Preparing for a Financial Audit & Corporate Due Diligence

2013 Biotech Seminar

Keeping the Devil Out of the Details:

An Ounce of Prevention

is Worth a Pound of Cure

Proactive Steps You Can and Should Take Prior to Undergoing a Financial Audit or

Corporate Due Diligence

Building Biotechnology

Navigating the Current Climate and Avoiding Common Pitfalls

Sharlyn Turner, CPA, Partner

Bob Bowman, CPA, Senior Manager

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

Current Climate: Challenges of Biotech

Since the collapse of the U.S. financial markets in late 2008, biotech companies face an increasingly difficult climb to push products all the 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

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

Venture Capital InvestingVenture capital has been one of the predominate sources of capital for biotechs, but has declined due to trickle down effect of the “limited partners” of venture capital firms, such as pension funds, college endowments, and other institutions, being unable to liquidate investments. Biopharmaceutical Venture Capital IRR by Initial Investment Year

Source: Michael D. Hamilton, Independent Study, Tuck School of Business at Dartmouth

Public Equity Valuations• Combined effect of the dot.com 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).

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

Debt vs. Equity Financing

Capital Raised in North America and Europe by YearSource: Ernst & Young 2012 Global Biotechnology Report

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

New Research ModelsTwo 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).

Project & Royalty FinancingProject Financing•An alternative to a standard merger or acquisition, in project financing the financier purchases the rights to one or more products typically in Phase I, forms a joint venture around those specific assets, and then hires the biotech to conduct the studies. In most deals, the biotech has the option to reacquire the rights at a predetermined price upon successful completion of Phase II clinical trials.

Royalty Financing•Also called revenue interest financing, works by turning over a percentage of future product revenue in exchange for an immediate cash infusion. Typically only available for products in the late stage of development.

Stand Out in a CrowdIn a market with limited resources, how do you set yourself head and shoulders 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 Ventures

Be the exception. Limit risk to your investors by avoiding common pitfalls…..

Avoiding Common PitfallsWhat can you do now to get your company ready for potential investors and 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

Establishing Policies and Procedures

Develop, 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’s accurately recorded? Which employee is responsible?

Don’t Wait to ImplementEstablish polices and procedures now to ensure accurate records from inception.

Complex Agreements and Transactions

Complex agreements, including those related to the new financing strategies and complex transactions discussed previously, can have significant accounting implications. Equity-based transactions (options, warrants, convertible debt, and other special provisions) are extremely common among start-ups and they can seem like an easy answer to financing. But companies need to make sure they understand the accounting ramifications of the agreements and transactions they enter into.

Examples:•Convertible debt, mandatorily redeemable stock, or down-round provisions can result in large derivative liabilities needing to be recorded•Derivative liabilities tied to stock prices can be affected by large swings in volatility and impact net income•Stock options frequently involve complex valuation and tracking calculations•Awards contingent on milestones require probability analyses and potentially a valuation expert

Avoid GAAPs in Your AccountingKnow the differences between “modified cash” and GAAP accounting. Frequent mistakes in accounting for emerging companies center around:•Incomplete or inaccurate entries for equity-based and debt transactions•Not accounting for what is not transacted in cash currently or in the near 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 of revenue sources and terms of agreements)•Incorrect treatment of start-up and R&D costs (including collaborative arrangements)

Working with an ExpertAssurance and attest services:

– Audit

– Review or Compilation - “Audit-Lite”

– Agreed-upon procedures, such

as an internal control evaluation

Other services:

– Valuations

– Litigation support

– Accounting

– Process improvement

– Tax

– Grantwriting

Benefits of “Audit-Lite”Even if you don’t currently need an audit, electing to have a review or compilation (“audit-lite”) performed can be valuable and help put your company 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 internal controls•You will gain confidence that your records are accurate and ready to be presented to investors and lenders•When and if an audit is required you will be that much more prepared and the process will be more efficient•You’ll have an experienced professional a phone call away to consult when complex issues arise

Audit-ReadyIf and when you are ready to undergo an audit, organization and detail 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 have occurred•Identified significant and unusual transactions which may need accounting assistance•Read the document request list from the auditor, and all requested documents have been pulled in advance of the auditors’ arrival•Key employees are available to answer questions during fieldwork

Thank You!

Sharlyn Turner & Bob Bowman

Peterson Sullivan LLP

601 Union Street, Suite 2300

Seattle, WA 98101

(206) 382-7777

[email protected], [email protected]

mailto:[email protected]


Corporate Due Diligence

Heidi M. Drivdahl

Legal Definition: “a measure of prudence, activity, or assiduity, as is properly to be expected form, and ordinarily exercised by, a reasonable and prudent person under the particular circumstances; not measured by any absolute standard but depends on the relative facts of the case.”

What is Due Diligence?

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

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

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

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


• 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


• 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


• 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

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

Thank You!

Heidi Drivdahl

Summit Law Group, PLLC

315 Fifth Avenue South, Suite 1000

Seattle, WA 98104

(206) 676-7018

[email protected]


Ensuring a Seamless IP Due Diligence

Gary M. Myles, Ph.D.


• Steps taken NOW will greatly enhance your success LATER when seeking:– An investment round– An acquisition or merger– A big pharma/biotech partner


1. 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?

• 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



• 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


• 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?


• 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


• Are you seeking patent protection in key commercial markets?– Consider commercial markets of potential acquirers and

partners


• 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

• 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

3. Do you own your patents?


• 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

• 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


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?

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?

Thank you!

Gary M. Myles, Ph.D.

Of Counsel

Merchant & Gould

Columbia Center

701 5th Avenue, Suite 4100

Seattle, WA 98104

[email protected]

(206) 342-6226


SALT & Biotechnology

Rachel A. Le Mieux, CPA, CMI

Partner, State and Local Tax

State & Local Tax

• Washington State Taxes – Generally

• Local Jurisdiction Taxes – Generally

• Tax Incentives• Legislative Climate• Importance Of Staying Current

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

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

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

– 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)

State & Local Tax

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

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

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

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

Thank You!

Rachel A. Le Mieux

Peterson Sullivan LLP

601 Union Street, Suite 2300

Seattle, WA 98101

(206) 382-7711

[email protected]


Preparing for a Financial Audit & Corporate Due Diligence

Documents

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