IN BRIEF
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Sustained market conditions have created challenges for many life sciences companies to
raise equity capital at attractive pricing, as venture investment activity, initial public offerings
(IPOs), and other offerings remain at multiyear lows.
– In contrast, royalty financings have grown rapidly due to their highly flexible and non-dilutive
structure, growing investor base, and economics that are less closely tethered to
macroeconomic forces.
– Life sciences companies looking to fund later-stage asset development, capital-intensive
clinical programs, or early commercialization efforts may consider pursuing royalty
financing arrangements for fast, efficient, and less dilutive upfront capital.
Many biopharmaceutical companies are facing challenges raising cash through traditional equity
markets. While venture investment activity saw a slight increase in the first half of 2024 as
compared to the equivalent period in 2023, overall volume remains well off 2021 highs. Global life
sciences venture investment activity experienced a year-over-year drop of 24% in 2023, after 2022
saw a year-over-year drop of 35%. The largely frozen IPO markets of 2022 — down 71% in number
of debuts for biotech companies from 2021 — continued throughout 2023 and 2024, with only three
IPOs occurring in the second quarter of 2024. For biotech companies that are already public,
market values remain depressed, with the sector up only 1.13% in 2024, while the S&P 500
experienced a gain of 18.5%. Rising interest rates over the same period, which are now near a 20
year high, have made the alternative of debt financing less attractive to borrowers, and at the same
time lenders have pulled back sharply on venture lending activities.
Royalty financings, in contrast, have provided a bright spot for the sector. These transactions involve
the sale of some or all of the rights to an actual or potential royalty or other income/revenue stream
in exchange for an upfront lump sum payment. Royalty transactions and similar monetizations of
revenue streams have been estimated to provide approximately $14 billion in per-year deal flow,
with the total value of these deals growing at a compound annual rate of 45%. Their attractiveness
for both buyers and sellers is due in part to their ability to offer returns and terms that are dependent on the risk and return profile of a particular drug candidate or program rather than the
macroeconomic factors generally at work in the capital markets. In addition, many deals in this
sector lack a variable interest rate component, which allows buyers and sellers to add or deploy
capital that is decoupled from rapid changes in the interest rate environment. Finally, shareholders
view these transactions as non-dilutive and efficient sources of capital, and so generally react
positively to royalty deal announcements. As royalty financing and monetization transactions gain
momentum as alternatives to traditional debt and equity financing, life sciences companies may
look to take advantage of these methods of fundraising to accelerate product development, launch
clinical programs, or acquire additional assets.
The flexibility and variety of transactions in this sphere lead to variable and sometimes confusing
nomenclature. Under the umbrella term “royalty financings,” there are two primary transaction types
that we will discuss here: (1) royalty/revenue monetization transactions and (2) development
financing transactions.
Royalty/Revenue Monetizations
Royalty/revenue monetization transactions involve the sale of some or all of the rights to a royalty or
other income stream for an upfront lump sum payment. In practice, the seller is often an intellectual
property (IP) owner who has licensed its IP to a third party in exchange for royalties on the sale of
drugs utilizing that IP. These royalties are then sold for a lump sum, generally subject to a cap on
total return on investments for the buyer in the range of 1.5 to 4 times the initial investment,
depending on the investor’s risk analysis of the royalty stream. This allows companies to
immediately realize the full value of a royalty stream while shifting some or all of the risk of poor
future performance of a particular drug to the buyer. Typically, buyers do not look to encumber
company assets in these transactions, providing sellers with maximum flexibility for additional debt
or royalty financings down the road.
This same structure is applied where the seller owns a revenue stream other than from license
fees, for example a royalty-based earnout payment from the sale of an asset or a line of business. It
can also be utilized where there is no underlying license or asset/business sale, and where the
transaction monetizes a product revenue stream owned directly by the company.
Historically, these monetizations have been structured as a straightforward “true sale” of an entire
royalty or revenue stream or a portion thereof, with only minor differences between transactions.
However, flexibility has increased as the market has matured, and bespoke deals tailored to meet a
company’s needs are on the rise. Partial sales as well as sales subject to capped returns and
put/call rights have become more common. In some cases, these transactions have occurred in
tranches or strips over a course of time.
These monetizations provide a dynamic mechanism for companies with a product at or near FDA
approval to immediately realize the full value of their assets.
Development Financings
Development financings, which include many synthetic royalty transactions, traditional development financing deals, and royalty-backed debt financings, generally involve an investor providing an
upfront lump sum amount and/or commitments to fund future amounts needed for development
and commercialization of products, in exchange for all or a portion of an existing or future income
that a product or group of products may generate, usually coupled with a lien on the assets
underlying those products or group of products. Repayment terms may share attributes with those
of a traditional loan. For example, if the acquired royalty streams do not meet certain milestones,
sellers may be obligated to provide “gross-up” payments that ensure buyers receive a particular rate
of return on their investment. As with a traditional secured loan, failure to make these payments may
result in an acceleration of existing investment amounts and all future payments owing to the buyer
as well as a subsequent sale of the collateral if the seller is unable to make the accelerated
payments. These financings are typically in play earlier in a company’s life cycle, with availability
usually opening up around the time of a positive Phase 3 data readout.
In short, these transactions live somewhere among equity financings, traditional asset sales, and
secured debt financing. While it may leave some (or most) company assets unencumbered, the lien
and covenant package required by buyers in development financings will usually, by its nature,
severely limit a seller’s ability to layer in additional third-party debt or royalty financings down the
road, and in some cases can even create impediments to partnering activity for other products in the
pipeline. Great care should be taken at the term sheet stage with these transactions to clearly
delineate lien and covenant scope in order to avoid surprises at the documentation stage, and
companies should be aware that lenders may struggle to find viable ways to step into intercreditor
relationships with development finance partners.
By not necessarily requiring a preexisting royalty stream, development financings allow companies
to avoid out-licensing transactions prior to monetizing development assets. This provides life
sciences companies with the unique opportunity to retain more control over their IP and the
production and commercialization of their products while still obtaining necessary investment
capital. Furthermore, the non-dilutive nature of these transactions makes them generally popular
with shareholders (though, as with royalty/revenue monetizations, the prospective effect of these
transactions on stock price should still be examined diligently). In all events, companies should be
keenly aware of the limitations that may be placed on their ability to do future debt or royalty
financings without investor consent during the life of their development financing facilities.
The Takeaway
The cost for research and development of new products has increased significantly over the past
decade, while at the same time traditional debt and equity markets for life sciences companies
have tightened. For companies with late-stage or commercialized drugs, royalty/revenue financings
and development financing transactions may provide the upfront financing needed to fuel research
and development, pay off expensive capital, bridge operations to approval of the next product in the
pipeline, or avoid out-licensing of late-stage products to maintain more control and economics
when those products reach commercialization. Streamlined documentation and diligence (as
compared to traditional secured debt financings) allow for accelerated timelines to closing and
lower transaction costs. Not to be overlooked, however, is how covenant packages and lien grants (or negative pledges on assets) can hamper future financing flexibility, particularly in development
financings with broad lien grants and extensive covenant packages. Life sciences companies
interested in these types of bespoke financings should look to engage a legal advisor with
substantial, targeted experience navigating this complex landscape to structure the transaction,
lead diligence efforts, and draft and negotiate the deal documentation in order to maximize the
benefits offered by royalty financing transactions.