Canadian Biotech Companies: When and Where to Go Public

Biotech companies have an insatiable need for cash. This means that, at some point, every biotech company considers whether or not to go public, and the thin venture capital market in Canada propels Canadian biotechs to consider this decision earlier than their U.S. counterparts.

Canadian companies wishing to go public must also decide whether to go public in the U.S. or in Canada, or both. The European public markets are not currently receptive to biotech firms.

No single answer is right for all companies. Each one needs to consider its current and long-term cash requirements, its available financing alternatives and the quality of the dealers or underwriters wishing to promote a public offering.

Market Considerations

Ideal Situation

Ideally, a biotech company will go public after several rounds of private financing. A well-respected underwriter will do extensive due diligence prior to the offering, thus giving the company a seal of approval. The underwriter will work hard to ensure an active aftermarket, so that following the public offering there will be adequate liquidity and shareholders can trade freely. Funds will be raised in the offering; the company will be able to use its liquid stock as consideration for pursuing acquisitions and strategic partnerships; and the venture capitalists and even the company founders will be able to liquidate some of their holdings in the company.

If the underwriter is Canadian, it will continue to groom the company so that at some point the company will be in position to enter the larger U.S. market. If the underwriter is American, it will work to ensure that both Canadian and U.S. shareholders can properly trade and that the company continues to expand its reach with both investors and potential partners.

Reality

A large number of Canadian biotech companies are unable to access venture capital either in Canada or in the U.S. and are forced to go public prematurely. Going public through a reverse merger into a public shell has become more common for biotech companies on both sides of the border. While there are proposed rules in the U.S. to increase the disclosure requirements applicable to reverse mergers, these mergers are still quicker and will involve substantially fewer transaction costs than an underwritten offering. However, a reverse merger does not assure liquidity or even a successful capital raise. There are no underwriters to conduct due diligence and rigorously review the company. Reverse mergers are most successful when combined with an equity raise with a sophisticated lead group of investors who will conduct due diligence others can rely upon, and when an active market trading can be achieved.

In the U.S., Canadian public companies can combine a PIPE (private investment in public equity) financing with a U.S. registration. These transactions allow a private raise of equity from mostly hedge funds. These funds buy restricted shares (not freely tradable) with the condition that the shares will be registered and freely tradable in a short time period (generally one to three months). Because the purchased stock cannot be traded before the registration statement is effective, hedge funds are able to purchase the shares at a substantial discount to market, and generally receive warrants. While PIPEs are a poor sister to public offerings, they have been a lifeline for many biotech companies since the markets dried up in 2000.

Caution

Hedge funds and private investors in Canada and the U.S. have made a tremendous amount of money in the biotech sector by betting that a company’s stock price will decrease and selling the company stock short. News of significant short positions can actually cause the stock price to fall and therefore shorting can become a self-fulfilling prophecy. Shorting a company’s stock is legal, but manipulating the company’s stock price is not.

Because shorts can use a variety of mechanisms to achieve a desired goal, any company looking to go public must be prepared and have strategies in place to defend itself against these situations. Companies must be proactive, rather than reactive, in dealing with potential shorts and should rely upon sophisticated advisers who understand the local market and know the nature and techniques of such investors.

Firms should also beware of “pump and dump” schemes. Those with low valuations are often approached to go public at a premature stage. A promoter (generally with little biotech industry experience) may approach a company and offer to take it public for fees and equity in the company. The game is to bring the company public, have the promoter and his friends hype the stock, sell it into the market at a relatively high price and then allow the stock to take its natural course. In such cases, the insiders are generally precluded from selling into the market during the initial hype period, the early purchasers of the stock are “burned,” and the company’s stock goes out of favour. These schemes generally benefit only the promoters and their colleagues, and can destroy a company.

Other Considerations

Compliance Requirements

Once public, a company will be subject to the periodic reporting and continuous disclosure requirements imposed by securities regulatory bodies (the documents filed under those requirements are collectively referred to as “periodic reports” in this article). These requirements include annual and quarterly reporting of financial results and business developments, prompt reporting of the occurrence of certain material events and other reporting requirements. For a Canadian company that is public in the U.S., a reconciliation of the company’s Canadian Generally Accepted Accounting Principles (GAAP) financial statements to U.S. GAAP is also required unless it voluntarily prepares its financial statements under U.S. GAAP. Complying with the public company reporting requirements can be both time-consuming and expensive.

Furthermore, as a result of corporate scandals such as those involving Enron Corp. (Houston, TX) and WorldCom Inc. (Ashburn, VA) (now known as MCI Inc.), regulators in both Canada and the U.S. have recently adopted new legislation and rules (including the U.S. Sarbanes-Oxley Act of 2002) that require extensive new disclosure in periodic reports, shorten the time available to companies to file required reports, and impose other obligations on the governance of public companies. For example, a company’s chief executive officer and chief financial officer must personally certify the information contained in annual and quarterly reports filed with securities regulators. Also, beginning with fiscal years ending after July 15, 2006, auditors of Canadian companies that are public in the U.S. will be required to annually audit the companies’ internal financial controls (in addition to the financial statements). Similar rules have been proposed in Canada, but have not yet been finalized. As a result of the new rules, companies must now have extensive controls and procedures in place to ensure the accurate and timely filing of periodic reports.

Public Disclosure of Information

A private company is generally under no obligation to publicly disclose information about its operations and financial results. Public companies, however, must provide in their periodic reports (and any registration statement or prospectus filed in connection with a public offering, including the company’s IPO) full disclosure about the company’s operations, financial results, executive compensation, transactions with insiders and other matters. Given the wide dissemination of this information, the company may be subject to second-guessing by investors, analysts and the press if its results do not meet the company’s earlier predicted or announced expectations. As a result, before going public, a company must determine whether the disclosures it will be required to make during and after its IPO will be unacceptably burdensome or harmful to the company.

For biotech companies, the requirement to disclose details of alliances and licences, and to file the related deal documents, is particularly onerous, especially since pharmaceutical companies often obligate biotech companies to keep this information confidential. The U.S. Securities and Exchange Commission (Washington, DC) generally allows the material financial terms (royalty rates, amount of milestone payments, etc.) to be kept confidential, but companies must apply for such confidential treatment and there is no guarantee that any particular piece of information will be granted confidential treatment. In Canada, commercially sensitive information may be kept confidential without the need to apply for such relief.

Restrictions on Sales by Insiders

Although being a public company will enhance the liquidity of trading in the company’s shares, insiders are subject to volume and manner-of-sale restrictions if they wish to sell their shares over a stock exchange in the U.S. Furthermore, it is illegal for anyone possessing material non-public information about the company to trade in the company’s stock until the information becomes public; this means that company insiders, such as officers and directors, are often prohibited from trading in their company’s shares unless they comply with rules that permit certain trades that were contemplated before they possessed the inside information in question. Finally, company insiders are subject to reporting and other requirements relating to buying and selling their company’s stock, so that their trades will become public knowledge. Certain Canadian statutes also prohibit insiders from engaging in short sales and trading in put and call options.

Possible Loss of Control

An IPO in Canada or the U.S. dilutes the percentage of the company held by pre-IPO shareholders. Therefore, if the pre-IPO shareholders hold less than a majority of the voting power of the company after the IPO, they may ultimately lose their ability to control the company as a result of board elections or a takeover. There are several methods that pre-IPO shareholders can use to reduce their risk of losing control after the IPO — for example, selling fewer shares in the IPO, adopting a “poison pill,” creating tiered classes of shares with differing voting rights, and staggering the election of directors. However, none of these methods are likely to be viewed favourably by the market and they may reduce the company’s share price.

Short-Term Focus

Post-IPO, if the company is successful in attracting market attention, it will be followed by research analysts and investors who will focus on the company’s quarter-to-quarter financial performance. Today’s stock markets are volatile, and even a small market disappointment (particularly with another unrelated biotech company) could lead to a drop in the company’s stock price. Therefore, going public could provide a disincentive for managers to take corporate actions that will benefit the company in the long term, but could be neutral, or even slightly negative, in the short term.

Management Time

Pre-IPO, company management need only focus on running the company. Post-IPO, however, management must also focus on other issues, such as investor relations and the preparation and review of documents to be filed with securities regulators, all of which reduce the time available to run the company.

Canada versus the U.S.

For many Canadian companies, once the decision to go public has been taken, a second decision must be made: whether to go public in Canada or the U.S., or both countries simultaneously (such as was recently done by life science companies Aspreva Pharmaceuticals Corp., Victoria, B.C., and OccuLogix Inc., Mississauga, Ont.). Although circumstances are changing to a certain degree, the regulatory regime applicable to public companies in Canada has historically been somewhat more relaxed than the regime existing in the U.S. Furthermore, Canadian capital markets are generally more accepting of smaller companies than U.S. markets.

On the other hand, U.S. capital markets are much deeper and more liquid than Canadian ones, so a public company in the U.S. may have enhanced access to capital and a more liquid trading market, each of which could lead to a higher valuation and stock price for a dual-listed company versus a company that is public only in Canada. In addition, U.S. venture capitalists are more familiar and comfortable with the U.S. regulatory regime than that in Canada, so those investors generally prefer investing in companies that are (or will be) public companies in the U.S.

There is also a hybrid approach that some Canadian companies utilize in order to take advantage of the relative benefits of both the Canadian and U.S. capital markets. To benefit from the more relaxed Canadian regulatory regime and to gain access to funding in excess of that available to small companies from private equity firms, young companies may initially go public in Canada and then later — when they have grown large enough, have sufficient resources and require increasing amounts of funding to maintain their growth — go public in the U.S. Most Canadian public companies with at least $75 million US in market capitalization and a one-year reporting history in Canada that decide to go public in the U.S. have the unique advantage of being able to rely on the Canada-U.S. multijurisdictional disclosure system, which reduces such companies’ obligations to comply with dual disclosure requirements.

Since most biotech companies, if successful, will need access to the U.S. markets, an initial strategy that incorporates a U.S. public market component is vital.

Conclusion

Whether, when and where any particular company should go public are decisions that need to be tailored to the company’s specific circumstances. If properly considered, becoming a public company can provide enormous benefits and facilitate its growth and success. However, without thorough planning and thought, going public can be a mistake that will be difficult to rectify.

Cheryl Reicin, practice leader of the Technology and Life Sciences Group at Torys LLP (Toronto, ON), focuses on biotechnology companies and representation of private equity/venture capital funds and investment banks that fund such companies. She assists companies in formulating domestic and international growth strategies and in sourcing capital. She advises on venture and later-stage financings, IPOs, mergers and acquisitions, licensing transactions and joint ventures or alliances with strategic partners.

Dan Miller, an associate in Torys’s Corporate Department, focuses on U.S.–Canada cross-border securities transactions and mergers and acquisitions. He has extensive experience advising Canadian companies on U.S. public and private securities offerings.