Biotech companies are a fertile hunting ground for the special situation investor. Many of them fail and undergo some form of corporate action (liquidation, reverse merger, bankruptcy…), or they are successful and get acquired. Most of them fail, but whatever the outcome, something always happens. But that something might not always be a positive event, and before that moment comes, they will usually burn cash like crazy with nothing to show for it. Last year Kronos Bio entered my radar when it announced a plan to “evaluate strategic alternatives”.

At the time the company had $124.9 million in cash, but was contending with a significant cash burn rate and large lease liabilities ($25.8 million present value). With a share price around $0.85 and market cap around ~$52 million it’s easy to see the attraction for special situations investors. That setup should offer plenty of room for some cash burn, get rid of the lease liabilities, and still generate a good return, right? Right?…

The Tang Capital Deal

After a couple of months of silence the company announced it would be acquired by Tang Capital for $0.57 in cash/share plus a contingent value right tied to a whole Christmas tree of different milestones. Tang Capital is basically involved in every busted biotech, and he often offers to buy the company at a not too big discount to net cash value, and share in the upside of the disposition of the (failed) clinical assets using a contingent value right.

The $0.57 in cash per share amounts to just $35 million, and was quite a disappointment. Not just for the entrepreneurial special situations investor, but also for the market in general because the stock dropped from ~$0.90 to ~$0.70 the day the deal was announced. So, what happened here? Where did all the cash go?

If we take the latest quarterly statement, filed a week after the merger agreement, we see the following balance sheet:In the six months between the start of the strategic review and the deal announcement, the cash balance dropped from $124.9 million to $99.7 million. Liabilities also decreased by about $10 million, and there were $3.7 million in costs related to an 83% reduction in workforce. That’s a lot of money down the drain, but at the same time nothing too unexpected happened. Adjusting for the changes in liabilities and the one-time restructuring expenses that results in a cash burn of less than $6 million per quarter, and with the 83% reduction in headcount the future cash burn is supposedly a lot lower. Note that this cash-burn figure doesn’t include the lease payments, because they result in lower liabilities on the balance sheet when paid (ignoring some net present value accounting movements).

So looking at this it’s still tough to see why the company is basically being acquired for $35 million plus some rights. A basic analysis would start with the latest cash balance, deduct all liabilities, make an adjustment for the lease liabilities to take the undiscounted value and add one quarter of cash burn until the merger closes. This gets us to the following estimate:

So, did Tang Capital simply get a very good deal? Are shareholders getting screwed? Why is this being sold for $0.57/share?

The contingent value rights

Of course, I haven’t started to discuss the CVR, and at first sight that one offers some hope of a recovery of the missing cash. The CVR has a total of four milestones, two of them related to the disposition proceeds of their clinical assets, one related to the (lease) liabilities and one that is especially of interest with regards to the missing cash question. Shareholders will get the right to get 100% of the Closing Net Cash (capitalized terms, because this is of course a carefully defined term in the merger agreement) above the cash balance of $40 million.

So a rough estimate would suggest that there should be $18 million of cash available above the $40 million threshold, and that could translate into ~$0.30/share of addition consideration. If you would have bought some shares to bet on this contingent payment I wouldn’t fault you, it is a thesis that makes sense, but something doesn’t quite add up. Why agree on a $35 million cash deal if there is no real question that the net cash is a lot higher?

Today, the tender offer statement was released, and it contained some interesting information. Because, surprise, surprise, the estimated payout of this specific milestone of the rights is not close to $0.30/share, but estimated between just $0.02 and $0.05/share. So we are back at our original question, where did the money go? Well, as I said, “Closing Net Cash” is of course a carefully defined term in the merger agreement, and it does not match the calculation above at all.

“Closing Net Cash” means, without duplication, (i) the Company’s cash and cash equivalents, restricted cash, and investments as of the Cash Determination Time, determined in accordance with GAAP, applied on a basis consistent with the Company’s application thereof in the Company’s consolidated financial statements, minus (ii) Indebtedness of the Company as of the Cash Determination Time, minus (iii) the Transaction Expenses, minus (iv) the Estimated Costs Post-Merger Closing, minus (v) $400,000 for the CVR Expense Cap under the CVR Agreement.

Besides some small differences, and not all negative, because here restricted cash is included in the calculation, the single item that should get you worried is called “Estimated Costs Post-Merger Closing”. In the merger agreement this is defined as following:

“Estimated Costs Post-Merger Closing” means all costs that the Surviving Corporation would incur post-Merger Closing, including costs associated with: (i) CMC Activities; (ii) clinical activities; (iii) remaining lease-related obligations (including rent, common area maintenance, property taxes and insurance); and (iv) an aggregate of $250,000 for any legal Proceedings and settlements.

Paying for the remaining lease obligations, sure, but apparently soon to be former shareholders are paying 100% for all future clinical activities and who knows how much money is budgeted for that? Schedule I, that should contain a pro-forma Closing Net Cash Calculation is strategically not publicly filed with the SEC. Current shareholders will be paying 100% of the costs to maximize the value of the preclinical assets, but will only receive 50% of the proceeds. And that is assuming they will receive anything, because if the assets are not sold in the first two years after the merger closes shareholders will get nothing. Does it make sense for Tang to sit on these assets two years to get all the proceeds? Probably not. I’m skeptical about the value of preclinical assets that failed their trails, but two year old failed assets must be even worse.

Finishing remarks

So where did the money go? I’m not sure. It certainly looks like Tang Capital got a good deal, but perhaps the reality inside the company was worse than expected. Tang Capital started with an offer of $0.95 per share, assuming at least $67.2 million in closing net cash, but that was quickly revised down to the current proposal after due diligence. It still doesn’t quite add up to me.

Perhaps it’s also related to the lease expenses. If we, for a moment, ignore the colossal stupidity of an early-stage biotech company signing an 11-year lease, there’s a curious liquidation analysis in the tender offer documents on page 23. Total lease expenses are estimated at $42.9 million, while the latest quarterly statement lists just a $30.8 million undiscounted liability. Once again, it doesn’t quite add up, but the $12 million difference is more or less what we are missing.

For investors who have confidence in the value of the preclinical assets, the stock might still be of interest. Tang Capital estimates the probability-weighted value of the CVR between $0.21 and $0.35 per share, while you can now effectively buy it for $0.13 per share. Potentially a good deal – but they’re not exactly a neutral party I’d rely on…

Disclosure

No real position, except some shares to track what happens.