Top five corporate and tax considerations for early-stage and spin-out biotech companies

In this first article of our three-part series, we focus on the key corporate issues that founders should consider when establishing and operating an early-stage / spin-out biotech.

1. Founding equity

One of the first and most important steps in forming a biotech company is determining how founding equity will be allocated amongst the founders and any research institution which is contributing IP. Equity allocation should reflect both the expertise each founder brings and their expected future contributions, including time commitment and ongoing involvement with the company. Founders should also engage early with the relevant technology transfer office to understand the research institution’s expectations around equity.

At incorporation, consider adopting a tailored set of articles of association or entering into a simple shareholders’ agreement, rather than relying on the default model articles, to “lock-up” the company and prevent founders from selling their shares to third parties. Also consider including mechanisms for reclaiming equity from founders who leave the project early or otherwise decrease their anticipated contribution.

2. Tax considerations on incorporation / spin-out

The Employment Related Securities (ERS) tax regime applies when shares are issued to founders who are (or will become) directors or employees. This means that employment tax charges can be triggered if the price paid by a founder to acquire shares is less than the market value of the shares (i.e. there is a ‘discount’). Income tax (and potentially NICs) arises on the discount at the time the shares are issued. Future employment tax charges can also arise if the founder’s shares are subject to ‘clawback’ provisions or other restrictions affecting the value of the shares. In order to prevent those future charges from arising (at a time when the shares could be very valuable and the resulting tax liability very high), it is possible to elect to be taxed ‘upfront’ on the value of the shares as if no restrictions apply.

As a result of these tax rules, it is generally always advisable to:

1. get shares into the hands of founders as early as possible – ideally on incorporation but certainly before the company has any demonstrable value - so as to minimise the risk of upfront tax charges; and
2. ensure that a ‘Section 431 Election’ is entered into between the employing company and the individual within 14 days of the shares being acquired in order protect against future tax charges.

Any subsequent reallocation of equity which results in an employee or director acquiring more shares or any steps that ‘artificially increase’ the value of an employee or director’s shares could also trigger ERS tax charges.

Academic founders involved in the underlying IP may benefit from academic spin-out relief, which excludes the value of the IP from any ERS charge that is triggered on acquisition of shares or on a later increase in the value of the academics’ shares when the IP is acquired by the company. This relief often alleviates ERS concerns on the formation of a spin-out but is narrowly focussed to academics involved in the IP creation. The position for non-academic founders should always be carefully considered.

3. Navigating the investment climate

It’s clear that securing investment is challenging in today’s market. We appreciate founders are well aware of those challenges, but we set out below a few tips for managing the process:

• Be realistic in your business plan – overly ambitious plans and projections can lead to difficult conversations later. A grounded, achievable plan builds investor trust and will provide comfort to the founders when they will inevitably be required to provide warranties as to the business plan as part of the investment.
• Expect delays – the investment process, from initial discussions to signed term sheets and final equity documents, often takes longer than anticipated. Stakeholders in the process may simply not be able to move as quickly as you want them to, and that is often a function of their internal approval processes rather than any intended negotiation strategy.
• Stay organised – whilst more relevant for companies past the seed fundraising stage, keeping your house in order will help streamline the due diligence process with your prospective investors. Keep key documents – collaboration agreements, employment and consultancy contracts, equity investment documents – well-managed and accessible.

4. Governance and compliance

Once investment documents are signed, it’s likely that the company will be subject to various obligations, including complying with investors’ information rights and post-closing undertakings, and the investors/their appointed directors will have veto rights over certain matters. Establish internal workflows to ensure compliance with these obligations and avoid inadvertent breaches. For example, it can be helpful to remind directors of veto rights at the start of board meetings to ensure necessary consents are obtained before decisions are made.

As the company grows, so will its legal and contractual responsibilities, particularly, for example, when work starts in the clinic as the company starts collecting significant patient data. Investors will expect robust governance and compliance systems to be put in place. Budget for the time and resources needed to meet these expectations, including legal support and internal systems for tracking obligations.

5. Leveraging success

The traditional biotech path – taking a candidate through clinical trials and exiting via IPO or acquisition – is no longer the only route to success. Founders should consider alternative strategies that align with evolving market dynamics:

• Out-license earlier-stage assets – pharma companies are increasingly willing to invest in earlier-stage technologies, making out-licensing a viable option even before the technology / platform has been validated in the clinic.
• Spin out separate technologies – if developing multiple platforms or targeting multiple indications, consider spinning out new entities to attract targeted investors and maximise value.
• Monetise royalty streams – if you have already out-licensed IP, explore ways to unlock value from those agreements, such as selling future royalties.

Conclusion

Navigating the life cycle of a biotech company can be incredibly rewarding, with successful entrants to the market bringing real change to the lives of others, but there are challenges on the way to success which need to be overcome. By addressing the issues above, founders can build a strong foundation for growth and resilience and put themselves in the best position for future fundraising, the road to exit and, crucially, positive patient outcomes.