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SWORD Financing of Innovation in the Biotechnology Industry

Michael E. Solt
Financial Management
Vol. 22, No. 2 (Summer, 1993), pp. 173-187
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665868
Page Count: 15
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SWORD Financing of Innovation in the Biotechnology Industry
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Abstract

A financing arrangement known as stock warrant off-balancesheet research and development (SWORD) has been used recently in the biotechnology industry to finance innovation. Innovation is important to biotech firms because it provides the competitive edge necessary for survival, yet it is very risky because of the uncertainty about the commercial viability and regulatory approval of new products and technologies. Biotech firms are so small that they cannot diversify this risk internally across projects, and conventional internal financing of innovation is generally not possible because biotech firms tend to be lacking in both profitability and cash resources. Since a SWORD is offered to the investment public, the innovation risk can be diversified across many investors and their portfolios. The SWORD technique may lead to a more efficient allocation of the risk of innovation over the financial markets. The primary objective of this paper is to show how a SWORD can promote innovation in a manner not possible when more conventional financial management techniques are used because a SWORD structures the innovation as a real option. While conventional capital budgeting is like an ex ante commitment to the untested technology, a SWORD's license option agreement, which is the real option, permits the commitment to be made ex post. A SWORD provides a biotech firm with greater control over the developed technology and its own future survival. It has a niche as a special, all-equity form of project financing for R&D that is nearing the implementation stage. Since 1988, several biotech firms have used a SWORD to set up a new, separate R&D organization whose financing comes from a public units offering, consisting of one share of the new venture common stock that can be called by the parent, and one warrant to purchase one share of common stock of the parent firm. The cost of a SWORD's flexibility is the dilution that occurs when the warrant is exercised. The warrants are intended to align the incentives of the investors and managers and to signal that the new venture has value because the current shareholders are willing to share the value of assets in place. Rather than being an indication of adverse selection, the warrants simply entail a cost that current shareholders must bear if they want the R&D to proceed. The SWORDs for ALZA, Centocor, Immunex, and Genzyme are examined in this paper. The stock market reaction generally is positive for each SWORD, allaying fears that the potential for adverse selection renders the SWORD valueless. Two-day abnormal returns around the SEC registration and trading dates are typically between 3.85% and 5.84% for ALZA, Centocor, and Immunex. For Genzyme, the registration date results produce the largest (positive) one- and two-day abnormal returns. However, the Genzyme trading date abnormal returns are the most negative of the four, but this is recovered over the next two days. The market's positive response suggests that the SWORD R&D is perceived to be valuable. ALZA and Genzyme experience a significant decrease (at the 0.01 level) in variance both around and after the SWORD announcement. Centocor also exhibits a similar decline in variability, but the decrease is significant only during the announcement period. The variance increases for Immunex, and significantly so in the post-announcement period. At best, these results moderately support the contention that these SWORDs enhance their parents' survival value. Non-SWORD events affecting Centocor and Immunex underscore the large impact of the unsystematic risks found in the biotech industry and the importance of property rights and regulatory approval. While the analysis indicates that the four SWORDs examined here are expected to produce valuable R&D, each future SWORD should be judged on its own merit because the possibility that SWORD investors face potential adverse selection cannot be eliminated a priori. Yet, the sagas of Centocor and Immunex turn more on riskiness than asymmetric information. The benefits and usefulness of the SWORD arrangement can only be obtained through proper recognition of biotech risk. This paper focuses on biotech firms, but SWORD financing is likely to be successful in other situations, such as when product development is technical in nature or obtaining financing is difficult because of the large risk of the product development or because of firm size. The contractual relations imbedded in a SWORD are likely to be most important when control over manufacturing and marketing rights is central to the firm's future performance.

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