Preparing for a Financial Audit & Corporate Due Diligence


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Preparing for a Financial Audit & Corporate Due Diligence

  1. 1. 2013 Biotech Seminar Keeping the Devil Out of the Details: An Ounce of Prevention is Worth a Pound of CureProactive Steps You Can and Should Take Prior to Undergoing a Financial Audit or Corporate Due Diligence
  2. 2. Building BiotechnologyNavigating the Current Climate and Avoiding Common Pitfalls Sharlyn Turner, CPA, Partner Bob Bowman, CPA, Senior Manager
  3. 3. The Power of Biotech “Biotech is probably the most powerful and the fastest growing technology sector. It has the power potentially to replace our fossil fuels, revolutionize medicine, and touch every aspect of our daily lives.” – Ellen Jorgenson, Molecular Biologist, Ted Talks June 2012
  4. 4. Current Climate: Challenges of BiotechSince the collapse of the U.S. financial markets in late 2008, biotechcompanies face an increasingly difficult climb to push products allthe way through to market.Difficulties center on: – Sources of capital have dried up – Depressed public equity valuations – Decline in FDA approvals – Market movement toward investments with less risk
  5. 5. Sources of Capital of BiotechsHistorically, biotechs have had the following forms of capital available to them: Investor Typical Funding Structure Venture Capital Equity Investment, Venture Debt Non-Venture Capital Private Equity Equity Investment, Project Financing, Milestone Monetization Investment Banks Initial Public Offering (IPOs), Follow- on Offerings, Registered Direct Offerings Established Biopharma Companies Equity Investment, In-Licensing/Co- Development
  6. 6. Venture Capital InvestingVenture capital hasbeen one of thepredominate sourcesof capital for biotechs,but has declined dueto trickle down effectof the “limitedpartners” of venturecapital firms, such aspension funds, collegeendowments, andother institutions, Biopharmaceutical Venture Capital IRR by Initial Investment Yearbeing unable to Source: Michael D. Hamilton, Independent Study, Tuck School of Business at Dartmouthliquidate investments.
  7. 7. Public Equity Valuations• Combined effect of the burst in the early 2000s and the financial crisis of 2008 have made many investors shy away from investments with high volatility.• Since 2009, most IPOs have failed to achieve target prices, with 68% of the companies’ share prices falling behind the IPO price.• The companies who have had the most successful recent IPOs, Zogeniz and AVEO Pharmaceuticals, did their IPO after they either received FDA approval for their lead product or their product was in late stage development (Phase III clinical trials).
  8. 8. Biotech IPO Returns Returns on US Biotech IPOs Post Financial Crisis to December 2010Source: Michael D. Hamilton, Independent Study, Tuck School of Business at Dartmouth
  9. 9. Debt vs. Equity Financing Capital Raised in North America and Europe by Year Source: Ernst & Young 2012 Global Biotechnology Report
  10. 10. Industry Response• Due to the increased challenges of financing for biotechs, the industry has responded with new strategies: – Improve efficiency through “virtual biotech” and “lean proof-of- concept” models – Project and royalty financing – Acquisitions with “earn-out” terms – Collaborative agreements with other development biotechs, or in conjunction with large pharmaceutical companies – Crowdfunding
  11. 11. New Research Models Two models are becoming increasingly popular as they limit up-front expenditures until there is more assurance that the product is feasible. Lean Proof Of Concept (POC) •Targeted key studies that help inform the go/no- go decision are performed. If those studies indicate positive results, then more robust studies are undertaken. Virtual Biotech Model •Focus on outsourcing to CRO firms who perform the actual studies and large capital investments are only made after the drug has been taken through the POC stage (where failure is most likely to occur).
  12. 12. Project & Royalty FinancingProject Financing•An alternative to a standard merger or acquisition, in project financingthe financier purchases the rights to one or more products typically inPhase I, forms a joint venture around those specific assets, and thenhires the biotech to conduct the studies. In most deals, the biotech hasthe option to reacquire the rights at a predetermined price uponsuccessful completion of Phase II clinical trials.Royalty Financing•Also called revenue interest financing, works by turning over apercentage of future product revenue in exchange for an immediatecash infusion. Typically only available for products in the late stage ofdevelopment.
  13. 13. Stand Out in a CrowdIn a market with limited resources,how do you set yourself head andshoulders above the rest? “Biotech is all about picking the exception. Granting access to capital to everyone doesn’t strike me as the right idea.” -Bob More, General Partner, Frazier Healthcare VenturesBe the exception. Limit risk toyour investors by avoidingcommon pitfalls…..
  14. 14. Avoiding Common PitfallsWhat can you do now to get your company ready for potential investorsand limit the amount of work, time, and money needed later?•Establish policies, procedures, and processes•Ensure accounting is complete and in accordance with GAAP•Understand the impact of complex agreements and transactions•Decide if you need to work with an expert•Make sure you are ready for your audit
  15. 15. Establishing Policies and ProceduresDevelop, review, and/or enhance your policies and procedures now.Items to consider:•What type of accounting system will you use?•Who has access to your systems and electronic records?•How is cash handled and who is authorized with the bank?•Where and how are documents stored? How long are they stored?•What checks and balances are in place to prevent error or fraud?•How are records backed up to prevent loss or corruption of data?•Who monitors the company to ensure compliance with regulations?•When a transaction occurs, what is the process for ensuring it’saccurately recorded? Which employee is responsible?
  16. 16. Don’t Wait to ImplementEstablish polices and procedures now to ensure accurate records frominception.
  17. 17. Complex Agreements and TransactionsComplex agreements, including those related to the new financing strategies andcomplex transactions discussed previously, can have significant accountingimplications. Equity-based transactions (options, warrants, convertible debt, andother special provisions) are extremely common among start-ups and they canseem like an easy answer to financing. But companies need to make sure theyunderstand the accounting ramifications of the agreements and transactions theyenter into.Examples:•Convertible debt, mandatorily redeemable stock, or down-round provisions canresult in large derivative liabilities needing to be recorded•Derivative liabilities tied to stock prices can be affected by large swings involatility and impact net income•Stock options frequently involve complex valuation and tracking calculations•Awards contingent on milestones require probability analyses and potentially avaluation expert
  18. 18. Avoid GAAPs in Your AccountingKnow the differences between “modified cash” and GAAP accounting.Frequent mistakes in accounting for emerging companies centeraround:•Incomplete or inaccurate entries for equity-based and debttransactions•Not accounting for what is not transacted in cash currently or in thenear term – Complex agreements can have significant accounting implications. Review all agreements for provisions and terms which will impact accounting•Improper revenue recognition (depends on the nature and type ofrevenue sources and terms of agreements)•Incorrect treatment of start-up and R&D costs (including collaborativearrangements)
  19. 19. Working with an ExpertAssurance and attest services: – Audit – Review or Compilation - “Audit-Lite” – Agreed-upon procedures, such as an internal control evaluationOther services: – Valuations – Litigation support – Accounting – Process improvement – Tax – Grantwriting
  20. 20. Benefits of “Audit-Lite”Even if you don’t currently need an audit, electing to have a review orcompilation (“audit-lite”) performed can be valuable and help put yourcompany ahead of the competition.Potential benefits:•You will get an expert opinion on your accounting policies•You will receive recommendations on how to improve your internalcontrols•You will gain confidence that your records are accurate and ready tobe presented to investors and lenders•When and if an audit is required you will be that much more preparedand the process will be more efficient•You’ll have an experienced professional a phone call away to consultwhen complex issues arise
  21. 21. Audit-ReadyIf and when you are ready to undergo an audit, organization anddetail in advance are key to reducing the time and cost involved.Before your audit, make sure you have:•Properly closed your books and recorded all necessary entries•You have retained documentation of the transactions that haveoccurred•Identified significant and unusual transactions which may needaccounting assistance•Read the document request list from the auditor, and allrequested documents have been pulled in advance of theauditors’ arrival•Key employees are available to answer questions duringfieldwork
  22. 22. Thank You! Sharlyn Turner & Bob Bowman Peterson Sullivan LLP 601 Union Street, Suite 2300 Seattle, WA 98101 (206),
  23. 23. Corporate Due Diligence Heidi M. Drivdahl
  24. 24. What is Due Diligence?Legal Definition: “a measure of prudence, activity, or assiduity, as isproperly to be expected form, and ordinarily exercised by, areasonable and prudent person under the particular circumstances;not measured by any absolute standard but depends on the relativefacts of the case.”
  25. 25. When is Due Diligence Important?• Prior to equity investment• Mergers and acquisitions• Strategic partnerships/joint ventures• In connection with bank loans• Public offerings – underwriters’ responsibility• Grants• Financial audits
  26. 26. Reasons for Due Diligence• Identify strengths and weaknesses of the business• Gives a fair value of the investment (directly affects valuation of company in both financing and M&A transactions)• Helps in identifying problems• Assessment of risk
  27. 27. Areas of Due Diligence• Financial: – Financial information (historical, current, and projected); tax issues• Legal – Corporate records; IP ownership; securities compliance; litigation risk; contracts review• Operational – Checks and balances; key employees; suppliers; independent contractors
  28. 28. Some of the Most Common Problems Uncovered in Due Diligence• Disputed claims of equity ownership – Often based on informal written communications like emails, short contracts, etc. – Sometimes due to sloppy drafting of agreements – Unsigned documents
  29. 29. Some of the Most Common Problems Uncovered in Due Diligence• Ownership of patents, trademarks, copyrights – Often overlooked is founders’ assignment of IP – Trademarks not necessarily owned by a company; if licensed, could have significant limitations on use – Software copyright is owned by the person who wrote it – unless specifically assigned
  30. 30. Some of the Most Common Problems Uncovered in Due Diligence• Contracts that provide “springing” rights or obligations upon occurrence of certain events – Payment obligations triggered – Equity issuance provisions• Third party consent or termination rights – Change of control provisions
  31. 31. Some of the Most Common Problems Uncovered in Due Diligence• Problems with early equity fundraising rounds – Improper or missing board and shareholder consents – Noncompliance with right of first offer – Antidilution provisions – Could give rise to rescission right
  32. 32. What Should You Do Now?• Start early to develop a system for collecting and managing documents• Work with experienced advisors• Know your strategy, and keep it in mind when negotiating with third parties
  33. 33. Thank You! Heidi Drivdahl Summit Law Group, PLLC315 Fifth Avenue South, Suite 1000 Seattle, WA 98104 (206) 676-7018
  34. 34. Ensuring a Seamless IP Due Diligence Gary M. Myles, Ph.D.
  35. 35. Ensuring a Seamless IP Due Diligence• Steps taken NOW will greatly enhance your success LATER when seeking: – An investment round – An acquisition or merger – A big pharma/biotech partner
  36. 36. Ensuring a Seamless IP Due Diligence1. Do you have a sound strategy for identifying and protecting your company’s inventions?2. Is your company’s patent portfolio aligned with its business objectives?3. Do you own your patents?4. Will your patents withstand challenges to validity and/or enforceability?5. Will you infringe another’s patents when your product enters the marketplace?6. Are you relying on the patents of others?
  37. 37. 1. Do you have a sound strategy for identifying and protecting your company’s inventions?• Patents vs. Trade Secrets – Patents • Exclusive rights • Easy to reverse engineer or independently develop • Medium length product cycle – Trade Secrets • No exclusive rights • Difficult to reverse engineer • Very short or very long product cycle • Value in not being generally known • Reasonable efforts to keep secret
  38. 38. 1. Do you have a sound strategy for identifying and protecting your company’s inventions?• Periodic vetting of R&D activities – Patent protection strategy accommodates changes in R&D direction and emphasis • Open lines of communication between technology, business, and legal functions • Keep outside counsel informed – Formal invention disclosure system – Policy regarding publication and public disclosure • Patent first, publish/disclose/sell later • Obtain confidential disclosure agreements with third parties
  39. 39. 2. Is your company’s patent portfolio aligned with its business objectives?• Barriers to Entry – Do you have issued patents or patents pending? – Do your patent claims “read on” • Your commercial product? • Your competitor’s commercial product?
  40. 40. 2. Is your company’s patent portfolio aligned with its business objectives?• Barriers to Entry – Are your patent claims difficult to design around? • Claim scope • Picket fence – Seek protection for compositions, formulations, and methods • Life-cycle management – Patent term is 20 years from date of filing – Continue to supplement portfolio as R&D activities progress
  41. 41. 2. Is your company’s patent portfolio aligned with its business objectives?• Are you seeking patent protection in key commercial markets? – Consider commercial markets of potential acquirers and partners
  42. 42. 2. Is your company’s patent portfolio aligned with its business objectives?• Are you over-investing in patent protection? – Stay focused on your commercial objectives – Out-licensing for profit is an unlikely value proposition for an immature company
  43. 43. 3. Do you own your patents?• Ownership of inventions vests in inventors – Transfer of ownership achieved through assignment from inventors to company• Beware the lessons of Stanford v. Roche (S.Ct. 2011) – “Actual assignment” trumps “obligation to assign” – Consider obtaining actual assignment of future inventions upon employment of all inventors• DO NOT DELAY in obtaining and recording assignments with the USPTO – A former (esp. terminated) employee is often reluctant to cooperate in assigning inventions
  44. 44. 4. Will your patents withstand challenges to validity and/or enforceability?• Are your patent claims free of the art? – 35 U.S.C. § 102, novelty – 35 U.S.C. § 103, non-obviousness• Premature publication/non-confidential disclosure/sale will invalidate your patents – Inside U.S. -- 1-year grace period – Outside U.S. -- Absolute novelty• Have you disclosed to the Patent Office all material prior art of which you are aware? – Duty to disclose – Inequitable conduct renders a patent unenforceable
  45. 45. 4. Will your patents withstand challenges to validity and/or enforceability?• Are your patent claims supported by a well drafted specification? – 35 U.S.C. § 112, first paragraph • Enablement – Teach how to “make and use” the claimed invention • Written Description – Demonstrate that applicant had “possession” of the claimed invention – Beware the trap of a poorly drafted provisional
  46. 46. 5. Will you infringe another’s patents when your product enters the marketplace?• Do you have freedom-to-operate? – Patent ≠ FTO – Are you familiar with the patent landscape? – Have you conducted a formal FTO search/analysis? – Have you received letter from third parties that identify their patents? – Have you obtained formal opinions of non-infringement and/or invalidity?
  47. 47. 6. Are you relying on the patents of others?• Have you in-licensed another’s patent portfolio? – To obtain exclusive rights? • Exclusive license • Right to litigate – To obtain freedom-to-operate? • Non-exclusive license • No right to litigate• Does the licensor own those patents? – Chain of title• How involved are you in patent prosecution? – Can you control scope of issued claims?
  48. 48. Thank you! Gary M. Myles, Ph.D. Of Counsel Merchant & Gould Columbia Center 701 5th Avenue, Suite 4100 Seattle, WA (206) 342-6226
  49. 49. SALT & BiotechnologyRachel A. Le Mieux, CPA, CMI Partner, State and Local Tax
  50. 50. State & Local Tax• Washington State Taxes – Generally• Local Jurisdiction Taxes – Generally• Tax Incentives• Legislative Climate• Importance Of Staying Current
  51. 51. State & Local Tax• Washington State Taxes – Generally – Business & Occupation Tax • Gross Receipts – due whether there is a profit or a loss • Various Rates - .0471 – 1.8% • Paid Monthly, Quarterly, or Annually
  52. 52. State & Local Tax• Washington State Taxes – Generally – Business & Occupation Tax Deductions/Exemptions • Income received from the Life Sciences Discovery Fund • Sale or distribution of biodiesel or E85 motor fuels • Grants/Endowments – not for profits
  53. 53. State & Local Tax• Sales & Use Taxes – Sales tax is paid at the time of purchase of tangible personal property, unless there is an exemption – Use tax is self assessed if sales tax was not paid at the time of purchase, unless there is an exemption – State tax rate is 6.5% and various local rates are added – depends upon where the item purchased is delivered or where it is first used
  54. 54. State & Local Tax– Local Jurisdiction Taxes - Generally • 40 cities impose a gross receipts tax – Big 5 are Seattle, Tacoma, Everett, Bellingham & Bellevue – City of Kent – became effective January 1, 2013 • Mostly follow the state’s taxing scheme but be careful • The B&O is paid directly to the city, the local portion of the sales/use tax is collected by the state. • Various rates - .001 - .00215 • Usually paid quarterly • Federal Life Science Research Grants Deduction – Annual Report Requirements (April 30, 2013)
  55. 55. Tax Incentives – Available to Biotechnology– Biotechnology & Medical Device Manufacturing Sales & Use Tax Deferral/Waiver – RCW 82.75.005 • Available to biotechnology & medical device manufacturers • Qualifying activity is certain construction & equipment purchases for new and expanding business • Expires January 1, 2017– High Technology B&O Tax Credit for R&D Spending • Available to businesses in the biotechnology industry • Qualifying activity – qualifying R&D in the state
  56. 56. Tax Incentives – Available to Biotechnology– High Technology Sales/Use Tax Deferral/Waiver • Available to biotechnology businesses conducting R&D and pilot scale manufacturing • Qualifying activity is certain construction & equipment purchases for new and expanding businesses Annual Reporting Requirements– 2012 Annual Surveys • Must be filed electronically • Due April 30, 2013 • Penalties for not filing are severe
  57. 57. State & Local Legislative Climate– Governor Inslee’s loophole pronouncement– Desire for tax simplification by the state • Vehemently opposed by the cities • Cities tax simplification efforts
  58. 58. The Importance of Staying Current– Tax codes are constantly changing • Incentives expire • Government and new interpretations • Crowdfunding???– Errors may impact your value– You can make a difference
  59. 59. Thank You! Rachel A. Le Mieux Peterson Sullivan LLP601 Union Street, Suite 2300 Seattle, WA 98101 (206) 382-7711