Elan may pay a premium to cut R & D risk

HOW would you like to set up a new company, raise £56 million to fund it, yet have no equity interest in it? Not very enticing, is it?

However, add the following riders, and it takes on a warmer glow. You get fees for development and other services from the company. If the new company fails you lose nothing. But if it looks like being successful, you exercise an option to acquire it.

As the often hackneyed phrase has it, it could only happen - in the US and that is exactly where Elan Corporation, the Athlone based pharmaceutical group, is going with its latest proposal to raise $90 million (£56 million) for a new research and development project. The full details were circulated at the end of last week to potential shareholders. The offer closes on November 18th but it has already been underwritten by Merrill Lynch & Co.

The funding is, in effect, a form of delayed rights issue. If the R&D works, leading to new product sales, thereby triggering the execution of an option, it will prove to be an expensive form of rights issue.

The new company, Axogen, is to have a public share offering and its stock will be traded on the New York Stock Exchange. The document reveals that the 10 cents shares will be issued at between $19 and $21. Elan will have to pay a "substantial premium" if it exercises the options.

If the R&D programme looks like be in a success, it could be in Elan's interests to exercise the option early, rather than later. If the offer price of each share is $20, then the option would cost $34.56 before January 1st, 2000, that is a premium of $14.56, or 72.8 per cent. This rises to $45 if the option is exercised before January 1st, 2001 and to $61.04 if it is exercised between January 1st and December 31st 2001.

It is clear this is a very expensive form of rights issue. If the option is exercised at the final date, the premium would be a heady 205 per cent. In cash terms, the cost to Elan would be $280.8 million. This is bound to prompt some investors question this form of financing.

However, these are the types of potential premiums that would be needed to encourage investors in the US to take a share in what is essentially a high risk venture. Indeed, the risks are highlighted in the prospectus.

It notes that the development contract, purchase option and service agreement were approved by Elan, as the controlling shareholder of Axogen "which, in such capacity, may have influenced the board of directors of Axogen to enter into such agreements". Also, the development contract "was not negotiated on an arm's length basis and Elan and Axogen did not retain separate counsel in connection therewith. In particular, the board of directors of Axogen may have been influenced by Elan, as the controlling shareholder of Axogen, in entering into the development contract".

Under the development contract, Axogen will have to pay Elan a royalty equal to 60 per cent of the net sales of any product sold. Elan will receive a 9 per cent margin on the development expenditure. Under a service contract, Axogen will pay Elan a quarterly fee of $100,000.

However, it will not be a one way traffic. Elan is putting in four products that have gone past the pre clinical testing stage. If Elan sells any of the products outside the US, it will pay Axogen 4 per cent of net sales and 30 per cent of ancillary fees.

Axogen has a clearly defined focus. It was formed to develop therapeutic products for the treatment of neurological disorders. Its primary focus will be on multiple sclerosis, but it also expects to develop products for other neurological diseases and disorders.

All the proceeds from the offering wild be used to undertake clinical testing, final product development and the sale of the products under a development contract with Elan, and its wholly owned subsidiary, Athena Neurosciences. Elan and Axogen will each have certain licensing, manufacturing and marketing rights to the products.

A cash flow statement shows that Axogen will spend $2.7 million this year, $26.4 million in 1997, $29.4 million in 1998, $20.4 million in 1999 and $11.1 million in 2000. The phasing of this expenditure should favour Elan. Most will have been expended by 1999, so it should have a clear idea, by then, if the products are marketable.

The funding of R&D by way of a deferred rights issue is expensive. However, it accelerates its development programme, it gets rid of the risk element and, on balance, it makes commercial sense.