As traditional fundraising methods falter for smaller firms, the rise of royalty deals is reshaping how companies access capital, offering an alternative that bypasses equity dilution and debt.
The environment for biotech and smaller pharma companies to raise capital has been difficult in recent years. Investor confidence in the biotech industry has struggled since the highs seen during the pandemic, with the XBI index of stocks remaining largely flat over the last two years. Though there are signs that 2024 represents a resurgence in investment, with IPOs and M&A activity surpassing levels seen in 2023, the industry is still recovering from the flight of capital.
Life science companies have reacted to the difficulty in sourcing capital in various ways, such as the broad industry move to downsize and restructure workforces to extend available cash reserves and a trend for companies to delay potential IPOs. In the background of such strategies, there has been a shift to an alternative option for sourcing capital, through royalty financing.
Though they have been around for decades, royalty deals are a means of raising capital that involves an investor buying a percentage of future revenue from a drug manufacturer on specific single or multiple assets. In this way, a manufacturer can receive an upfront fee and potentially future milestone payments dependent on the development of the asset, which can then be used for short-term capital needs.
This type of financing is distinct from an equity deal because it offers the company a non-dilutive means of raising funds for development or commercialization costs. It can also be a more flexible arrangement than taking on debt because there are no interest payments to meet nor is the deal itself dependent on the economic environment. The latter advantage is one of the major reasons that this type of deal is on the rise and why more can be expected in the future.
George Shuster Jr., partner at law firm WilmerHale, told BioSpace that the number of such deals has grown “exponentially” in the last three years, following a steady increase over the last decade.
WilmerHale earlier this month released an analysis of the surge in royalty financing in the “difficult” life sciences fundraising environment. “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 report found.
Twin Drivers for Deals
Previously, these types of deals were considered highly specialized transactions that only fit a narrow set of circumstances, according to Shuster. However, with the entry of a greater number of private credit investment funds, there has been more interest in creating novel transactions to expand their portfolios and to meet demand for capital, he said.
In convergence with the rise of private investment has been the downturn in the overall market environment for supporting smaller companies and biotechs. Not surprisingly, royalty financing is a popular option for emerging biopharma.
“The market for life sciences companies in equity transactions has slowed down to a point of all but drying up—not just at the IPO level, but really all the way down to much earlier stage financings,” Shuster explained. “And as that happened, the stock price for public life sciences companies has suffered. That means not only is it harder to get the equity financing in the door, but if you are going to raise equity financing, it is at very unattractive prices that would be extremely dilutive to the existing shareholders.”
For companies seeking to complete royalty financings, part of the appeal is being able to raise capital without having to dilute existing shareholders, especially at the later stages of developing a product. For the investors, it is attractive to have a return from such deals that is not dependent on the stock market or interest rates, with the profit driven instead by the success of the product at the heart of the deal, according to Nathan Moore, partner at WilmerHale.
As a result, the number and scale of such deals is increasing, with Royalty Pharma—a specialist buyer of royalties—striking deals potentially worth close to $2 billion in May 2024 alone. In one of those deals, Royalty Pharma paid $525 million to acquire the royalties and milestones for ImmuNext’s anti-CD40 therapy frexalimab, which is currently in Phase III trials for multiple sclerosis. In return, Royalty will receive 100% of annual worldwide net royalties that ImmuNext would have received under its licensing deal with Sanofi, up to $2 billion.
In a report based on 2022 data, management consulting firm ZS found that over the preceding four years, the average value of royalty deals increased more than twice as fast compared with other financing types, with the total value of royalty deals growing at a compound annual growth rate of 45%, compared with 25% for equity deals. “This suggests greater resilience against the macroeconomic factors impacting today’s equity market,” ZS concluded.
Big Pharma on Sidelines
Traditionally, it has been Big Pharma stepping in to snap up the rights to assets that are closing in on commercialization. Private investment companies entering into the market to swoop for these potential products would seem to be encroaching on this territory. Any products that proved to have potential in key therapeutic areas would then have a less attractive revenue potential for any would-be buyers.
Shuster instead suggested that Big Pharma has been happy to take a backseat and allow other companies to take a risk in the short term, permitting private investments to fill the financial hole needed to get assets over the line. In this way, there is less pressure for Big Pharma to spread its investments across too many assets, and they still retain the opportunity to swoop in to acquire the company or product should it prove to be successful.
With the economic environment being such a driver for these royalty deals, the question remains as to whether this trend will continue if the market becomes more friendly to traditional forms of investment. While a more open equity market could potentially see the need for this type of investment reduced, Shuster contends that it would not see completely disappear as a financing option.
“This investment product will be sustained at levels above where it used to be because now there is a group of lenders who know how to do these transactions, and who know the pros and cons of these transactions,” Shuster concluded. “These companies know how to fit this in with other equity and debt financing strategies that they may have—once you have the tool in the toolbox, you’re going to continue to use it.”
