Print BCTV: Death & Taxes -- Creating tax incentives for patient capital investing in R&D startups

Death & Taxes

Transcript of BioCentury This Week TV Episode 156

 

GUESTS

 

Jeff Hatfield, President and CEO, Vitae Pharmaceuticals,

Michael Grisham, Chairman of Virginia Bio

Chris Ohmes, Partner, National Tax Federal Tax Services, Ernst and Young.

 

PRODUCTS, COMPANIES, INSTITUTIONS AND PEOPLE MENTIONED

 

Commonwealth of Virginia

Internal Revenue Service

NIH

Health Diagnostic Labs

Enbro

Remicade

Genentech

Amgen

Biogen

GPB Scientific

JOBS Act

Coliation of Small Businesses

IRS Code: Sections 469, 382 and 1202

STTR Grants

 

HOST

Eric Pierce, Publisher

 

SEGMENT 1

 

STEVE USDIN: Death and taxes are inevitable, but biotech's looking to get some tax relief from Uncle Sam for young innovator companies. I'm Steve Usdin. Welcome to BioCentury This Week.

 

NARRATOR: Your trusted source for biotechnology information and analysis, BioCentury This Week.

 

STEVE USDIN: Two constants are death and taxes. But many R&D industry startups face death before taxes. Unless investors are willing to finance years of losses, technologies that could transform health and society die on the vine.

 

Now biotech and other members of the Coalition of Small Business Innovators have a plan to change this picture. They want to relax provisions of the tax code that they say are keeping capital at bay. The three proposals would allow investors to offset their taxable income through their investments in loss-making R&D companies.

 

How much could they help? The accounting firm Ernst & Young estimates these changes would spur $20 billion of investment and create more than 600,000 jobs. The Coalition's optimistic proposals could improve the climate for startups akin to what the JOBS Act of 2012 has done for IPOs.

 

But is it doable? The Coalition says all three measures are simply tweaks to existing law. However, if Congress fails to take on overall tax reform, these proposals could disappear as well. Today my colleague Eric Pierce explores the Coalition's prospects.

 

ERIC PIERCE: Today I'm joined by Jeff Hatfield, President and CEO of Vitae Pharmaceuticals, a privately-held drug discovery company, and Michael Grisham, Chairman of Virginia Bio. We're also joined by Chris Ohmes, a tax partner at Ernst & Young.

 

Jeff, I'd like to start with you. You're a CEO of an innovative company. You are also a Bio board member. And you're very close to the tax reforms. Let's build the case for biotech tax reforms. Why does biotech tax reform need changing?

 

JEFFREY HATFIELD: So innovation is happening faster than ever. We're delving into more and more complex fields that hold so much promise for the future. As we do that, the research becomes more complex. It's taking more time. It's more capital-intensive. At the same time, the number of private investors, venture capitalists, are dropping in their support of seed an early-stage companies.

 

Now, there are some clear things that can be done to boost the attractiveness of high research-intensive companies that are pre-revenue to be able to reignite that growth, much the same as the JOBS Act has reignited the IPO markets for small businesses that are starting to really blossom.

 

ERIC PIERCE: So this is to really be a catalyst to that, could attract more venture activity into early-stage innovative companies?

 

JEFFREY HATFIELD: Exactly.

 

ERIC PIERCE: Michael you actually are a serial entrepreneur. You had a company that actually benefited from an R&D tax credit. Talk a little bit about your experiences there.

 

MICHAEL GRISHAM: Well, in the Commonwealth of Virginia, we have done a lot to really improve the climate for business and for innovation and for early-stage startups. And the General Assembly recently passed what we call an angel tax credit, which allows for companies in early formation, i.e. they've raised less than $3 million, where the investors that either put in equity capital or subordinated debt can get a 50% tax credit, i.e. get half of that refunded back in the next year's tax. And that was very instrumental in us being able to raise a key amount of seed capital to achieve a milestone to then attract more sophisticated investors. And so--

 

ERIC PIERCE: And that was your own company that you had started.

 

MICHAEL GRISHAM: Yes, a company called GPB Scientific. And it was very instrumental and had a group of angel investors in northern Virginia and then down in Richmond. And that was the catalyst, or forcing unction, allowed us to close the financing and move the company forward.

 

ERIC PIERCE: But Chris, Ernst & Young, you guys just did a report on the economic impact of these R&D tax reforms. Why don't you top line what you guys have found out?

 

CHRIS OHMES: I think there's a couple of things to say there. The EY QUEST Group report looks at some of the economic benefits that might be derived from the proposals that are out there to help small startup companies receive additional investments and attract seed capital. And they found the three specific proposals that were analyzed, if you put them together, would generate about an additional $20 billion in economic activity in the United States annually, which is substantial.

 

ERIC PIERCE: It is. What's the duration? $20 billion over the next five years, or --

 

CHRIS OHMES: The way they put the report together, this is an annual set of savings as long as the incentives remain in place and people can count on them, which has been something of a difficulty with research incentives over the years. But as long as they remain in place, they continue to have that effect on an ongoing basis.

 

ERIC PIERCE: And you work with a lot of companies on the existing R&D tax credits presently. A lot of companies just don't take advantage of them. Explain.

 

CHRIS OHMES: Well, so, particularly when you talk about small, research-intensive companies, everyone is dedicated to developing the technology. You don't have people who are preparing the records that are necessary to use the R&D credit x number of years down the line when you become profitable and start paying tax, because x might be a fairly long period of time. And so what happens is, in effect, the information gets lost in the process. And so the data is not there to enable the companies, when they ultimately get around to paying taxes, to go back and capture the carry-forward effect of all of those benefits.

 

ERIC PIERCE: So it's really a housekeeping issue. Jeff and Michael, you guys are running companies. Is that an impact for you?

 

JEFFREY HATFIELD: Yeah. I think those numbers are exactly right. And here's how I think about it. These small companies that we're talking about are research-intensive. They're pre-revenue. They may not see revenue in their company. They may not see profits in their companies for five years, 10 years, 15 years. I mean, my company has been at it 10 years now, and we're still years away from generating revenue.

 

So tax benefits that help at a revenue state aren't going to do anything for these incubators of the breakthroughs of tomorrow for years and years. The opportunity -- and by the way, those kinds of companies, like mine, face life-and-death experiences trying to fuel their innovation, draw in enough capital to keep them going. And that economic benefit is what happens when we ensure that the breakthroughs that really make the difference in the future are funded, that it's an attractive investment for people to bring capital in. And that's why those are spot-on, I think. Certainly for us, it would be.

 

ERIC PIERCE: Great. Excellent. More in a moment. But first, let's take a look at Ernst & Young's analysis of the investment impact for these three key tax reforms.

 

NARRATOR: You're watching to BioCentury This Week.

 

SEGMENT 2

 

ERIC PIERCE: So what are the specifics of tax reform for innovator companies? Let's find out more from our panel. Jeff, these tax reform initiatives that are gaining some traction, these are really small changes to some existing laws. We're really not talking about watershed new legislation here.

 

JEFFREY HATFIELD: That's exactly right, Eric. In fact, it's only restoring the legislation to its original intent by Congress. It's fixing changes that have happened, either inadvertent impacts of other legislation or what have you that have made them less effective. And for example, the first one, Section 469, which is about R&D partnerships, this was a tool that was incredibly effective at allowing companies like Genentech, Amgen, Biogen, to become the household name successes in biotech that they are today. These were utilized extensively back in the '80s. And now they've lost their effectiveness through other legislation, but it has to do with passive-activity loss.

 

ERIC PIERCE: And those, just to top-line it, those partnerships, those were the off-balance-sheet type of partnerships that we were talking about?

 

JEFFREY HATFIELD: They were discrete units that were invested in -- separate from the core of the company -- that's exactly right. But individual investors were drawn into that and were able to recognize the losses at that time rather than holding for 10 years.

 

ERIC PIERCE: So it's a way to accelerate the loss recognition for the investors.

 

JEFFREY HATFIELD: That's correct, yes.

 

So that's one. 382 is another one, just operating these research-intensive companies. And I should say this is not about biotech. It's about technology, whether it be clean tech, nanotech, advanced manufacturing, and biotech. Any of these apply to all of those research-intensive industries. 382 is about net operating losses. As we accumulate these, we can lose the entire benefit if new investors are coming in and that's classified as a change of control. So it's a nuance that isn't intended, but can really ruin the benefit of net operating loss.

 

The last one is called Section 1202. This is perhaps the most minor of the changes legislatively. It's just updating the qualifying threshold for this from $50 million, which was put in place years and years ago, to a more modern $150 million threshold.

 

ERIC PIERCE: So it's raising the limit around --

 

CHRIS OHMES: And Eric, I think what we saw with respect to the historic applications of some of these provisions was some concern about the transfer of tax benefits between parties. And that's what historically led to the demise of some of these benefits that had been there previously.

 

ERIC PIERCE: So there were loopholes that maybe investors were taking advantage of, buying net loss, net - NOL's -

 

CHRIS OHMES: Yeah, it was viewed as being a tax policy concern to have the tax benefit generated by one party, transferred over to another party. And so I think in terms of the industry, looking at presenting these proposals and advocating on behalf of them, you need to think about, yes, there are going to be some of these benefits that go to other people. But there isn't a good mechanism otherwise for these early-stage companies to get the seed capital that they need to grow and expand and become big companies.

 

ERIC PIERCE: And Michael, you guys in Virginia, you were instrumental in getting tax reform and some other reforms through the Virginia Senate. Talk a little bit about what sort of traps you had to run and how challenging it was to get that legislation passed.

 

MICHAEL GRISHAM: Well, first of all, to your point, capital formation and lowering the total cost of capital is essential for small businesses to get the lifeblood they need to hit that next set of milestones. For us in the Commonwealth, we're really looking at job creation, and we want to create high-end jobs. And for us, being competitive on a world basis in biotechnology, clean tech, is crucial. And we've looked at it from a policy level.

 

But it took getting out to each of the key state legislators and the General Assembly and letting them see the economic returns that have been achieved. We've got one company that was incubated in the biotech park that four years ago had four employees, and they have over 600 now. That's HDL, Health Diagnostic Laboratories. Teleget got founded, and has now done a big partnership deal.

 

But it starts with getting the cost of capital at a level that de-risks it enough to move things forward. And these kinds of incentives to get recognition of tax benefits early on is just made all the difference. But it is putting the shoulder to the wheel and talking about how you can align policy, tax incentive, and capital formation to create jobs.

 

CHRIS OHMES: And I might just comment, the process that was described about going around to the various legislators is a similar process to the one that needs to take place in Washington DC on Capitol Hill. The industry needs to continue to talk these proposals up, to use the tool that the EY QUEST report provides, to go ahead and let people know that this is important, even though there are other things in the news. This is important that this gets emphasis.

 

ERIC PIERCE: Absolutely. Well, biotech, as we mentioned, would not be the only beneficiary of these current tax reforms. Here's a look at E&Y's analysis of the qualifying industries.

 

SEGMENT 3

 

NARRATOR: Now, back to BioCentury This Week.

 

ERIC PIERCE: We're talking with Jeff Hatfield, Michael Grisham, and Chris Ohmes about biotech tax reform. So we were talking earlier about, we have two ends of the spectrum here. One impact that the government has had is on the JOBS Act. And that seems to have really grown the IPO market for innovator companies.

 

But we also have an issue at the startup end of the spectrum. And it seems like the tax reforms and a lot of the initiatives that are put forth today are really dealing with that early-stage seed investment. Michael, how much of that incentive is needed out there today?

 

MICHAEL GRISHAM: It's absolutely crucial. If we can't get our companies get liquidity events through IPOs, which are really what you were talking about, then the venture capitalists aren't going to move back to funding pre-revenue companies. Without that exit in their return, they become very risk-averse. And they're today largely funding post-revenue companies, which really doesn't drive forward our innovation. By getting those exits, the venture community will come back into pre-revenue financing, financing the R&D efforts. And that's really the lifeblood of our economy.

 

ERIC PIERCE: Because what we saw in 2007, 2008, we saw the VC sector almost en masse move to in-licensing companies, companies that had revenue, later-stage companies. Do you think that the JOBS Act -- I know it's still kind early -- but do you think that the JOBS Act and the liquidity events will have an impact on some of these investments? And I know you have a lot of venture investors in Vitae. What are you hearing from the investor side?

 

JEFFREY HATFIELD: Well, I think first of all, people are really thrilled, appreciative of what Congress did with the JOBS Act. Because the same kind of conversation we're having now about the pre-revenue, early, early stage companies, that was the same kind of discussion that happened around JOBS Act with getting the IPO markets opened up to be able to gain public investment around more mature companies. Now we've got the same kind of thing. Let's put together the package of these changes we've talked about that are going to enable VCs who get the exit to have an attractive investment in pre-revenue, early-stage companies, so they put the money in for the successes of tomorrow.

 

ERIC PIERCE: And Chris, the JOBS Act, I think when it was announced there were so many initiatives that -- there were more questions than there were answers. And we seem to have clarity on a lot of things, like test-the-waters meetings and whatnot. It almost seems like the biotech tax reform, at least the three reforms that are part of your report, have a little bit more clarity than at least the initial JOBS Act. What would you take the beyond that?

 

CHRISTOPHER OHMES: Well, The study that E&Y put together indicates that there would be 600-some-thousand additional jobs annually created if these three proposals were enacted and worked together. And I think, as was mentioned earlier, these are good, high-paying jobs in the U.S. that would arise from the combination of these three legislative proposals.

 

ERIC PIERCE: And one of the things, too, that we, I think, touched on earlier, is this really isn't just about biotech. It's broadly high-tech R&D-intensive companies. We're not in a position to really handicap what's going to go on in Washington, but that's got to be able to help drive advocacy and support for these measures. Mike, what's your take on that, at Virginia Bio?

 

MICHAEL GRISHAM: Well, we see it as a strategic investment. We think, for the long term viability of the Commonwealth, and actually for our country, being able to invest in technologies that will pay off down the road and give us a global competitive advantage. That's what it's about, strategic investment.

 

ERIC PIERCE: I think one of the things that the government's concerned about now is clearly the deficit, trying to reduce that deficit. How is this tax reform going to get paid for?

 

CHRISTOPHER OHMES: An excellent question. I'm not sure I have a good answer for you. And there is a little bit of tension here between what the government is trying to do broadly in terms of tax reform and simplifying the tax rules and eliminating incentives and some of the specific things that we're talking about here today. I think it is necessary to bring the message to the table that you need to help small businesses in this arena.

 

JEFFREY HATFIELD: I think we want to think about this in the sense that these topics aren't new taxes, they're simply changing the timing of existing taxes, so that there isn't a pay forward that's necessary, because it's just changing the timing of it and the recognition of it. So I think that's one thing that's very powerful about this. It's revising legislation. It's not a give me.

 

ERIC PIERCE: Jeff, we talked earlier about the JOBS Act and how it helps spur the IPO window. We also talked early in the show about the off-balance sheet financing structures. Talk a little bit about how this new setup might be a little bit different than before.

 

JEFFREY HATFIELD: OK, so what existed before was just the opportunity for investors to put money into discrete projects. That worked phenomenally, and it helped a lot of companies move important discoveries forward. For instance, Enbro, very well-known product, Remicade, those directly resulted from these kinds of investments.

 

What was wrong about that in the past was there were abuses. People used it to traffic tax benefits, and that's not helpful at all. What we want to do is get the part that worked, was a proven success, and created innovation that delivered value to patients, the investment, and make it so that companies have to spend at least 75% of proceeds on research activities directly so that we ensure the integrity of the program while getting all the benefits of it.

 

ERIC PIERCE: So in the past, maybe not a full proportion of funds were going into this arm. It was maybe going off into another investment vehicle.

 

JEFFREY HATFIELD: And this fixes that.

 

ERIC PIERCE: OK. Chris, and --

 

CHRISTOPHER OHMES: Yes, and Eric, just to reiterate that point, there were a whole series of administrative concerns that the Internal Revenue Service raised that led to a whole line of cases where they took people into court on the trafficking in tax benefits that was referred to. And so I think to the extent that we touch on these things, it's important to let people know that we have these mechanisms, and to point to these mechanisms and talk about how they work, because people are going to raise that history when we talk about it.

 

ERIC PIERCE: So it almost sounds like it's a large communication challenge. Because you mentioned earlier, these tax reforms aren't wholesale new initiatives, but they're little tweaks. And it seems like what needs to get out there is, these are tweaks for the better. They're trying to fix what didn't work the last time. Do you think the industry is prepared to do that on the Hill?

 

JEFFREY HATFIELD: I certainly hope so. There's so much of our economy, so much of the future that's dependent upon the continued output of innovation, brand new ways to conquer all the challenges, again, whether it be biotech and cures for people with disease, clean tech, nanotech, so many great opportunities. And these are simple changes that really help, as Chris has outlined and as Mike has talked about in substance, the benefits that this can have.

 

MICHAEL GRISHAM: Well, for us, the fact that you make that adjustment allows the dollars go right to the projects that drive the innovation. And so that's the benefit to companies like us by refining that legislation and have it be focused.

 

ERIC PIERCE: How important will tax reform be in light of Washington's agenda and other pressing issues? We'll talk about it next.

 

NARRATOR: Now in its 21st year, visit biocentury.com for the most in-depth biotech news and analysis, and visit biocenturytv.com for exclusive free content.

 

SEGMENT 4

 

ERIC PIERCE: With sequestration and other pressing issues in Washington, how will tax reform fit into the broader agenda? Chris, we're in a, what they're referring to as, a jobless recovery. This type of tax reform proposal seems to fit perfectly into what Washington is trying to accomplish here. What's your take?

 

CHRISTOPHER OHMES: Well, as I mentioned earlier, one of the things that came out of the E&Y report was that there would be a substantial increase in jobs, as you would expect these proposals to enhance investments and innovation. But what we also found was that there would be an increase in jobs as a result of these additional investments.

 

ERIC PIERCE: And Mike, you and both Jeff run innovator companies. You're privately held. What type of impact could this type of tax reform have on your ability to hire?

 

MICHAEL GRISHAM: Well, GPB has technologies that address some very large unmet needs, but because of the capital constraints we've been under, we have been just moving the technology slowly forward through NIH, STTR grants and the like. But with these kinds of reforms we could really move out on our technology. We've got a couple of Fortune 500 companies that would like to co-develop our product and get it to market. We would be hiring manufacturing people and sales and distribution people, and complementing our overall R&D. So that would be the crucial thing to let the clutch out and really get our company moving.

 

ERIC PIERCE: How about you, John?

 

JEFFREY HATFIELD: Yeah. Like what Mike just described, Vitae is now an emerging clinical stage biotech company. Our discovery platform, and how we leverage it, has led to a consistent success record of breakthrough discoveries in fields like chronic kidney disease, diabetes, and Alzheimer's. But they've been serial. They've been one after another after a couple of years in between because of limit of funds.

 

ERIC PIERCE: So you see you haven't been able to take your pipeline and sort of move it forward, sort of in sequence? It's almost been one after the other based on the funding level.

 

JEFFREY HATFIELD: That's it. We have an engine that works, and we'd love to be able to establish something like we talked about today -- the R&D partnerships -- to be attacking new therapies in other areas like autoimmune disorders, which a very promising field. Immunotherapy, we've got great ideas, we need more capital to be able to take advantage of the ideas, take advantage of a successful track record of discovery, and really find some cures that matter in the United States at a more productive level.

 

ERIC PIERCE: We've got about one minute. I wanted to get your take on -- there are some optics to this legislation as we talked about earlier, as being perceived as maybe a tax break for high net worth investors. How does the industry, and who needs to support it, to sort of get that around the corner so we're talking more about implementing the topics as opposed to having to deal with some of those blow backs? Chris, what's your take?

 

CHRISTOPHER OHMES: Yeah. Well, it's a good question because the tax policy concerns will probably arise. And so I would think there needs to be an emphasis on enhancing U.S. technology, job growth, some of the things that were mentioned in the E&Y report that are an outgrowth of funneling additional investments into technology based companies.

 

ERIC PIERCE: Excellent. Great. That's this week's show. I'd like to thank my guests, Jeff Hatfield, Michael Grisham, and Chris Ohmes. Remember to share your thoughts on today's show on Twitter. Join the conversation by using hashtag #biocenturytv. I'm Eric Pierce. Thanks for watching.