Investment in the pharmaceutical and drug development sector is, as we’ve already discussed, largely driven by the advancement and de-risking through the phases of clinical trials.
It sounds so simple, though along the way there a variety of value triggers and inflection points that can provide opportunities for investors.
Clinical trial progress
Plainly, the successful conclusion of clinical trials presents an obvious catalyst.
READ: This is how you should be valuing drug companies
Both the chance of success and the value of a new drug entity improves once each of the clinical developmental milestones is successfully negotiated.
Similarly, failure in this regard can be terminal for a company.
Charity or government funding
Not only does this stave off the need to tap the market for additional cash, it provides third-party validation of the asset.
In other words, a bunch of independent scientists will have taken a look at the drug candidate and deemed it to be worthwhile recipient of funds.
Regulatory intervention
The FDA in the US and the EMA Agency here in Europe can, in certain circumstances, circumvent the normal approval process in order to get a drug to market earlier than it might under normal protocols.
This is an immediate kicker to the valuation of the compound or molecule, although the market is often slow to react to this sort of news.
It is because the processes are often nuanced and conditional on certain R&D hurdles being negotiated along the way.
Licensing Deals
It is a rare occurrence for a small-cap company to take a drug candidate from first principles to and through the arduous process of pre-clinical testing, then clinical development and right through to regulatory sign-off.
In the US doing this is called hitting a home run.
Success stories in the States are more frequent than they are here in the UK – and notably the likes of Amgen and Gilead chartered the pathway to grow into multi-billion-dollar giants of the drugs arena.
Here, success is measured by whether a drug developer can find a partner willing to do the heavy financial lifting associated with late-stage clinical trials.
Deals of this ilk are by far the biggest value catalyst for the ambitious drug developer.
We have seen transactions that have been that are worth hundreds of millions of dollars.
Dilution
Small-cap healthcare stocks are by their nature prodigious cash burners. Clinical trials don’t come cheap. Some companies are hybrids with a cash generative arm that funds the R&D effort, but, those are the exception rather than the rule.
In the main, fledgling drug developers will come to the equity market for funds at multiple intervals to replenish their coffer. Investors in the sector must be aware of this. Raising even small tranches of funding is problematic, requiring a significant discount to the prevailing share price to tempt investors to take part in a funding round.
Arguably, there are two types of dilution – which we’ll imaginatively label good dilution and bad dilution. Bad dilution is quite easy to spot, you’ll quite likely know it when you see it.
It is when a company starts down the slippery slope of issuing shares at ever lower prices, or are forced to keep coming back for capital because they end up raising sub-optimal sums without sufficient value creation between placings.
An example of good dilution is where the company is issuing stock at a small discount to the prevailing market price, and ideally at a much higher-level price than was achieved in the last funding round.
In this case, the coffers are full enough to fund the clinical work in the pipeline plus enough left over to survive for 12-18 months afterwards. The latter point is an important one.
Having enough money to survive often protracted discussions with would-partners strengthens the hand of the smaller company through what are often uneven negotiations.