October 31, 2017

Acquisitions in the Life Sciences Start-Up Space: A Principal-Agent Problem in the Making

Acquisitions in the Life Sciences Start-Up Space: A Principal-Agent Problem in the Making

By Matthew Literovich

The original article appeared on Deal Law Wire, a blog hosted by Norton Rose Fulbright.

Earlier this year, Bloom Burton & Co. hosted the 2017 Bloom Burton & Co. Healthcare Investor Conference. The conference brings together early stage life sciences companies with professional advisors in the industry for two days of talks given by the companies on what they are trying to accomplish and how they have been progressing. Over the course of the conference, there is a familiar refrain among companies in the drug, processes or technology development space. Frequently, we hear these companies talking about acquiring other intellectual property (be it drugs, processes or technology) for the purposes of “stabilizing their pipeline.” The logic behind this is that since any individual drug, process or technology has a snowball’s chance of succeeding, bringing together a number of these intellectual properties increases the company’s chance of survival.

The point and counterpoint

From an investor point of view, however, “stabilizing the pipeline” doesn’t always make a lot of sense. Diversification is important in the aggregate, but it can be accomplished by investing in multiple different companies at minimal transaction costs in comparison with the costs of an acquisition by a company of another company that may or may not result in synergies for the two. For an individual company to seek to successfully acquire and integrate other similar companies from the point of view of diversification, it now needs to be adept at investment analysis and technology integration, two skills that most small companies do not have in reserve and cannot easily acquire. In some cases, investors are better off making their own investment decisions on a piecemeal basis.

This does not mean that all acquisitions made by small life sciences companies are necessary fraught. In some cases, where there is a significant overlap of talent requirements, such acquisitions can help to leverage underutilized skills within the organization. Sometimes this is as simple as economies of scale on office space, supplies, etc. In other cases, this can involve regulatory know how, investor relations or management functions that were being duplicated between the firms. Our own deal list is full many examples of well-executed acquisitions that help companies to be more profitable than they would have been as their pre-acquisition constituent pieces.

Where theory meets reality

That said, diversification in small life sciences companies can also be a great example of the principal-agent problem at work. While investors would arguably prefer that small life sciences companies stick to their core competencies and work on developing their drug or technology, the reality is that a single-drug company is far more likely to fail than one with a diversified pipeline. Investors can mitigate that risk by investing widely but management, their agents, are not in the same position. Investors in a life sciences company with a failed drug have lost on one of their lottery tickets; management has lost their livelihood. Therefore, management can find its incentives out of alignment with the incentives of its shareholders and end up pushing acquisitions that will improve the likelihood of management remaining employed but not actually provide investors with the highest possible returns.

The argument, therefore, is not that investors should always balk at the notion of a company in which they are invested undertaking an acquisition. Rather, investment decisions like these should be taken with a sense of caution and never as fait accompli. Investors would be well-served to take a little extra time with the due diligence on the acquisition target, both on the legal and financial ends, before accepting acquisitions proposed by management of the company. This is especially true when the management of the company is not a major investor in the company or board oversight is minimal. This allows investors to be sure they are getting good value for their investment and to keep management and investor incentives aligned, which is, in the long run, in the best interest of the company as well.

Matthew Literovich is a private company lawyer with experience in the life sciences, technology and charities space.

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