Amidst talk of the need for renewed economic stimulus and the desire for America to invest in innovative industries, I thought I’d highlight two practical tax policy ideas for how to accelerate biotech sector growth: enabling NOL tradability and creating ultra-long term cap gains rates.
These are ideas that have floated around for some time, and were also highlighted as part of the recent BIO “Unleashing the promise of biotech” report that was profiled in Nature Biotechnology this month.
Enabling Biotech Net Operating Loss Tradability.
Biotechs, as we all know, are incredibly good at spending money and accumulating losses over the long R&D cycle to bring drugs to market. One of the balance sheet assets they accrue during this period are their tax-deductable Net Operating Losses (NOLs). These NOLs can be carried forward as tax deductions, subject to a bunch of cumbersome limitations, but come into play during licensing and some M&A discussions.
But since most biotechs never make it to profitability (and 50+% of them fail to return their invested capital), most of these companies never realize the value of these NOL assets. If tax policy were changed such that biotech NOLs could be traded (sold) to profitable companies as tax shields it would allow these high risk startups to reap the benefits of these NOLs while accessing scarce capital.
This type of an approach has been used in a few states, in particular New Jersey. Since 2000, NJ has enabled $220M worth of funding into biotechs on the basis of NOL transfers (~$2B of NOLs at the state corporate tax level of 8%). According to an analysis earlier this year, this program has helped create ~4000 jobs in biotech and 80+% wage growth (although didn’t really work in Technology industries). A number of foreign countries have systems like this, including Austria.
If this type of tradable NOL policy was adopted for biotech at the federal level, it could bring up to $1.5B of capital into the sector – hugely valuable influx of capital for startups. Here’s the math: $6.3B in life science venture capital was invested in 2010. Assuming that 85% went to loss making biotechs (1 out of 6 companies funded), with the federal corporate tax rate is 35%, then this represents $1.9B of tax deductions. Selling this at a 20-25% discount (to provide a market spread) creates a funding stream of ~$1.5B. [UPDATE: I've neglected to include all the publicly-traded loss-making biotech's, which probably more than doubles the values here!]
Another way to put it: every loss-making biotech could get 20-25% of every dollar it spent back through the sale of its NOLs. This would be particularly valuable to early stage companies who are cash starved and looking for any opportunity for additional capital efficient funding.
One could envision limitations on this to support the smaller biotechs that need the funding rather than well-funded but loss making biotechs (like Vertex last year): caps on the NOLs tradable in any year, the size of the company, etc…
This Tradable NOL policy could also be a solution to the $1 Trillion offshore profits repatriation problem: Pharma and other companies could bring back profits each year by buying these NOLs to reduce their tax burden.
Lastly, if tradable NOLs were enabled, not only would the money support job growth in biotech, but as the trading market formed there’d be new jobs in the advisory/banking, legal, and audit worlds to support the market.
What’s not to like about this idea?
Creating an Ultra-Long Term Capital Gains tax rate.
Biotech takes a long time. Early stage angel and venture investors are often invested in companies for 7-10 years before a liquidity event – vastly different than even 1-2 year holdings that get “long-term capital gains”.
Creating a 3rd tier for very low capital gains taxes (<10%) that would be applied to “ultra long term” holding periods of 5-7 years would reward “patient capital” that is so scarce today. Establishing this tax rate would almost certainly increase the pool of available risk capital.
I like these ideas in particular because they offer market-based private sector driven solutions for channeling capital to innovative biotech companies in an efficient and low-cost way. Its worth noting that most top-down government-led solutions to funding for private-sector companies are frought with challenges and the recent $1B biotech tax credit Qualifying Therapeutic Discovery Project Program of 2010 was no different. While successful at deploying the funds, they adopted a rather egalitarian approach and gave every successful project with >$500K in eligible spending the exact same amount (~$244K per year). Companies that submitted one big proposal got $244K/year (e.g., one of our companies filed for its $12M project) and those that submitted many small $500K proposals got many of them funded (e.g., a bunch of companies got 5 or more projects funded at the max level). I guess this was better than the government trying to decide which companies were better than others, opening the door to influential lobbyists. But in the end, leaving the selection of which companies should be funded to government bureaucrats is probably not the optimal approach.
Both of the above market-based solutions offer real potential to reduce the cost-of-capital for early stage biotech companies. The first by enabling the monetization of their NOL assets could generate >$1B of additional non-equity capital, and the second by reducing the tax-adjusted hurdle rate for long-term investors.
If Congress and the White House are serious about supporting biotech innovation and both growth & employment in the sector, these proposals should be put forward expeditiously. But I’m a realist and recognize that nothing is likely to happen; at least it makes for good blog fodder though.