Henrik Ekman BioTech Equity Analyst

So why the big gap? It’s all about perception of risk which constantly change. Firstly, even though the development of a product doesn’t change from a scientific perspective when risk appetite drops – often expressed through rising interest rates – the present value of long-term cash flow drops which leads to a falling market value. Secondly, as risk and interest rates rise, the demand for risky assets drops making it more difficult for biotech and life-science companies to raise capital and secure funding. 

This year we have seen both effects in the market affecting the biotech and life-science stocks negatively – both from an absolute and relative perspective. The indexes are down 15-20 percent which is x percent worse than the broad MSCI World index. When risk appetite fell earlier in the year, high risk areas as biotech fell even more, but recently when interest rates have dropped again and risk appetite has risen, the biotech index has risen faster than the broader index.

From an operational perspective, lower stock market valuations or more volatile markets due to changes in risk appetite are not a major problem for a biotech company. The same applies for the investor (unless you are forced to sell). But the difficulties – or even inability – to secure funding can be a major challenge for a company as we have seen for many biotech and life-science companies recently. As risk appetite fell, some biotech companies have cancelled, postponed, or lowered (the amount of) planned share offerings, refocused, and reprioritized the pipeline, obtained debt or established alternatives structures to secure vital funding for the company’s development plans.

In addition to different ways to obtain external funding, most biotech companies also rely on internal funding, particularly through warrant programs etc. We take a closer look at warrants in the next section.

Warrants are supportive and keeps biotech alive but can be diluting
A warrant gives the holder (typically the management of the company) the right to buy a stock in a company at specific price on a specific date. The mix of price and dates comes in many different forms, but often the holder will have a big incentive to exercise the warrant, if the price is lower than the current price at some future point in time. This way the company can expect to receive funding in the future when issuing warrants, making it an attractive funding option for the company.

Generally, the issuance and exercise of warrants acts as an important internal supplement to external funding. Warrants would typically be considered a stable source which is less dependent on risk-on and risk-off sentiment in the market. Also, many investors believe warrant programs should be an integral part of funding in high-risk companies like biotech as is sends an important signal of confidence when the management is willing to commit substantial amount of their personal future wealth at a high risk. This would typically make external investors more inclined to invest in the company.

But when the flow of external funding is put on hold or reduced in size, the warrant program can become almost the only source of funding, and this is something you should be aware of when investing. Most investors appreciates when the management is be supportive of the company, but if the company is only able to fund itself if the management can secure personal financing to excise their warrant program, that could increase the overall risk of the company. 

More importantly, however, is the risk of dilution. Depending on the size of the warrant program, and the combination of the exercise price and date there can be a potentially substantial diluting effect to the existing investors. 20-30 percent dilution is not uncommon in biotech and life science companies. You can assess the potential dilution effect by 1) comparing the exercise price in the warrant program with the current stock price, and take into account the duration period of the program to assess how likely it is that the warrant will be in-the-money at the expiry date, and 2) calculate the size of the dilution by dividing the number of new shares that will be exercised relative to the current stock count.