Going public? For life sciences companies, pivoting in a down market

The Wall St entrance to the NYSE  is seen in New York
The Wall Street entrance to the New York Stock Exchange (NYSE) is seen in New York City, U.S., November 15, 2022. REUTERS/Brendan McDermid

November 17, 2022 - As part of their growth strategy, private biotech and pharmaceutical companies often seek to raise capital through initial public offerings (IPOs). In addition to raising capital, an IPO can give a life sciences company a higher profile and potential access to new and widespread investors.

But with the IPO market currently in a slump, private companies may want to consider two alternative paths to going public — reverse mergers and special purpose acquisition company (SPAC) mergers — that could provide them the resources necessary to continue growing.

A cold front passes through the health care and life sciences IPO market

Both macro and micro forces have chilled the health care and life sciences IPO market. At a macro level, following record-breaking years in 2020 and 2021, the overall 2022 IPO market is on track for its worst year in two decades ("IPO Market Faces Worst Year in Two Decades," The Wall Street Journal, Aug. 22, 2022).

Demand for IPOs has taken a nosedive thanks to geopolitical instability, near-record levels of inflation, and rising global interest rates, leading the money raised by 2022's U.S. IPOs to be trending toward roughly 5%, of what was raised in 2021, according to EY Global IPO Trends.

At a micro level, 2022's softening economic conditions are frightening away the generalist investors that came into the health care and life sciences industry in recent years seeking outsized returns. Investors today are more discerning after witnessing several companies suffer from development setbacks or failures after their IPOs, and are now looking for ways to derisk, such as by investing in companies developing multiple products or products that can treat multiple indications, to afford more "shots on goal."

With valuations falling due to industry pressures, startups are hesitant to go public for fear of locking in lower valuations and providing less-than-stellar returns to their early investors.

As a result, by roughly the midpoint of 2022, about a third as many biotech companies (“Get ready for the biotech market rebound,” Reuters Legal News, July 28, 2022) had completed an IPO as had done so by that same point in 2021. And, in the second quarter of 2022, both the number of biotech IPOs and the value of the companies that went public via IPO were the lowest since at least the first quarter of 2017, according to Fierce Biotech, a news website for the biotech industry.

The pros and cons of reverse mergers and SPAC merger

When leaders of private biotech and pharmaceutical companies and their in-house counsel are contemplating a reverse merger or SPAC merger as an IPO alternative, they must be cognizant of the pros and cons of each so they can avoid doing more harm than good to their company's valuation, reputation, and prospects.

Reverse mergers: a simplified, but less stabilized, process

A reverse merger occurs when a private company acquires a majority stake in a publicly held company, which then absorbs the formerly private company. The result is a combined publicly traded company in which the owners of the formerly private company have a controlling interest.

In the life sciences space, the reverse merger is often into a public life sciences company that has cash on hand and has experienced a failed clinical program. Following the 2020–2021 boom of early-stage IPOs, this is an option many currently distressed public life sciences companies are considering.

Unlike an IPO, with a reverse merger a private company can go public without raising more capital, so the company will need to have a funding plan to make up for this lack of capital infusion. That's why attractive reverse merger targets typically have cash on hand, and why there is often a side-by-side Private Investment in Public Equity (PIPE) to raise additional funds, ideally putting the private company in the position it would have been in, funding-wise, post-IPO.

Reverse mergers can be beneficial because they can usually be completed more quickly than an IPO and for less cost. Given the fundraising climate today in the public markets, and the cash on hand most targets have, reverse mergers are currently attractive options.

Private companies contemplating reverse mergers need to be mindful of certain considerations. First, the matchmaking process can be difficult as several private companies are turning to this alternative, so competition is high. This process also usually entails private companies competing in an auction process with respect to their valuations and post-merger equity splits, and with respect to their ability to raise a PIPE to ensure a sufficient cash runway.

Second, the public company will need to secure a stockholder vote for the deal, which will add time to the process. If the U.S. Securities and Exchange Commission closely scrutinizes the deal (which has been a recent trend), the private company might need to consider securing bridge financing from existing investors to buy it time until closing.

Third, without a banker drumming up demand before an IPO, and then maintaining demand while stabilizing the stock price after, newly combined companies must do so on their own, which could lead to stock price instability. Additionally, the target company needs to be careful to understand the public company's assets and conduct thorough diligence to understand what liabilities it could be taking on. Likewise, the public company should also conduct diligence on the target's assets to ensure they're securing the best deal for their shareholders.

SPAC mergers: Another option to consider

A SPAC merger can provide a private company access to capital markets while providing the SPAC's initial investors a quick exit option. In a typical SPAC structure, a SPAC goes public through the traditional IPO process, raising significant capital, and then has a limited amount of time to find a private company candidate to merge into it through a reverse merger.

For the private company, SPAC mergers carry many of the same advantages and disadvantages as reverse mergers. They can be completed faster than a traditional IPO, but require a vote of the SPAC shareholders, and carry the same lack-of-stabilization risks post-merger.

Because a SPAC hasn't conducted business prior to going public, there are fewer diligence concerns for the private company. While a SPAC initially raises a significant amount of capital in its IPO, SPAC IPO investors have the right, in connection with a later proposed merger, to have their shares redeemed by the SPAC, which depletes the cash held in trust for the company that merges with the SPAC. For this reason, a contemporaneous PIPE is often an important add-on to a SPAC merger, as the trust funds can't reliably be counted on to be available post-closing.

In addition, because SPACs are considered 'shell companies' under SEC rules, the post-merger company will be subject to increased SEC regulation, such as having to wait longer to rely on Rule 144 for resales of securities, or not being able to become a well-known seasoned issuer (WKSI) for at least three years post-merger.

Through 2021 and 2022, the SEC increased its rulemaking regarding SPACs. These rules require enhanced accounting and business disclosures. Whether these rules slow the popularity of SPACs, or give them more credibility, remains to be seen.

Determining which IPO alternative could be the right one

When deciding whether to pursue a reverse merger or a SPAC merger, the leadership and in-house counsel of a life sciences company should consider the following additional factors.

First, how confident are the executives and their counsel about their company's ability to fundraise? Either option will likely require a PIPE, but that funding will be more crucial for a SPAC. Are the executives confident they can tell a compelling story to investors about why the company has forward momentum and why investing now will help it get to another value inflection point?

Second, who are the current investors in the reverse merger candidates? If they include high-profile biotech investors, that could be a boom to the private company's efforts to grow and could give this option an edge over a SPAC merger.

Third, who would be the potential SPAC sponsors? Sponsors often have post-closing board representation. If a sponsor has deep industry connections, including individuals who want to pursue a board seat, this option could be more attractive than a reverse merger where the target's investors are primarily retail investors.

Fourth, who would be the investors in the PIPE? PIPEs often attract high-quality investors, so PIPE investors with industry experience and connections could make up for the lack of either in the reverse merger candidate's investors or the SPAC sponsor's connections.

Finally, how important is it for the private company to acquire legacy assets from a merger partner? If the answer is "very," a reverse merger will likely be the better option.

Sticking the post-pivot landing

Until economic conditions are once again attractive enough for private biotech and pharmaceutical companies to pursue IPOs, reverse mergers and SPAC mergers will be viable alternatives. However, leadership at these companies and their in-house counsel should carefully weigh the pros and cons of each alternative, and take into account several considerations, before pursuing a particular one.

Rachael Bushey and Jennifer Porter are regular, joint contributing columnists on the life sciences industry for Reuters Legal News and Westlaw Today.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Rachael Bushey is chair of Troutman Pepper's Health Sciences Department. She represents life sciences companies, boards, and senior management in capital markets and M&A transactions as well as provides corporate counseling to boards of directors. She can be reached at rachael.bushey@troutman.com.

Jennifer Porter is a partner in Troutman Pepper's Health Sciences Department. She represents life sciences companies, boards, and senior management in capital markets and M&A transactions as well as provides corporate counseling to boards of directors. She can be reached at jennifer.porter@troutman.com.