3
Legal, Accounting, and Process Issues

In session three, the hypothetical voluntary health organization, the Colten Foundation, has a leadership team in place and is beginning to think about challenges it may face in terms of appropriate accounting and legal practices, as well as other process-related issues. It is interested in learning about what other organizations have already done. Workshop participants offered key points of consideration and specific lessons learned, as well as provided legal and accounting models from their own experiences.

Setting up any large organization is challenging and complex, and a large-scale translational research program is no exception. Some of the issues a new program will face are fairly routine—for example, accounting and financial reporting for a large nonprofit, while nontrivial, is a documented process based on widely accepted principles. The primary task is hiring competent staff and outside accounting support. But there are challenges that are unique to the translational research field and that may require the assistance of knowledgeable legal counsel with real domain expertise. Workshop presenters discussed a wide range of issues and proposed a series of questions the Colten Foundation should consider as it works to build the bones of its organization.



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3 Legal, Accounting, and Process Issues In session three, the hypothetical voluntary health or- ganization, the Colten Foundation, has a leadership team in place and is beginning to think about challenges it may face in terms of appropriate accounting and legal practices, as well as other process-related issues. It is interested in learning about what other organizations have already done. Workshop participants offered key points of consideration and specific lessons learned, as well as provided legal and accounting models from their own experiences. Setting up any large organization is challenging and complex, and a large-scale translational research program is no exception. Some of the issues a new program will face are fairly routine—for example, account- ing and financial reporting for a large nonprofit, while nontrivial, is a documented process based on widely accepted principles. The primary task is hiring competent staff and outside accounting support. But there are challenges that are unique to the translational research field and that may require the assistance of knowledgeable legal counsel with real do- main expertise. Workshop presenters discussed a wide range of issues and proposed a series of questions the Colten Foundation should consider as it works to build the bones of its organization. 27

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28 VENTURE PHILANTHROPY STRATEGIES SOCIAL ACCOUNTING Proper financial processes must be established to ensure that a volun- tary health organization is being fiscally responsible and fulfilling the requirements of tax law. But in the voluntary health organization world, many workshop participants also believed that some level of social ac- counting was necessary to ensure that a group is supporting its charter, advancing the group’s broader mission, and providing a positive impact on its constituents. In order to achieve these ends, an organization should develop mechanisms to assess and measure the progress and impact it is having on the field. While a typical venture capital fund will try to get a return of 30 per- cent to 40 percent each year, Peter Heinecke, chief business officer of Experimed Bioscience, suggested that voluntary health organizations would probably be satisfied with much less than that. “A venture philan- thropy fund has a double bottom line: one line is still return, but the other line is the social good that you are advancing,” he explained. These two bottom lines exist in tandem because while the Internal Revenue Service requires one, a voluntary health organization’s donors and constituents require both. It is important for an organization to have reasonable near-term ex- pectations for its social bottom line. For most voluntary health organiza- tions, the long-term goal is to cure or eliminate disease. However, other achievable goals are nearer term and help to measure investment and medical success; therefore, resetting expectations to include shorter-term definitions of success while not losing sight of the longer-term ones is smart, Heinecke suggested. Those definitions will be dependent on the target of each grant or project. For organizations funding a small start-up, success might be finding animal models that provide enough proof of concept to help them attract new private-sector investment. For a later- stage program, the definition could be the conclusion of a successful clinical trial. Heinecke also insisted that even in failure an organization must take the time to understand why it failed and commit to making data and information available to others. Carol Mimura’s Intellectual Property & Industry Research Alliance Department at the University of California, Berkeley, also uses a double bottom line and agrees with defining success in short-term blocks. The bottom line in terms of social impact is lives saved and medical costs reduced, she explained, but these are not easy metrics to collect. The eventual social impact of an action might be decades removed. The ad-

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29 LEGAL, ACCOUNTING, AND PROCESS ISSUES vice to the Colten Foundation is to ensure due diligence, but also work to create and communicate its own nonfinancial definitions of success. LEGAL ISSUES The legal activities of any voluntary health organization are designed to do two things: protect the organization and provide a legal framework under which the actual work gets done. Operating in a product-driven (and sometimes profit-driven) world raises a host of contractual issues that do not exist in the nonprofit community. Setting up successful legal agreements in these situations requires extensive communication and due diligence between the parties involved, as well as an understanding of the issues that may arise. The more questions that are answered prior to en- tering into a contract, the more assured an organization can be that it will be successful and protected in the case of failure. Return on Investment The Colten Foundation will need to make a fundamental decision about its approach to investment returns: does it demand a return on in- vestment from funded partners? Many foundations feel they should re- ceive a return on the investment they made in academic research, said Kenneth Schaner, a lawyer in private practice with extensive venture phi- lanthropy experience with the Cystic Fibrosis Foundation among others. However, Schaner shared that while he has put it in many agreements, the truth is that they have not received many returns. One problem with returns is simply the time frame. Typically, the time between when a grant is given and when a marketable invention is out of the lab and on the market is quite long. Often, there are previous or subsequent grants (and grantors) on the pathway from research to product. In the case of a successful, marketable product, there is little debate that a funding organization should get a portion of the proceeds, says Schaner, but what portion? In Schaner’s experience the answer is frequently that any return should bear the same relationship as the grant had to the total cost of de- veloping the product. This determination introduces complexities of its own, and many organizations simply forgo any attempt to recapture

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30 VENTURE PHILANTHROPY STRATEGIES revenue from academic contracts. Yet, he maintained, others keep it in because one contract may be unique from the next. Process Considerations More than any other part of the workshop, the discussion of legal and contract issues was one of simply highlighting a variety of areas that par- ticipants had dealt with in the past. The following subsections outline some of the questions and considerations that the Colten Foundation may encounter as it moves forward with its translational research program. Where available, the rapporteur has included relevant experiences shared by participants. Accountability Most voluntary health organizations live under clear mandates to use the organization’s resources to pursue specific goals. It is critical that an organization be able to assure donors that the money they give will be used on the projects they are being asked to fund. Likewise, if the Colten Foundation makes an investment, how will it know that its money is being used as intended? One way to do this is to include an interruption, or “diligent commercialization,” clause. These clauses state that if a con- tracted partner fails to continue research in a field for a period of some consecutive number of days, then the contract is terminated and the organization gets exclusive rights to the results of the research, explained Schaner. Of course, the intent is never to invoke these clauses. Most founda- tions will not be well served by engaging in legal battles over intellectual property (IP) rights (see Chapter 4 for more information on IP). Even if a foundation succeeds in gaining control of IP, assigning that IP to a new research team or hiring a contract research organization to complete the work has both implicit and explicit costs. Mimura’s group at the University of California, Berkeley, takes a slightly different approach. If the licensee of an IP right is not perform- ing, one option is to reserve the right to reduce an exclusive license to nonexclusivity so it can be relicensed, she explained. With an exclusive license, there is sometimes a mandatory sublicensing clause, as with Mimura’s office. Such tactics would give the Colten Foundation substan-

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31 LEGAL, ACCOUNTING, AND PROCESS ISSUES tial flexibility without invoking draconian terminations. If the foundation becomes aware of unanticipated uses of a particular IP, either the licen- see has to pursue it or the foundation can seek additional partners. In this way, no undeveloped new niche will go unaddressed, said Mimura. In her experience, companies rarely object to such terms because many see it as free market research. Core Structure Should the Colten Foundation establish a separate entity to award grants? A separate entity can be convenient, but it is not strictly neces- sary. Workshop participants emphasized that indemnification from grantees and insurance is still needed to protect the foundation. Domain Will the Colten Foundation assert rights to any application of the research it funds? If the research yields results for a disease not in the Colten Foundation’s disease space, how does the foundation want to treat those revenues? Due Diligence How detailed does the assessment of a particular grant need to be? What are the assumptions in the due diligence process? Intellectual Property Will the Colten Foundation have the rights to the new invention through some form of option, especially if the awardee does not use it after a particular time? What role will it take in owning, maintaining, and enforcing IP rights?

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32 VENTURE PHILANTHROPY STRATEGIES Involvement Level How passive will the Colten Foundation be in its grants? Does the foundation want to take a more active role? Schaner cautioned that the more active an organization is, the higher the possibility of liabilities. Milestones With near-term, easily identifiable, and unambiguous milestones, the Colten Foundation’s contracts will be less difficult to evaluate and en- force. Linda Van Eldik of Northwestern University Feinberg School of Medicine thinks most voluntary health organizations have made good progress in striking the balance between excessive micromanagement and loss of control. Clear goals, milestones, and continuous open com- munication are in place with several successful academic, industry, and foundation partnerships, she explained. Royalties Traditionally, investing in research through a grant with an industry partner is structured to provide return royalty payments to the voluntary health organization. Some organizations also invest in direct equity or purchase debt from a target company. All three avenues have implica- tionns that can create both complexities and opportunities. For example, if the Colten Foundation gives a grant in return for royalties, accounting rules treat those grants as program expenditures. But if the Colten Foun- dation invests through equity, it would be treated as an investment. That has an impact on fund-raising ratios and, depending on the Colten Foun- dation’s fund-raising profile, could be important. If the Colten Foundation will require royalties as the condition of a grant, it needs to consider the terms of the royalty agreement. For in- stance, will royalties be capped, limiting the return back to the founda- tion? In capping the return, explained Heinecke, “the company is not worried that it has given you too large a royalty rate, hampering its abil- ity to license the drug or raise venture funding later on.” The issue of capping a royalty return can be argued from the opposite side too. As Schaner suggested, “when the investment is large, when we’re talking

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33 LEGAL, ACCOUNTING, AND PROCESS ISSUES about taking the risk that no one else is going to take, then a traditional royalty is appropriate.” Raw Return Even an established royalty stream can be difficult to value. Equity, on the other hand, is in most cases priced frequently in venture capital valuations, so the Colten Foundation would have a sense of what its in- vestments were worth. Equity generally tends to produce a return more quickly than a royalty structure; in addition, many biotech companies are merged or go public well before they make any money, said Heinecke. Termination What happens if the Colten Foundation does not like the path a line of research is taking? Or if other developments prove more promising, leading to a particular grant’s irrelevance? A voluntary health organiza- tion cannot write in the contract that it can terminate the contract in one month, for example, because the contracted company has to hire people to do the research, commented Schaner. Ultimately, the organization has to strike a balance between assuring the contracted company that it can hire the appropriate staff and having the right itself to get out of the program. Tool Sharing It is usually in the interest of a voluntary health organization that has developed various research and diagnostic tools to make them widely accessible to researchers in the field. Providing access to new tools is one key way to advance an organization’s “second bottom line,” discussed previously in this list. Issues involving the licensing of developed prop- erty should be addressed up front when Colten is entering into preclinical research contracts. Cynthia Joyce of the Spinal Muscular Atrophy Foundation shared an evocative example. To continue a line of research for spinal muscular atrophy, the foundation needed access to an animal model. While one existed, it lived behind the walls of an academic investigator who was not going to be part of the research. The foundation had to obtain li-

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34 VENTURE PHILANTHROPY STRATEGIES censes to the mice and put them in a facility where they could confirm that they were characterized and standardized so that the foundation could compare drug studies, recalled Joyce. The process took 3 years. Some voluntary health organizations now deal with the issue of sharing newly developed research tools up front in the contracting, before they are even developed. This could save years of repetition later due to an outdated contract. The Spinal Muscular Atrophy Foundation has taken things a step further, actually prenegotiating material transfer agreements and sublicenses if it is required for research tools. Case Study: Fast Forward, LLC A thorough, process-driven funding decision matrix that involves ex- tensive due diligence on the legal, financial, and scientific aspects of a potential opportunity is extraordinarily helpful, according to Timothy Coetzee of Fast Forward. Before a contract is signed, a grant written, or a check disbursed, the Colten Foundation needs to have a process in place. Andrea Tobias explained the process that Fast Forward, LLC, uses for funding. Fast Forward is the dedicated venture philanthropy group inside the National Multiple Sclerosis Society. The Fast Forward process for mak- ing grants and investments was modeled after the Wellcome Trust’s process. In the Fast Forward model, the foundation gives loans or grants that are ultimately converted into either series A or series B stock in the particular biotech company. The objective is not solely to get a return on investments, but also to invest in the best life science technologies. Fast Forward took Wellcome Trust’s application process and remodeled it. The application process is designed to be onerous and to act as a significant gate so that application proposals that reach the review stages are in order and can move quickly to the next steps, explained Tobias. The second step is far more rigorous. Fast Forward’s core due dili- gence process is identical to that of a traditional venture capitalist. A team of experts descends on the target company and produces an exhaus- tive due diligence book covering the science, technology, clinical proto- cols, IP, and management team at the target company. This book also includes any other due diligence reports from the other venture capitalists that are looking at the opportunity with Fast Forward. This package is

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35 LEGAL, ACCOUNTING, AND PROCESS ISSUES passed on to a scientific and business advisory committee for review and comment. Next, a conference call is held with the company, and the company makes a presentation. By the end of the conference call, a decision is made on whether or not the company will move on to the next step, which is presentation to the foundation’s board. At the board meeting, the proposal is presented very much like a venture partner would present it to his partnership. A case is made, including the recommendations from the scientific and business advisory committee review and core in- vestment justifications. A vote is taken, and the investment is made or not made. Fundamentally, this is the venture capital process applied in a different domain. Key messages from session three are captured in the summary box below (Box 3-1). BOX 3-1 Key Points: Legal, Accounting, and Process Issues • Knowledgeable legal counsel and accounting support with real do- main expertise is critical. • Social accounting is necessary to ensure that a patient group is sup- porting its charter and advancing the group’s broader mission. • Set short-term milestones in addition to longer-terms ones. • Devise a plan of accountability for how to keep your partnership in good standing. • Recognize that sometimes the more active your organization is, the more liabilities you have. • Address issues involving licensing of developed property as you enter into a preclinical contract.

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