In Biotech, Bad Management Trumps Good Science

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"Honesty and reliability, including full and accurate disclosure of corporate results, achievements and expectations, is a fundamental condition of good management, which investors must be able to rely upon as a condition of investing."

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Not long ago we were approached by a publicly traded biotech company to participate in a financing round it was pursuing. A look at company management revealed that the CEO had left his previous company after being reprimanded by the Securities and Exchange Commission after filing false and misleading statements regarding the achievements of his company. We unhesitatingly declined to participate.

There are a fair number of incidents in which the management of a company will misstate its scientific achievements. In some instances, public company executives "take cover" behind "safe harbor" statements to exaggerate a company's reasonably anticipated results. "Safe harbor" statements, presented at the beginning of a public company presentation, warns the public that the company's "forward-looking statements" should not be taken at face value.

Since there may be an element of uncertainty about the results of a clinical trial, statements contained in a presentation may be incorrect and should not be relied upon unquestioningly. Under this pretext, some executives will knowingly overstate reasonable corporate expectations as to future results. This is not infrequent in the world of corporate biotechnology, where expectations of successful clinical trial results directly affect the company's stock price and its ability to raise money. It may be argued that such misstatements are made to protect the positions of existing shareholders, (including management and the board of directors), but this is absolutely no excuse for deceiving the public. Honesty and reliability, including full and accurate disclosure of corporate results, achievements and expectations, is a fundamental condition of good management, which investors must be able to rely upon as a condition of investing.

Overcompensation Stifles Company Advancement

Of similar importance to investors is comfort with the dedication of management to advancing the science of the company, as well as the interests of the shareholders, ahead of management's self-interest. A natural starting place is executive compensation.

A top executive in a small biotech company faces many challenges and deserves to be adequately compensated both in the form of salary and stock options. As to salaries, there are no absolute guidelines, but investors should be comfortable that executives are not being paid disproportionately relative to the resources of the company. For example, a recently discharged biotech executive was earning $350,000 per year for many years while his company languished with a shrinking market cap and diminishing resources. During this period advancement in the clinical trial process was minimal, despite the reasonable expectations that the science addressed an unmet need and showed great promise. Part of the reason for the lack of favorable results was insufficient funds to finance the clinical trials. The absence of sufficient financing was based in large measure on the unreasonably high valuation placed on the company in negotiations with potential investors. The unreasonable valuation was based in large measure on the desire of the CEO and his cronies on the company's board to protect ownership of a high percentage of the stock, as well as their control of the company. This dominant position had been achieved as much through the award of large numbers of stock options as through purchase of company stock at low prices in earlier investment rounds. Like executive salaries, the award of stock and stock options should be based on the achievement of significant milestones.

How does such overcompensation of key executives in salary or stock come about? Salaries and stock option rewards are supposed to be governed by a board of directors elected by shareholders. In particular, personnel and audit committees of the board are supposed to be headed and controlled by independent directors who are not part of management and are beholden only to shareholders. In reality, in too many instances, the supposedly independent directors are management cronies or are fearful that if they stand up to management they will be replaced as soon as conveniently possible by other supposedly independent individuals who will bend to management's will.

Board members are easy to find since board membership is usually amply compensated. Typically, management plays the key role in the selection of board members, and an understanding that a condition of election to the board is serving interests determined by management need not be explicit. While overcompensated management may act effectively in managing and advancing the scientific development of the company, it is important that compensation be proportionate to achievements and to the company's resources. The avarice of key managers to secure the lion's share of the financial success of a company often results in unwillingness on the part of investors to support the company's efforts, and thus starves the company of much needed financing.

Skill in the Lab Does Not Necessarily Translate to Running a Company

Another reason for failure of biotech companies (as well as other scientifically based enterprises) is management incompetence. It is understandable that an inventor will want to control and protect the development of his or her brainchild. Unfortunately, skill and ingenuity at the laboratory bench are not always matched by skills in running a company. The management of personnel, negotiation of agreements, management of the complexities of the clinical trial process, understanding the workings of the world of finance and countless other issues, which managers must confront daily, are often beyond the purview of good ^+or even great^+scientists.

One factor that can be a source of problems is scientific ego. A scientist used to being the smartest person in the room may be unwilling to take guidance on management issues from lesser mortals. This can be fatal to development and commercialization of even the best science.

Even decisions involving the science itself can be problematical. When a company is formed around an important new scientific development, not infrequently the science may need further tweeking before it is ready to enter clinical trials. Frequently a drug that provides therapeutic benefits is taken into the clinic before other, potentially more potent drugs, are ready. The drug pipeline of a company can continue to grow through later development while earlier drugs are moving through the clinical trial process. In a few instances, however, a scientist will tell the world, "This drug is 80% effective, but if I had another year and another million dollars, it would be 100%." A year and a million dollars later, the scientist says, "The drug is now at 90% but if I had another million and another year, it would be at 100%."

As time and money are expended, the asymptote continues to grow closer to the 100% access, but never seems to reach it. Smart management keeps the company moving forward by adding to the pipeline as new drugs develop, but earlier drugs that have shown significant efficacy are moved forward in the clinical trial process.

It's Not Just the Scientists

This does not suggest that scientists as a class are incompetent corporate managers. Many scientists bring their brilliance at the bench to the tasks of running a company, with the ability to hire others who bring knowledge and skills they do not possess to a company.

Indeed, management ignorance and incompetence are widespread among nonscientists. Management of a biotech company is a particularly complex and difficult task requiring the knowledge and skills to manage drug development, clinical trials and company finance, as well as personnel management and a host of other issues. A capable manager in a biotech company, like an able manager in any other type of enterprise, will recruit a team capable of handling complex issues within necessary fields of expertise.

Experience in biotech corporate management is certainly a factor. Even management of an unsuccessful company can be a valuable source of experience if the executive learned valuable lessons from the failure.

Not the least of the skills required by a successful manager is an understanding of the world of finance. Several years ago, a successful bioscientist with promising preclinical technology in the field of cell biology was visited by a pair of Wall Sreet stock manipulators who convinced him to put his science into a publicly traded vehicle. They then proceeded to raise a lot of money through aggressive retail stock sales to the proverbial "little old ladies." Much of the money went into their pockets, and after a short time the stock price collapsed. Such "pump and dump" schemes can destroy a company and severely damage the reputation of the scientist and his work.

The lesson to be learned is that an investor must look beyond the science, as exciting as it may seem, and explore in depth the capabilities of the management team expected to carry it forward. That is why smart investors undertake an extensive due diligence process. Investors must be reasonably satisfied that bad management will not trump good science.

Stephen Nagler
MedPro Investors LLC

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