Where to start an ‘Asset-Centric’ Biotech Firm?

In an era of payer aus­ter­ity and fund­ing chal­lenges, more and more biotech en­tre­pre­neurs and in­vestors, alike, are re­al­iz­ing the con­sid­er­able risks as­so­ci­ated with si­mul­ta­ne­ous de­vel­op­ment of mul­ti­ple as­sets and in­stead opt­ing for a more stream­lined ap­proach that has come to be known as “as­set-cen­tric­ity.”

An as­set-cen­tric biotech com­pany (ACC) is es­sen­tially a sin­gle-pur­pose en­tity fo­cused on just one prod­uct can­di­date. Fi­nanc­ing is tightly linked to achiev­ing the next mile­stone, so that only the amount nec­es­sary to jump the next hur­dle is put at risk.

This ap­proach de­con­structs the R&D process into a straight­for­ward se­quence of de­ci­sions in­flu­enced only by the spe­cific mer­its of the pro­ject, rather than the dis­trac­tions of a larger port­fo­lio strat­egy.

As­set-cen­tric­ity marks a re­turn to fun­da­men­tal val­ues: it’s about find­ing new drugs, not nec­es­sar­ily on cre­at­ing mas­sive new com­pa­nies.

Given this laser-like focus, lit­tle or no over­head or in­fra­struc­ture is re­quired to set up an ACC. Most if not all lab work can be out­sourced, thus height­en­ing the ven­ture’s cap­i­tal-ef­fi­ciency. Hav­ing such low over­head costs al­lows a great deal of flex­i­bil­ity in terms of where the com­pany can be lo­cated. This is im­por­tant, be­cause with a team of just, on av­er­age, be­tween four to six peo­ple work­ing on a pro­ject, there’s no ac­tual need for these team mem­bers to be in the same coun­try as one an­other or in­deed as the com­pany it­self.

En­sur­ing a Re­turn

It helps to have the whole team under one roof, of course, but that’s less im­por­tant than en­sur­ing an over­all fa­vor­able re­turn on the in­vest­ment to the in­vestors and the en­tre­pre­neurs. Based on our sev­eral years’ ex­pe­ri­ence in cre­at­ing, and now ex­it­ing, these as­set-cen­tric biotechs, one of the most im­por­tant con­sid­er­a­tions in terms of where to lo­cate the ACC has turned out to be tax on pro­ceeds from the trans­ac­tion, be it a share sale, an asset pur­chase, a phased pur­chase, or li­cens­ing.

Most gov­ern­ments are keen to pro­mote and nur­ture small- and medium-sized busi­nesses (SMBs), es­pe­cially those that are tech­nol­ogy- or knowl­edge-based, as they are viewed as crit­i­cal dri­vers of eco­nomic growth. Many coun­tries offer in­cen­tives to lo­cate one’s com­pany there, and some of the in­duce­ments can be very at­trac­tive in­deed.

Until, that is, one takes a close look at how the exit trans­ac­tion pro­ceeds are han­dled. This topic gets less air time than it should: the dif­fer­ences be­tween coun­tries are re­ally quite pro­nounced. The Table shows a com­par­i­son be­tween the U.S., the U.K., the Nether­lands, Switzer­land, Lux­em­bourg, and an off­shore tax haven.

In this analy­sis, the tax haven wins, of course, but at a price. There is an ab­sence of in­cen­tives for the ACC as it de­vel­ops and wres­tles with the with­hold­ing tax and anti-avoid­ance rules of other coun­tries dur­ing the life of the com­pany and on exit. In that case, few biotechs are based in tax havens and for good rea­son.

Of the other coun­tries, it turns out that the U.K. is the most fa­vor­able regime, when­ever there is a need to re­turn cor­po­rate cash to in­vestors, mainly due to the lack of div­i­dend with­hold­ing tax and the in­com­ing 10% “patent box” cor­po­rate tax rate. This need is al­ways the name of the game for an ACC.

This be­comes mas­sively im­por­tant in a deal struc­ture we’re start­ing to see come up again and again: an “asset pur­chase” struc­ture. This is where the pur­chaser sim­ply buys the in­tel­lec­tual prop­erty (IP) and the rights to de­velop the asset, with the com­pany then left be­hind. The com­pany is, after all, merely a ves­sel for the asset and this struc­ture is highly tax ef­fi­cient for the pur­chaser.

The tax hit for the in­vestors and en­tre­pre­neurs can be con­sid­er­able, though, de­pend­ing on which tax regime it falls under.

U.K. Is the Place to Be

The best domi­cile for this turns out again to be the U.K. For ex­am­ple, as­sume in­vestors put in $50 mil­lion and ob­tain a $100 mil­lion exit via asset sale:

  • If 50% of $50m is spent on R&D, U.K. R&D tax cred­its will be $6.25m
  • The ACC will have $25m of non-R&D re­lated U.K. tax losses
  • Cor­po­rate in­come tax li­a­bil­ity re­al­ized will be $100m–$25m @ 10% = $7.5m
  • The re­main­ing $92.5m can be dis­trib­uted to In­vestors with­out with­hold­ing tax
  • The ACC only suf­fers net $1.25m of tax over its life­time

The U.K. tax sys­tem has al­ways worked on the sim­ple prin­ci­ple that div­i­dends are paid out of prof­its after tax and should not be taxed fur­ther. It is not nec­es­sary to read a bi­lat­eral tax treaty or work out if a com­plex ex­emp­tion sys­tem ap­plies, as there is sim­ply no rule in the U.K. tax sys­tem that im­poses tax on div­i­dends, so there is no need to worry about where a myr­iad of in­vestors are lo­cated—the div­i­dend can be paid and there is no tax to be ac­counted for.

No coun­try is a panacea of course, the U.K. in­cluded. The U.K. tax sys­tem for in­vestors and man­age­ment teams who are U.K. res­i­dents still hasn’t caught up with de­vel­op­ments for com­pa­nies. Mile­stone deals can still be taxed up front based on the total po­ten­tial pro­ceeds, with re­lief if mile­stones fail to ar­rive.

Given the at­tri­tion in drug pro­grams and un­cer­tainty over those mile­stones, this is un­fair. Pro­ceeds should be taxed as they are re­ceived, not be­fore.

Flex­i­bil­ity on an exit would be fur­ther en­hanced if the cur­rent com­plex de­merger and re­or­ga­ni­za­tion pro­vi­sions were sim­pli­fied to allow one-step trans­ac­tions that move as­sets from one com­pany to an­other, pro­vided both are under com­mon own­er­ship. These seem pretty log­i­cal to us, and the mo­ti­va­tion for up­dat­ing the rules is that the U.K. would be­come the ju­ris­dic­tion of choice for the best as­sets and the best peo­ple, re­gard­less of where they orig­i­nate from.

We are often asked, “Where’s the next Genen­tech com­ing from?” It cer­tainly isn’t going to spring into ex­is­tence just be­cause that’s seen as a good out­come. It is, how­ever, much more likely to hap­pen if one coun­try in par­tic­u­lar be­comes the ag­gre­ga­tor of sea­soned prod­uct de­vel­op­ers and the best as­sets the planet has to offer.

Over­all, though, we were sur­prised to ar­rive at the con­clu­sion that the U.K. is cur­rently the best coun­try in which to lo­cate an ACC. We have an in­ter­na­tional per­spec­tive and are gen­uinely in­dif­fer­ent to where these com­pa­nies are lo­cated.

An­other sur­prise was the de­te­ri­o­rat­ing at­trac­tive­ness of the U.S. as a place for a startup. This is in­ex­orably tied to the macro trend from com­pany pur­chase deals to asset pur­chase deals. Un­less the exit is a share sale, for Amer­i­can firms the trans­ac­tion losses to tax in an asset sale deal are con­sid­er­able.

In a world of in­creas­ingly choosy buy­ers of as­sets, and the in­creas­ing in­ter­na­tion­al­iza­tion of deals, the need to re­turn cash to in­vestors in mul­ti­ple ju­ris­dic­tions with­out bur­den­some tax levies has in­creased. The U.S. has al­ways slapped a 30% with­hold­ing tax on in­vest­ment re­turns as they leave the U.S., but this steep hit is being in­curred more fre­quently, thus low­er­ing the at­trac­tive­ness of the U.S. mar­ket for ACCs over­all.

Of course, an ad­vo­cate of start­ing an ACC biotech in the U.S. could stand his/her ground and in­sist that the deal is ac­tu­ally just a share pur­chase, but this could re­sult in there being no deal at all.

Our view is that we’d like as much flex­i­bil­ity as pos­si­ble to make a deal work. We feel that, ab­sent a se­ri­ous shift in U.S. tax pol­icy, these trends will con­tinue and the U.S. will fall fur­ther be­hind the U.K. on the at­trac­tive­ness scale for ACCs.

* This piece, by Kevin John­son, Ph.D. part­ner, Index Ven­tures, and Colin Hai­ley, part­ner, Con­flu­ence Tax, orig­i­nally ap­peared in the May 1, 2013 edi­tion of­Ge­netic En­gi­neer­ing News.