Life sciences companies face accounting implications of financing crunch

Life sciences companies are facing cash management issues in the wake of recent bank failures, labor strains, and elevated inflation and interest rates. Decreased valuations have resulted, and there is heightened risk around going concern and liquidity. Many companies are seeking financing more frequently and turning to alternatives to raise capital.

“Often, in order to secure these financings to meet the company's short- and long-term goals, life sciences companies are known for entering into pretty complicated equity or debt transactions that result in the recognition of complex financial instruments that can have significant accounting implications that might not be initially obvious,” says Rachel Rabinowitz, RSM partner, and the firm’s life sciences audit policy leader.

Rabinowitz joined Dave Cash, RSM’s life sciences industry audit leader, and Mike Lundberg, RSM’s industry audit policy leader, for a nine-minute discussion about the latest business issues and accounting implications facing life sciences companies. Below is a transcript of the discussion, edited for clarity and length.

They covered the following topics, with the corresponding time stamp noted for your convenience:

• Economic conditions in the life sciences industry (1:12)
• Accounting implications of the need for more frequent financings (2:25)
• Prevalence of going concern and how companies can address it (4:40)
• How companies can be proactive with their auditors and third-party providers (5:43)

Mike Lundberg: Dave, what's new in life sciences?

Dave Cash: There's a lot that is new in life sciences. I'll just give you an overall economic update. The economy I would describe right now as being resilient, but there is a risk of recession. And if there were to be a recession, we believe it could actually happen in the second half of this year.

There are definitely some other economic factors that are driving decisions in middle market companies in the life sciences space, including a historically low unemployment rate, which was 3.5% in July and is really tightening the labor market; as well as other high inflationary periods, peaking in June of 2022 at 9.1% and now leveled off a little bit but still very high.

I would also say life sciences companies are dealing with the recent bank failures and historically high-interest rates. And so one thing I would highlight is given those high-interest rates and looming recession, we've seen both public and private company valuations decrease over the last year to year and a half, which has really had a large impact into the life sciences community.

ML: So, Rachel, given the economic backdrop, what business trends in life sciences are you seeing in your role as our life sciences audit policy leader?

Rachel Rabinowitz: Given the looming potential for a recession and the current economic climate, there are companies who continue to struggle with cash management. With a significant decline in the number of IPOs (initial public offerings), life sciences companies have had to turn to other alternatives to raise capital.

Life sciences companies are also finding that with longer clinical trial durations and slower FDA (Food and Drug Administration) approval timelines, they are burning cash at a much higher rate than expected, which translates into the need for more frequent financings.

So, what does this mean for accounting? Often, in order to secure these financings to meet the company's short- and long-term goals, life sciences companies are known for entering into pretty complicated equity or debt transactions that result in the recognition of complex financial instruments that can have significant accounting implications that might not be initially obvious.

Another important consequence of the more limited financing environment is the heightened risk around going concern and liquidity.

ML: Wow, there's a lot going on here. Given those trends, how do you think these companies can be better prepared?

RR: First things first: Be proactive with your service providers, including your auditors, your technical accounting consulting teams, and your third-party appraisers.

As it relates to the complex financial instruments I was mentioning earlier within these financing arrangements, from an accounting perspective, it's definitely important that the company is considering whether there are any instruments that require separate accounting treatment. We're talking about conversion options, other embedded derivatives, warrants—should those be accounted for as liabilities or equity? And then even preferred tranche liabilities that are popular in the life sciences industry, especially those that are contingent upon meeting certain regulatory or FDA milestones.

You need to make sure you're thinking about whether you need to involve a third-party appraiser to prepare that initial fair value for those separately recorded instruments. And how often does that instrument need to be revalued? If it's a public company, you're probably revaluing it quarterly. Private companies are typically revaluing that on an annual basis, and you want to make sure you're being proactive with your appraisers.

As it relates to going concern and liquidity, that's definitely not a term that's unfamiliar for most life sciences companies, but it definitely still is one that has a lot of negative stigma around it. In layman's terms, going concern is the company's ability to pay out its short-term debt with its short-term assets. And cash is typically the largest driver of the company's going concern status.

Overall, investors understand going concerned, and it is common for early-stage life sciences companies to either issue an emphasis of matter paragraph related to going concern or to include management's plans to alleviate going concern within the financial statements. But it's important and imperative for companies to make sure everybody is on board—their auditors, those charged with governance, the audit committee, the board, members of management, and their investors.

ML: So, Dave, given everything we've talked about, what would you say are the top takeaways for life sciences companies in the middle market?

DC: Given the many macroeconomic challenges companies are facing, it's imperative to be proactive with your auditors and other service providers on these complex accounting areas, including debt and equity transactions and going concern evaluations. These things can take time, and you wouldn't want it to delay the process.

Also, I would say lower company valuations may drive other accounting issues, including the impairment of goodwill and intangible assets, as well as the company's ability to obtain additional rounds of financing. We've seen other clients where they've had the same budget and same projections for the year, but they've had increases in the interest rate and the WACC rate (weighted average cost of capital), and that has decreased the valuations. It's definitely something to think about as you're moving forward through the audit process.

I would also say lastly, although we have been talking about a lot of challenges facing the life sciences community, there are some positives, including billions of dollars of dry powder waiting to be deployed. Specifically, just in the last month, over a billion dollars of new life sciences funds have closed, which makes us optimistic about the future of the life sciences industry. In the near term, which you've probably heard, we'll have to do more with less, but hopefully, this drives innovation and makes for a brighter future going forward.

ML: It's amazing to me how much this world has changed in the last year as we look back at the changes in interest rates and the banking environment and the overall market environment and everything. So, Rachel, what can companies do to help navigate these interesting times?

RR: These companies have to absolutely be proactive with their third parties, their service providers—again, whether that be their accounting teams, their financial outsourcing teams, consulting teams. Make sure they're staying ahead and looking ahead to any sort of potential accounting implications of anything that's going on in the market right now.

And then, in addition, use the resources that we've mentioned that are available on our life sciences industry web page and make sure that those are top of mind. They've got a lot of good information to make sure that companies are considering what they need to stay ahead of the game.

DC: And I would say we've seen with a lot of our startups and middle market companies that they have very lean accounting departments, so leaning on your service providers early and often is a recipe for success.