A going concern clause isn’t always a concern
by Peter Kolchinsky and Tess Cameron
Peter Kolchinsky is founder and Managing Partner and Tess Cameron is a Principal at RA Capital Management.
October 27, 2023
There’s a convention that public biotech companies should plan to raise money by the time they get down to one year of cash left on their balance sheets. So the goal of any financing is typically to bring in, at a minimum, enough cash to fund a company through a particular value inflection point, e.g., clinical trial data, and tack on a year of cash runway beyond that, expecting to then be able to raise on good data before falling below a year of cash.
But why a year of runway? Ask any biotech board director or advisor and the common answer you’ll get is that the year of cash allows them “to avoid getting a going concern clause.” But what’s that?
It’s a statement that companies, in consultation with their auditors, put into their financial statements (10-K, 10-Q) that might read something like this:
Substantial doubt exists regarding our ability to continue as a going concern through one year from the date that these financial statements are issued.
What is a going concern? Plainly put, it’s a company that is likely funded to do what it needs to do for the coming year.
Specifically, for a company to be considered a going concern, it must be probable that the company will be able to meet its obligations as they become due within one year after the financial statements are issued. If this is deemed not probable during any quarterly assessment, the company’s statements have to acknowledge that there is now substantial doubt about the company’s financial situation, regardless of what management has in mind to solve the situation in the future.
So, a “going concern clause” actually alerts everyone to the possibility that the company might NOT be a going concern. Convention has us act like the clause is something horrible and shocking, but is it? Some might think that there will be a “financing overhang” on their stock, as if investors will start selling, holding off from buying, or even shorting a stock when a company is down to less than a year of cash because they will be certain that a dilutive financing is coming that will likely price at a discount.
And yet, in terms of the day-to-day operation of a biotech company, the day after that filing is no different than the day before. One day a company has 365 days of cash and the next it has 364. Even the logic of an overhang suggests that investors should be speculating about a pending financing well before the company is down to a year of cash.
Imagine if, instead of a “down to one-year” going concern clause, everyone modified it to note when their cash is projected to last through, which is already a common disclosure elsewhere in its filings and earnings press releases (and the focus for investors). So it would say “there is substantial doubt that we can continue as a going concern because we estimate we have only 10 quarters of cash and yet still have many more years of R&D to do.” And the next quarter it would say “…9 quarters…” and so on. Then there's no binary moment when a going concern clause suddenly shows up, and everyone can hopefully focus on a company's risk reward profile more holistically.
We’re not sure that would go over well with the SEC, which likes its conventions. And the point of the clause is to raise concerns. But even if companies continue to put in these clauses when they are down to a year of cash, there should be nothing profound about that… it’s a matter of degree, right? Usually.
Surprises and non-surprises
There are surely reasons a going concern clause could be jolting. It would be a surprise if one day everyone thought that a company was well financed or even profitable and then suddenly major financial restatements revealed that the company had less than a year of cash. But that’s not how biotech typically works. A loss-making biotech’s burn rate is fairly obvious: we can all see when it has seven quarters of cash, six quarters, five, four… R&D-stage biotechs surprise us with preclinical, clinical, and regulatory setbacks, but the balance sheet and cash flow statements are reasonably predictable.
However, one particular reason why getting a going concern clause could reflect a qualitative impairment of a company is if investors know that management is so set against getting a going concern clause that they surely tried to raise more cash before getting it. And therefore, if the company got the clause, then it must mean that they tried but failed to raise cash and so there must be something really wrong.
If that’s the way investors interpret going concern clauses, then it is understandable why companies would fear being branded as “unable to raise money.”
But what if a company were deliberate about crossing that one-year threshold? Imagine if well before getting down to a year of cash, management said, “We have the cash we need to reach the value inflection point we intended to hit last time we raised, so we’ll see you all when we have data in hand?.” That’s a pretty confident and reasonable position. It’s rooted in first principles and shrugs off conventions. And it’s arguably a much more efficient use of existing capital.
If the data disappoint, the company would have less cash than if it had raised before data. But even that is a matter of degree; it’s not night and day different whether they had a full year’s worth of cash or seven months’ worth; either way, it’ll close up shop or pivot radically (maybe cut costs to stretch the cash) and then have to raise cash to do whatever the new plan calls for. That’s par for the biotech course.
And to be clear, we’re talking about companies that actually have a key value inflection coming up (e.g., interpretable data for a valuable program). When a company doesn’t have cash to get to a value inflection, it’s unclear why it would wait to raise more cash. May as well avoid a going concern clause by raising before the one year mark.
Less money, no problems
Operating successfully beyond the going concern threshold and waiting to raise on data is precedented. Zogenix took this position in 2017 when it got down to about six months of cash by the time it generated the data. Despite what anyone would have assumed to be a large financing overhang, the stock shot up on the data, and the company quickly raised more than $250 million to fund later-stage development of its epilepsy drug. See Figure 1.
Figure 1. Zogenix, Inc.
In early 2016 Celator had only about seven months of cash when their AML data sent their stock skyrocketing nearly 600%, again, despite what anyone would have thought to be a financing overhang. The company raised more than $40 million on the back of that data and was acquired soon thereafter by Jazz for a healthy premium. See Figure 2.
Figure 2. Celator Pharmaceuticals, Inc.
There are not many examples like this because few companies have both opted to just accept the going concern clause and gone on to have positive data. Obviously raising extra cash pre-data is not what make data positive. The data will be what they will be. Rather, there’s an inverse correlation due to adverse selection; most of the companies that get a going concern clause probably tried to raise but couldn’t because investors considered their chances of success to be too low. Those who have programs that ultimately yield good data often don’t take the chance that Zogenix and Celator took, opting instead to raise some cash on whatever terms they can, often draconian ones.
Still, the examples of Zogenix and Celator prove what’s possible.
If a company that projects nervousness about getting a going concern clause ends up getting one, that’s a signal of weakness since it telegraphs that the company tried to raise but couldn’t.
But if a company is approaching a data release with sufficient capital to get through but it would require burning down to less than a year of cash and they elect to do so, then we respect their confident and principled defiance of convention. Indeed, one year is only quantitatively and incrementally different from nine months or six months of cash. And with fiscal prudence, however much cash they have may turn out to last longer than observers expect.
Challenges of getting below one year of cash
Managing a biotech company with even two years of cash can be a challenge, and going below a year of cash is certainly not easy. But neither is raising money in this market. We’re merely alerting some teams that they have a real choice. To choose the first option, management will have to work with employees, vendors, investors, and their board for them to appreciate the logic of going below one year of cash while continuing to make progress.
Employees. Understandably, employees may be nervous and even start to look for other roles when they see the company’s cash balance dwindle. But there again, two quarters of cash is worse but not infinitely worse than four quarters of cash. And even eight quarters of cash may not be enough if it does not carry the company through key data readouts. Everyone who works for small biotech companies is used to the idea that their company doesn’t have more than a few years of cash and is dependent on raising more money. They know that positive data make raising more money possible. Properly incentivized and with good communication, employees can stick it out through a key data reveal.
If the data are good, there will be more work to do and they will be rewarded through their stock options (consider issuing retention options to key employees that vest on data). If the data disappoint, then who’s kidding around? Whether the company had a year of cash or only six months’ worth, the stock will crash and employees know that they likely need to find other employment. That’s the biotech employment contract. It’s not easy but it can be made easier by informing employees that their jobs don’t change qualitatively whether a company has 12 months of cash or nine or even six.
A company will have shareholder and employee obligations should the data disappoint. These can be planned in advance. It takes an iron gut and committed finance and legal teams to model out layoffs, plan for potential severance packages, plan for lease renegotiations, and consider the wind down of trials all while remaining optimistic that the data will work out and preserving morale.
Vendors. Some vendors, in particular those with long-term contracts such as landlords, CROs, and CDMOs, will likely start asking about the company’s dwindling cash balance. Management should be direct and open with them about their plans to see the data out and raise capital if it’s positive. They should reassure vendors that they are planning for contingencies in the event of negative data and also alert them to key changes in timelines.
Investors. The CEO will need to explain their company’s strategy to investors who prefer a more conventional cash buffer. This should not be hard to explain – good data will dramatically lower the company’s cost of capital (i.e., its stock will go up). Bad data means the company will either shut down or quickly pivot to a new strategy. Companies may wonder if it is worthwhile to have an extra buffer of cash to execute on a new plan if data don’t go as expected. We would argue that companies should plan for such a potential pivot in advance and test investor interest in the backup plan well before revealing data.
Expect investors to ask “what happens if the data don’t work out?” regardless of how much cash you have – maybe some will be intrigued at the prospect of funding you in a failure scenario for that pivot. Some existing investors may be nervous that if others are not stepping up to fund you in advance of data that such data are likely to be bad. At the same time, some existing and new investors may be nervous if you try to raise in advance of data. They’ll worry that management is telegraphing that those data will likely disappoint (even though management may have no sense of how the trial will turn out). Better to share your plans candidly with investors so they can develop their own conviction. Maybe some even offer to anchor a financing before data. Our message is that, if a public company has enough cash to get to data and maybe as little as a quarter beyond that, raising before data is an option, though maybe not the best option and definitely not a necessity.
The board. The company’s board of directors will also need to get comfortable with such an unconventional approach. In considering options, the board should remember that the first principles are clear: if you have the cash to get to data, you can get to data. And if the data make you valuable, then there are many examples of just how profoundly a company’s fortunes can change in a blink. Experienced board members will know - or should know - that their duties of care, loyalty, and obedience do not, on their face, require extra capital at dilutive prices just to be able to say that their company has a year of cash beyond data. So fears of losing a shareholder lawsuit for failing to keep the company capitalized with at least a year of cash are unfounded.
What about the overhang?
One common question we’ve heard is whether it helps to raise before data to mitigate a financing overhang. Let’s think through an example with specific numbers.
Let’s say your company planned on raising 1.5 years of cash after data, when it still planned on having a year of runway on the balance sheet. If the trial is delayed by six months, then you’ll need to raise two years of cash after data to get back to where you planned. If you have a $100M/year burn rate, that’s the difference between raising $150M and $200M. For a valuable program, that’s not the difference between success and failure. It’s just a matter of degree.
As we see with the companies in Figures 1 and 2, it’s possible for investors to bid up a stock based on good data even knowing that a financing is coming.
While that’s not dispositive of the concept of a financing overhang and a company might benefit from accepting cash if it’s offered before data, our point remains that raising before data to maintain a year-long runway afterwards is not existential if a company has the cash to get to data.
By the way, private companies already know that having one year of runway isn’t special. That’s something everyone is indoctrinated into after they go public. So let’s strip it away and get back to basics. Forget the going concern clause and focus on getting to the value inflection.
If you can raise and want to raise, by all means, raise! We’re not talking companies out of trying to raise. All we’re saying is “you don’t actually have to!”
So as hundreds of companies consider their options, shrugging off the going concern clause and strutting confidently across the one year of cash mark is just one more option. We certainly won’t hold that against anyone who does so intentionally, and we think many other biotech specialists won’t either.
Checklist to prepare for gettting a going concern clause
Employee communication plan
Employee retention plan
Key vendor communication plan
Auditor engagement/check-in plan
Investor outreach plan
Contingency planning for positive data
Plan out your budget and core value proposition for the raise that will follow on the heels of positive data. What’s the next major value inflection? How long will it take to get there?
Map out which investors you’ll speak with, what financing method will you use (see below on keeping fees modest), and who you’ll work with to get the financing done.
Consider what happens if the data are positive but the stock doesn’t go up, suggesting that investors don’t agree with you that the data are compelling. Do investors have the final “vote” on what constitutes good data or can you line up strategics to be ready to act quickly in case you can’t raise all that you need to go it alone?
Contingency planning for negative/mixed data
Are there residual assets/indications that could anchor a “pivot”? If so, develop long-range financial plans to get your new story to key inflection points and test investor interest in the potential pivot. If not, consider options for becoming a shell or winding down.
Wind-down/shell plan if no financing achieved (severance packages, approach to address outstanding liabilities, plan for identifying potential merger partners become a ‘shell’).
And for when you do raise …
As you do prepare for a financing, whether before or after getting an unconcerning going concern clause, we would like to remind everyone that there are efficiencies to be gained from shrugging off a few other conventions, like the idea that one must always pay banks 6% to help you raise.
At-the-Market offerings (ATMs) can be great options for taking in reverse inquiry dollars with very low fees (talk to BofA, Stifel, Virtu, or contact any friendly person you know at RA Capital for more ideas and an introduction. Fees for reverse inquiries can be as low as 25bps and fees for open-market sales just 1%, with or without getting sell-side coverage). You can even consider a registered direct offering that omits banks entirely if you already know which investors you are likely to work with (talk to your lawyers, who can line this up).
If you aren’t sure which investors are interested in investing or even how to get on the radar of potentially interested investors, that’s indeed a pickle and you’ll want a banker to help you figure out a plan. But instead of going with a whole banking syndicate and paying 6% fees, consider going with just one or two banks and paying them the same as they would have ordinarily made but lower fees overall (i.e., if your lead left bank would have made 40% of 6% of $100M, which is $2.4M, then you would think they would be psyched to get 100% of 2.7% to do the deal on their own). You’ll sacrifice some extra coverage, but in thise market you really have to consider whether having more analysts write their own versions of the same thing is more valuable to you than saving several million dollars.
These small amounts add up. All the public development stage companies under $10B in market cap collectively burn about $60B per year, which means that a difference of 3% fees is $1.8B/year. If it costs about $3-4B to launch a drug, then caring about fee differences as small as 3% means we could bring an extra new drug to market every two years. It’s not nothing.
The little efficiencies matter. For example, you can save money on D&O insurance by not overpaying for more coverage than you need (e.g., call Mike Milligan for a tutorial and quote – contact info at bottom of that article). We estimate our industry could launch an extra drug every three years by cutting about $1B/year of waste from what just the public companies pay for D&O.
We think that attention to these little efficiencies speaks to a management team’s and board’s approach to the details of everything.
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Further Reading
