Ken Schaner Answers Follow-up Questions on Venture Philanthropy

Ken Schaner provides additional insight on venture philanthropy deal-making in follow-up to his March 18, 2015 presentation with FasterCures:

http://fastercures.tumblr.com/post/116036333994/answering-your-questions-on-venture-philanthropy

 

Q: At what thresholds of funding do different levels of acceptable “asks” come into play? How is this landscape changing?  

A: To properly answer this question one must distinguish between provision of funding to academic research centers and funding of bio/pharmaceutical companies.

The academic researcher undertakes basic pre-clinical research, usually pursuant to a defined research program to be funded by one or more entities. The research program may result in an important invention. If so, the state of the science will have been advanced and the invention will be handed off to a third party licensee in return for a license fee paid to the researcher’s institution. Though the invention may be important, even scientifically startling, the effort generally ends before the much higher expenditures associated with clinical research and development begin. Thus, the academic award may be a material or even majority of the funding that produced the invention.

 A charitable award to a bio/pharmaceutical company, on the other hand, may be only a tip of the iceberg, because the clinical steps, particularly those after phase 1, are very costly.

Foundations should apply different principles in formulating their “ask” for a Return on Investment (“ROI”):

        (a) Academic Grants. We recommend two alternative forms of an ask in an academic grant:  (i) charitable funders should receive a portion of the revenues received from an invention that is in the same proportion as the awarding foundation’s funding to the academic institution bears to total direct costs incurred by the academic institution in connection with an invention. Thus, if the foundation’s funding was $50 and the total cost of the invention was $100, the Foundation would receive 50% of any resulting revenues. In order to avoid the results of the above according the charity the entire share of any revenues received, for example, if it funded all of the costs that resulted in the invention, we usually include a minimum return for the academic institution. Such minimum might be 30-50%. If the foundation’s award constituted 100% of the expenditure for the invention, the university would still get the agreed upon minimum. Universities often try to impose a cap on the awarding foundation’s ROI, such as 5X, but there is no reason for the awarding charity to accept a cap since the charity bears most of the financial risk. (ii) Another simplified version of the “ask” is to merely accept a pre-determined percentage of any revenue. Thus, for example the awarding foundation might specify in advance that it would receive 25% of any resulting revenues. While 25% might result in a lower percentage of revenues than the proportionate method, it eliminates the accounting complications of the proportionate method.

        (b) Bio/pharma awards. Determining the ask in a bio/pharma award is more complicated because the development process is likely to be longer and the amounts provided by the charity, while usually greater than academic awards in absolute terms, often constitute a lower percentage of the overall development costs expended by the awardee. However, it is important to note that most bio-pharma awards are made by the charity at the riskiest stages of technological development, when funding from private parties often is not available. Many people call this risky stage the “Valley of Death.”

There are many factors here that determine the ask. Below are some rules of thumb:

  • For pre-clinical awards of less than $5MM, we usually recommend an ask of 4-6X with two bonus X’s at various sales levels. Since the amount of the return is limited by the above multiple, the size of the award should not affect the requested multiple. However, as a practical matter, the larger the award the more leverage the awarding foundation possesses in its ask;
  • For later stage funding, the ask is usually lower, within the 3-5X range.
  • For awards in excess of $5MM, we recommend asking for an uncapped percentage of net sales. There are many facts and circumstances that go into what the percentage should be and you should work with your attorney and financial advisors to formulate the percentages. However, I would re-emphasize that all or some part of your return should not be capped in order to allow you to capture the upside of a successful therapy that your organization funded, particularly when such fundings come at the riskiest stages of development.

        © Interruption Rights. There is much more to write about the non-financial aspects of your ask, but I cannot emphasize enough that it should provide for a remedy in the event your awardee shifts priorities to other research/development, or financial difficulties, e.g. bankruptcy, force a cessation in its development activities for your product. Since the principal goals of most disease charities are to fulfill their charitable missions by fostering new therapies, charities must reserve a remedy if a potentially valuable therapy funded by the charity is stuck on the shelves of the academic institution or bio/pharma.

Q: Would a charitable organization that is considering pursuing venture philanthropy need to create a new organizational entity in order to make investments in companies?

A: The answer is no, if by “need” you mean legally required. Many charitable organizations pursue venture philanthropy directly, without creating special purpose affiliates. I don’t have to go far afield to give you some examples: The Leukemia and Lymphoma Society (LLS) is one and Lou DeGenarro, its President, spoke on the FasterCures Webinar about the very significant venture philanthropy activities in which LLS is engaged. Other examples of notable charitable organizations that have not created new venture philanthropy entities include JDRF and the Michael J. Fox Foundation for Parkinson’s Research.

The disadvantage of creating a new entity is that it adds some administrative burden in maintaining the separateness of the additional entity.

However, notwithstanding this added burden, a significant number of charities have created new entities through which to conduct their venture philanthropy activities, among them: the Cystic Fibrosis FoundationFoundation Fighting Blindness, and Autism Speaks.

The advantages of establishing a new entity are as follows:

  • If separateness is maintained, the new entity creates an additional barrier to liability exposure.
    • Generally liability exposure is somewhat greater in the context of venture philanthropy activities, especially if clinical trials are being conducted and particularly when the charity acts as a sponsor of the clinical trials.
  • The new entity also offers the opportunity to attract new leaders to the charitable organization who may have specialized skills in the bio/pharma business, but who may not be willing to serve on the main board.
  • The new entity provides a focus on translational research that may not be possible in the context of the many administrative, fundraising, etc. issues faced by the principal entity.

New separate entities are easy to form. Generally single member LLCs are used and, since these are disregarded entities for tax purposes, there is no need to file an additional exemption application to the IRS. The LLC receives its tax exemption derivatively from the principal organization.

Before advising clients to form a new entity, we examine with our client the liability protection and other benefits afforded by a separate affiliate and weigh these against the extra costs that come with maintaining a new entity.

Q: For program-related investments, how do royalty-based transactions differ from equity-based transactions? In regard to maintaining nonprofit status for a charitable foundation as well as the effect on fundraising ratios?

A: The form of investment does not affect whether the subject matter of the transaction is charitable or program related for IRS purposes. A program related investment can be royalty based, involve the purchase of equity in the funded entity, debt, or in some instances, transactions in which we have represented clients involve a combination of royalties, equity and/or debt.

Usually the transaction is related to the funding entity’s charitable mission, so in most instances it will be considered program related, provided that the charity includes certain public purpose provisions in the transaction, so that the returns, whether in the form of royalties, interest or capital gains, will be excluded from unrelated business income tax. However, I would note a caveat about later stage funding: there are some examples in IRS rulings of activities that have not been found to be program related because at the later stage of development at which the funding was made. In such instance, the IRS concluded the funding looked more like an investment and less like a charitable activity. However, this issue comes up infrequently since most charitable funding involves early stage/Valley of Death activities. Nevertheless, if your charity is considering a later stage funding, you should consult with your attorney to get an assessment of the risks that the investment could be viewed by the IRS as not mission related and the consequences of such a determination (it is not always fatal even if such occurs).

Notwithstanding the above, most charities choose to make venture philanthropy funding on a royalty basis. The reasons for this are two-fold.

1. First, from an accounting standpoint, equity based investments, even those related to the organization’s charitable mission, are generally treated the same as if the charity was investing in stock for its endowment.

  • The following example illustrates the potential accounting difficulty that can arise from an equity based transaction. Assume that Charity A wishes to maintain a fundraising ratio of less than 25%. In 2015, A raises $100 and has fundraising and administrative expenses of $20. In 2015, A spends $20 for funding academic research and spends the remainder of its available funds, $60, to fund early stage research through a start-up company in which it receives preferred stock in return. As the accounting rules are generally applied, the $60 equity investment would be treated as a capital expenditure and excluded in determining A’s fundraising ratio. Thus, for 2015 A’s administrative and fundraising ratio would be $20/$40, or 50%, obviously a ratio far exceeding A’s goal. If to the contrary, A had chosen to make its venture philanthropy investment on a royalty basis, the expenditure would have been treated for accounting purposes as program related and its fundraising ratio for 2015 would have been $20/$100, or 20%, well within A’s goal.
  • Of course the above is a highly simplified example, and charitable organizations often make equity based investments in combination with other investments that in the aggregate such investments do not have the dramatic adverse effect illustrated in the example.

2. Another possible disadvantage of equity based investments is the effect on the financial statement if the funded research fails and the stock received no longer has value, which very often is the case. This loss of value would be reflected on the funding foundations income statement, while a similar research failure in the event of a royalty based investment would not be shown.

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The above questions are all quite astute and deserve more in-depth discussion of various issues. Since FasterCures asked me for succinct answers, the above responses must necessarily be in summary form and cover only the most obvious issues. All issues should be considered in the context of the unique facts and circumstances presented.