In the last years, we have seen that royalty monetization has gained more momentum as an alternative source of funding for biotech and pharma companies (together referred to as “Biotechs”). With an increasing desire by biotech shareholders to dilute as little as possible, it is worthwhile for Biotechs to properly understand and analyse this financing alternative.
The concept of royalty monetization is based on the exchange of lump sum payment today in exchange for a stream of future payments on a licensing agreement. In other words, a royalty stream purchaser (referred to as “royalty aggregator”) will pay a fixed “purchase price” to a Biotech in exchange of (a piece of) the milestone(s) and royalty streams received by the Biotech from a third-party licensing partner (licensee). The advantages for the Biotechs are clear: 1. The company receives immediate, non-dilutive and non-recourse funding. 2. The out-licensed program is de-risked from the financial point of view of the biotech. The risk related to the program that is covered by the transaction is shifted to the royalty monetization aggregator. The acquired future milestone and royalty payments will directly flow to the royalty aggregator, meaning that all risk related to these payments is completely borne by the royalty aggregator. The reason for this is that theoretically, the “purchase price” paid out by the royalty aggregator should represent the fair value of the program – i.e. the value of all risk-adjusted milestone and royalty payments that the Biotech should receive in the future. As a result, if the program fails during the development, the Biotech does not face a total financial losses it has already received a “purchase price” that covers potential risk-adjusted milestone payments and royalty streams that are sold. 3. The biotech does not lose any control over the company and/or other programs in development as royalty aggregators are typically not looking for board seats or voting rights when providing the funding 4. The biotech can use the proceeds freely. The two most commonly usages of proceeds we see are: a) financing of other development projects or b) distributing funds to shareholders to recuperate some of (the initial) investment to de-risk their investment in the venture. The last option in particular would be more difficult with raising equity since this would not align with the interest of new investors. 5. In certain cases it can be an alternative for debt financing, which can be expensive (due to warrants) and encumbers the IP.
Valuation is at the heart of every royalty monetization transaction. The Biotech is selling (a piece of) the future cash flow of the contract for cash now. Hence the future value of the licensing contract needs to be established. Therefore, in a mutually beneficial royalty monetization transaction the “purchase price” should reflect the fair value of all risk-adjusted out licensing payments that the Biotech will receive in the future from the licensee. In reality, the Biotech will never receive 100% of the fair value of the out-licensing streams, even if asset performance expectations were identical for both royalty aggregator and Biotech (i.e. both parties use the same sales forecast). The reason for this is that the royalty aggregator should receive a risk premium for going into the transaction and offering capital today to the Biotech against the licensing cashflows in the future. In other words, the Biotech needs to pay a price to receive the future cashflow today.
Just as in the original licensing transaction negotiated between the Biotech and licensee, the difference in the expectations of the royalty aggregator and the biotech have to be bridged as the biotech typically has a more optimistic view on the future revenues than the royalty aggregator which may lead to varying desired purchase price estimations. Finally, other negotiation-related factors will play an important role when defining the purchase price, such as: the need for additional capital of the Biotech, other available financing options, the type of asset considered, the place of the asset in the licensee’s pipeline, strength and reputation of the licensee, risk appetite of the aggregator, geographical coverage, tax and legal considerations etc.
As with equity investors, royalty aggregators will have different preferences and limits in investment focus and mandates that will dictate the feasibility and structure of the final royalty monetization agreement.
Royalty aggregators are typically companies that purely focus on financial transactions – i.e. they do not take-over development efforts or organize commercialization of the out-licensed assets. In other words, they are solely a financial investor entering into a bilateral agreement with the biotech.
As mentioned, each royalty aggregator can have a different investment focus. The main investment criteria will be typically ticket size, therapeutic area / indication, geography and clinical development phase of the underlying asset. The last item is particularly important, as the more advanced clinical assets are, the less risky the investment becomes. This will have a positive impact on the valuation and corresponding ticket size. For the royalty aggregator this means that they will need to provide more capital or buy a smaller portion of the economics to make the transaction potentially interesting to the Biotech.
In recent times, royalty aggregators have emerged that focus on early clinical stage partnered assets rather than approved or marketed assets as the big players (such as Royalty Pharma) typically do. This opens up an avenue for Biotechs with early stage partnered assets to monetize (a piece of) the future economics. For these Biotechs it can be interesting to monetize a piece of the future economics in order to de-risk and obtain direct additional funding, whilst keeping a part of the potential upside and associated news flow that comes with reaching the different value infliction points.
Another important factor is the quality and reliability of the licensee. This factor will be relevant for the royalty aggregator, as they will depend on receiving the royalty and milestone payments from the licensee. This means that it is critical that the licensee has a good reputation that includes a low risk of default and a low likelihood of non-payment.
When screening for investment opportunities, royalty aggregators will take into account all the factors mentioned above in addition to the motivation of a biotech to enter into a royalty monetization transaction for the above-mentioned reasons.
Royalty monetization may be an interesting financing alternative for Biotechs that already have out licensed one or more of their (IND/clinical stage) programs to a (larger) pharma/biotech company and are looking for additional financing. There are multiple royalty aggregators that can be interested in providing such capital in return for (a portion of) the future economics of the licensing contracts concluded. When analysing the attractiveness of such a transaction, a robust and realistic valuation is one of the elements to consider carefully.
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