Archive for August 11th, 2012

Biotech Start-Ups See Benefits from Changing Structure, Lawyer Says

By Brian Gormley

Albert L. Sokol has been pondering the problems facing biotechnology start-ups and has come to a conclusion: many could improve their outlook by shifting their structures.

Sokol, a partner with the law firm Edwards Wildman Palmer, recently has helped two venture-backed biotechs convert from C corporations to limited liability companies, a change that he and some venture capitalists say could help many young drug-makers.

Because not enough of these companies have been acquired or gone public in the past few years, venture firms have been investing less in biotech. U.S. investment fell 45% to just over $1 billion in the first half of this year compared to the same period of 2011, according to VentureSource, which is owned by Dow Jones & Co., publisher of Venture Capital Dispatch.

The problem for many biotechs is that they try to sell themselves whole in one large transaction, according to Sokol. While that’s possible, it’s become more difficult given that the pool of acquirers has become shallower after a recent series of pharmaceutical-industry mergers. Many biotechs would be better off selling individual drugs from their pipelines in a series of smaller deals that, in the aggregate, would add up to more than they would have gotten if they had sold their business all at once, according to Sokol.

When corporations buy a biotech whole, they typically make offers that primarily reflect the value of the drugs that interest them. Start-ups that agree to these deals get little or nothing for their other products. By selling drugs piecemeal, a start-up can wring more value from each one, and buyers don’t have to spend time evaluating therapies that don’t interest them, according to Sokol. The biotech can then pass the gains from each sale on to venture investors, giving these firms a steady stream of income.

The approach is well-suited to biotechs with technology to continually produce new drugs, Sokol said. That would describe Forma Therapeutics and Viamet Pharmaceuticals, the two companies he has helped convert into LLCs, a more tax-efficient structure for passing on profits of asset sales to investors than a C corp.

There’s another reason to consider reorganizing as an LLC: employees are often better off if the company is sold whole, according to Sokol.

“Don’t think just about making life better for your investors,” Sokol said. “It’s all about optimizing it for all your constituencies.”

Employees in a C corp. usually receive stock options instead of shares. This way, they don’t have to pay for the shares and be taxed on them right way. But most people wait too long to exercise their options, Sokol said. As a result, they pay the short-term capital-gains tax rate, which is roughly double that of the long-term rate, when the company is sold. This isn’t a problem in an LLC, because employees are granted shares instead of options.

Employees of an LLC receive profits-interest shares, which aren’t taxed when they’re issued. Here’s the reason: if a start-up is worth $20 million on the day an employee receives profits-interest shares, and the company is sold that same day, the new worker would get nothing until his more senior colleagues got at least $20 million. If the company is sold five years later, when the business is worth more, that employee would pay the long-term capital-gains tax rate on the gains he makes from the sale of the profits-interest shares.

During his five-year employment, he has every incentive to help increase the company’s value. Otherwise, he’ll get nothing for his profits-interest shares.

“If you have a group of employees you’re trying to incentivize, that’s pretty cool,” Sokol said.

Write to Brian Gormley at brian.gormley@dowjones.com

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