Capital Structure Particulars in the Lifecycle of a Pre-Sales Revenue Biotechnology Venture Destined for IPO Success
Insight Mark H. Mirkin · July 31, 2014
The public securities markets and the underwriters that lead biotech companies into them dictate a common capital structure suitable for IPOs, which structure almost always deviates starkly from the capital structure of the venture at inception and during its growth phase. Startups frequently commence corporate life structured as limited liability companies with a few founders as members owning equity interests, which members are then often joined by investors in a “friends and family” round of seed financing who receive economic interests bereft of equity stakes. When the company shows promise, it often raises its first round of external financing in a convertible debt offering, with investors receiving promissory notes convertible into equity interests upon the occurrence of future financing. When the company shows further promise after having wisely deployed the capital provided first by the founders, then by friends and family and then by angel investors, it would be fortunate to attract the attention of a venture capital company. Because most venture capital companies invest for preferred stock positions, the company almost always converts its corporate structure from that of a limited liability company to that of a corporation in order to close a venture financing. The members and holders of economic interests become holders of common stock – sometimes voting common stock for the members and non-voting common stock for the holders of economic interests – while preferred stock is issued to the venture capital company investors. If all goes well, a biotech venture will need to raise investment capital in successive rounds of funding; often an early stage venture capital company investor will invest again in a subsequent round, with each round attracting other venture capital companies to the party. For those companies that manage to attract an underwriter willing to underwrite an IPO, the capital structure imposed on the young company will comprise the following, often after a restructuring and recapitalization exercise:
Prior to the IPO, the biotech’s outstanding capital stock will include common stock predominantly owned by founders and angels, and convertible preferred stock owned by institutional investors. Many disparate parties often hold options and warrants to purchase common stock. Conversion of the pref-erred stock occurs automatically upon closing of the IPO, such that the only capital stock outstanding of the freshly-public company will be common stock.
The common stock will be voted to determine the directors on the company’s board of directors. It will be entitled to receive dividends which may be declared by the directors. In the event of liquidation, the common stock is entitled to receive proportionately all assets available for distribution to shareholders after the payment of all debts and other liabilities.
The post-IPO corporate charter often contains a provision enabling the directors to issue preferred stock without shareholder approval, similar to the provision in the charter when the company converted from being a limited liability company to being a corporation. The directors have discretion to determine the rights, preferences, privileges and restrictions, including voting rights, dividend rights, conversion rights, redemption privileges and liquidation preferences, applicable to each series of preferred stock. This charter provision allowing for the issuance of preferred stock eliminates delays and expenses associated with shareholder voting and provides flexibility for possible acquisitions, future financings and other corporate purposes. Preferred stock authorization could make it more difficult for a third party to acquire – or could discourage a third party from seeking to acquire – a majority of the venture’s common stock.
Many biotech companies upon going public will enter into a registration rights agreement with the historical holders of their common stock – from founders to venture capital companies that receive common stock upon conversion of their preferred stock – that enable such holders to compel the company to register their shares with the S.E.C. so that they can participate in public market selling along with members of the public that purchase the IPO shares of registered common stock.
Delaware is by far the most popular jurisdiction for the charter of a company going public. Among the many reasons for that is that Delaware’s corporate statutes prevent a publicly-held Delaware corporation from engaging in a business combination such as a merger with any interested shareholder – a holder of a 15% or greater equity stake -- for three years following the date the person became an interested shareholder unless that person attained that status with approval of the company’s board of directors, the business combination is approved by the board of directors and shareholders, or the interested shareholder acquired at least 85% of the company’s outstanding shares when he/she/it became an interested shareholder.
Understanding a biotech’s pre- and post-IPO capital structure provides a useful backdrop to a discussion of corporate governance provisions, which will be the subject of the next article in the series.