programs offer tax abatements instead of cash grants. Although abatements are not as desirable as direct funding, they may make it easier to attract investors. Many states use job creation as a major selection criterion for grants, and they may be more open to projects located in economically depressed areas.
The availability of international government grants seems to change rapidly, and their requirements can range widely. The World Health Organization (WHO) is the focus for the United Nations' programs. The International Red Cross can also be a funding source for applied and delivery projects.
Many countries have established programs similar to Project BioShield. For example, Great Britain, the Netherlands, Sweden, Germany, Switzerland, and Israel have actively funded biodefense companies in recent years. These national programs generally require that outside companies partner with in-country organizations.
Foundations can be prime sources of research and development grants for biodefense and other medical applications. The first step for a spin-off seeking such a grant would be a letter to a foundation officer. The spin-off company that applies for multiple government and foundation grants, in cooperation with related universities or international partners, has a high probability of success and generally will carry no debt or loss of equity.
Research foundations have been established for most major diseases. Biodefense projects with the potential to prevent or treat a specific condition, such as cancer or birth defects, may attract funding from these targeted organizations.
Other foundations, both large and small, are oriented toward the general public health. Most of these can be easily identified through a web search.
Corporate foundations have been established to fund promising medical and public health research. These are most commonly biomedical: Johnson and Johnson's Robert Wood Johnson Pharmaceutical Research Institute is an example. Although these foundations are functionally independent of their corporate parents, a spin-off company seeking a corporate foundation grant can enhance its potential for success by matching a project with an area of corporate focus.
Although abatements are not as desirable as direct funding, they may make it easier to attract investors. To compensate for the high risks of early funding, investors typically seek equity or bond arrangements with high rates of return—often as much as an eight- to 10-fold return in five years.
Angels are private individuals. They may be successful entrepreneurs themselves, professional athletes, private medical and dental professionals, or other individuals attempting to shelter large, short-term incomes over long-term periods. Angels often invest as groups (known as "angel networks"), and their investments are typically in the range of $50,000 to $1 million.
Venture capitalists (VCs) are usually corporations that collect investment dollars from wealthy individuals and companies, and that invest in diverse portfolios. Their investments are usually in the range of $50,000 to $5 million.
Private and public corporations invest in spin-off companies to secure new technologies and to reap immediate financial returns. A biodefense spin-off may have success seeking funding from a corporation that serves the biomedical industry (providing products such as equipment or media) or one that possesses related technologies (such as other vaccines).
Because a biodefense start-up company is likely to have technologically advanced products and marketable technologies, it may able to secure advance-payment contracts that in effect fund production and operations. Government agencies, including the military, seeking to acquire products for the public good may choose to pre-purchase (in advance of production) some end-products and services.
Discounting can attract advance payments from corporations that are eager to secure products and technologies. For example, a biodefense start-up may be able to secure final development funding from a potential distributor or a contract manufacturer by offering a future fixed or percentage discount.
Unlike grants, investments, and pre-sales funding, loans carry a significant disadvantage: They must be repaid, and with interest. In S-corps and small C-corps, the principals may be required to sign personally for loans, assuming personal responsibility in the event of corporate defaults.
Banks typically make secured loans that are guaranteed by fixed assets (such as the company's equipment or the entrepreneur's home) or by future receivables (such as corporate future sales or the individual's potential future wages). For example, an automobile loan is secured by the title to the vehicle, and a credit card is issued based on the consumer's current and potential future income.
Corporations also make loans, often in the purchase of bonds, which are guarantees of repayment. Typically only the spin-off company's assets, including intellectual property, secure these loans; if the company defaults, the entrepreneurs lose the company, but they maintain their private assets.
The Small Business Administration (SBA) and similar state agencies generally operate by guaranteeing bank loans; they remove the need for the entrepreneur to sign personally. The approval formula for SBA loans generally includes job creation, the social value of the company, and financial issues.
Cost controls are not generally thought of as fund-raising strategies, but reducing expenses conserves grant money, decreases debt, and preserves equity. Effective cost controls include: deferring executives' salaries, reducing employees' salaries by offering equity, using business incubators to reduce space requirements and laboratory expenses, using interns, and participating in a variety of hybrid spin-off arrangements, such as contractual licenses to provide stock to a parent university.
Licensing a patent or technology does reduce potential income and profits; nonetheless, licensing represents an effective funding strategy for spin-offs, especially those more interested in science than in business. A patented technology is typically offered to a large or small outside company for research and development, regulatory approval, and production. On average, the farther along in the development process that the licensing occurs, the greater the value of the license and the greater the income for the spin-off company. Regulatory approval, such as new drug application (NDA) or biologic license application (BLA) approval, can maximize license value.
Other strategies for funding a spin-off include the production and sale of preliminary products, the formation of joint ventures with other organizations, and the sale of international patent rights to fund the development of US products.
A spin-off biodefense vaccine development company seeking growth and start-up funding must generally rely on sources other than traditional founders and their interpersonal networks. The approaches discussed above are not comprehensive and may be combined in a number of ways; funding can take the form of any combination of grants, investments, loans, and alternate strategies such as licensing. Indeed, spin-off companies can maximize their funding successes by pursuing a combination of the sources listed here.
In selecting which funding sources to pursue, spin-off owners should focus on the downside of debt and equity deals, even as they pursue the upside of profits and value growth. The worst-case scenario may not be stifled growth because of a lack of capital; it may instead be substantial personal debt resulting from a failed company, the promise of which, no matter how great, was never realized.
Sandy Weinberg, PhD, is an associate professor of healthcare management at Clayton State University, Morrow, GA, 404.606.0211, email@example.com
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