(a) Allon Therapeutics and Oncothyreon are in the biotechnology and pharmaceutical industries. Their primary objective is the discovery and development, through research, of new drugs and products for the treatment of diseases. As such they are not manufacturers or distributors of product and so their sources of revenue (if any) are from the sale of patents or technology developed through their efforts. During the many years in which the investment of the research is performed, very little revenue might be generated. The statements of operations of Oncothyreon reveal revenue from collaborative and licensing of some of its technology to other research firms or to pharmaceutical companies. The only source of income on the statement of operations for Allon Therapeutics Inc. is from interest and other income.
Because of the modest amounts of revenue realized compared to the significant research and development costs expended, predictably, these companies experience continued losses. Since the majority of the activity is basic research, the expenditures do not qualify to be capitalized and later amortized. The conditions under which this would be allowed are very restrictive and are usually only applicable at the end of the development phase of a product or process.
In general, investors in this industry know and expect the operating results to be negative. They continue to invest in these companies on the hopes of realizing a substantial return on their investment in the future when a powerful and lucrative drug is developed and sold to the giant pharmaceutical firms for subsequent sale and distribution.
The large and continued losses on the statements of operations are therefore not a surprise to anyone and are not a sign of failure. Success is measured rather in the progress towards the development of lucrative products, which can bring large royalties or gains from the sale of the product and/or technology itself.
RA22-4 (Continued)
(b) In order to finance what are expected to be several years of losses, biotechnology companies must obtain long-term financing. Since debt is impractical considering the risks surrounding the company’s future ability to repay debt, the sources of financing are generally from equity. Large sums of cash are obtained from the sale of shares. Share offerings are done every few years to replenish cash and cash equivalents to fund the company for the next few years. Per the statement of cash flows of Allon Therapeutics, large cash inflows occurred in fiscal year 2010 of $9.9 million from proceeds from convertible royalty and revenue agreement. These inflows assisted in offsetting the cash outflows from operations of 2010 and 2009 of $13.0 million.
This approach to financing is similar for Oncothyreon, which had large amounts of cash received from shares and warrants issues of $13.7 million in 2010. The statement of financial positions of both companies show high levels of cash and short-term investments and capital stock. For Oncothyreon, the warrants issued in 2010 are reported as liabilities as they have a price that may vary under certain circumstances and may be required to be settled in cash. The high levels of capital stock are needed to offset the huge deficits that have been accumulated over the years. (c) For both companies, in the last two fiscal years, it appears cash was
mainly used for operations.
Since these companies do not make substantial investments in property, plant, and equipment, their investment activities are mostly restricted. Oncothyreon invested cash from the issuance of common shares in short- term investments and later liquidated to fund operations. In 20108 Oncothyreon had large cash inflows from the issue of common shares and warrants. In both years, small amounts were invested in property, plant and equipment, representing $324 thousand in 2010, $1.4 million in 2009 and $744 thousand in 2008. In both years, Allon invested small amounts in property and equipment, totalling $13,195 in 2010 and $22,533 in 2009. For both companies, financing activities are principal sources of cash. Cash generated from the sale of common shares is used to finance current and future years’ operations. It appears that Allon invested the cash from the issue of common shares in highly liquid short-term investments, which were classified as cash and cash equivalents (e.g. short-term investments with terms to maturity when acquired for three months or less), as the statement of financial position shows the large balance of cash and cash equivalents and no account for short-term investments.
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(d) Due to the nature of the operations and the expectations of shareholders, biotechnology companies do not have substantial investments in property, plant, and equipment. Their ability to obtain debt financing is restricted by the risk involved concerning the company’s ability to repay debt from future operations. Therefore, equipment might be financed through capital leases or from the sale of equity instruments. Facilities are rented instead of owned. This provides more flexibility to the companies involved although the overall costs might be higher. This strategy is confirmed by the modest amounts of property and equipment reported on the balance sheets.
Other businesses that are able to generate cash from operations and demonstrate an ability to service debt can expect to be financed partially with debt. They can therefore obtain the financing necessary to make long-term investments in plant and facilities. In those industries it would not be surprising to find balance sheets with higher amounts in both property, plant and equipment assets and long-term debt.
(e) Because of the continued commitment on the part of shareholders to provide the necessary equity financing required by these companies to continue their research activity, Allon and Oncothyreon are in fact very liquid companies. They ensure that the amounts of cash and cash equivalents and short-term investments are at a level adequate to continue operating well into the future to reach their goals. So long as the biotech firms can demonstrate progress toward reaching the discovery and development of new products, investors will continue to fund these businesses by purchasing more common shares and warrants. This explains why investors are not necessarily as concerned about the financial condition of the company in which they invest as they are about the progress reports concerning research results provided by the firms on a regular basis.