XENO TECHNOLOGIES

Introduction

In March 2005, James Malone, president of Xeno Technologies located in London,

Ontario, was in a quandary. James had founded Xeno Technologies in order to develop and

commercialize a technology enabling the transplantation of cells from pigs to diabetic patients

(without the use of immunosuppressive drugs) to reduce or eliminate insulin dependence. James

had formed the company in April 2004 on the basis of promised financing of several million

dollars from Mexican billionaire financer, Juan Torres. It now seemed that Torres was no longer

interested in following through on his previous commitment. In subsequent phone and email

communications James found that Torres would ask vague questions and was very dismissive

and elusive. James finally realized that he was “kicking a dead horse.”

The promise of financing had been used to secure the patents owned by Biotech Venture

Corporation (BVC). Securing the patents had been a long and difficult process and the contracts

had finally been signed in December 2004. Now, James would have to find an alternative source

of financing or be forced to relinquish the agreements with BVC. In the latter case, he would lose

credibility with BVC and might lose the patents to a competitor. James realized that he needed to

act quickly.

________________________________________________________________________

This case was prepared by Dr. Colin Pillay, Gannon University and Justin Leushner, Sernova Corp., and is intended to be used as a basis for class discussion. The views represented here are those of the case authors and do not necessarily reflect the view of the Society for Case Research. The authors’ views are based on their own professional judgments. The names of the organizations, individuals and locations have been disguised to preserve the organizations’ and individuals’ request for anonymity. Presented to and accepted by the Society for Case Research. All rights reserved to the authors and SCR.

Xeno Technologies

He thought about the various financing sources and none looked very promising. “VC’s

tend to want too much control, their timelines are very slow, and their terms can be very

unmotivating, Angels tend to invest smaller amounts and we needed more than most Angels are

willing to invest. The government usually gives you money if you have money like a bank.”

Diabetes

Diabetes is a condition in which the blood glucose level is too high. It is the consequence

of insufficient production of insulin, a hormone made by the pancreas. The islets of Langerhans

are groups of specialized cells in the pancreas that make and secrete hormones. There are five

types of cells in an islet including the beta cells that make insulin. Insulin enables the glucose

made from food to enter the cells. If the body does not make enough insulin or if the insulin does

not work the way it should, glucose cannot get into the cells and remains in the blood instead.

The blood glucose level then gets too high, causing diabetes.

People can get diabetes at any age. Type 1 diabetes is usually first diagnosed in children,

teenagers, or young adults. With this form of diabetes, the beta cells of the pancreas no longer

make insulin because the body’s immune system has attacked and destroyed them. Although

insulin injections could be used to treat type 1 diabetes, sub-optimal management of insulin

levels quicken the onset and progression of eye, kidney and nerve diseases caused by diabetes.

Type 2 diabetes is the most common form of diabetes. People can develop type 2 diabetes

at any age. This form of diabetes usually begins with insulin resistance, a condition in which fat,

muscle, and liver cells do not use insulin properly. At first, the pancreas keeps up with the added

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demand by producing more insulin. In time, however, it loses the ability to secrete enough

insulin.

The Edmonton Protocol

The immune system is a biological defense mechanism that protects the body against

pathogens, biological micro-invaders which cause disease. These pathogens could be bacteria,

viruses, fungi or parasites. Because of the DNA information encoded in the cells, the immune

system is able to distinguish between the body’s own tissue and these pathogens. Consequently it

is able to produce a response to these pathogens which destroys them. This defense mechanism

causes a major problem in tissue transplantation. The immune system cannot distinguish between

a pathogen and beneficial transplanted tissue. Consequently it initiates a defensive response

against the transplanted tissue and destroys it.

In 1972, Paul Lacy, a researcher at Washington University in St. Louis cured diabetic rats

by transplanting healthy islets. This procedure was then extended to humans. However, human

islet cell transplantation was limited by the supply of cadaver pancreases. Another problem was

that prior to 2000, the immunosuppressive drugs that were used to prevent rejection of the

transplanted cells were not effective. In the summer of 2000, a team at the University of Alberta

in Edmonton, Canada reported in The New England Journal of Medicine that they had conducted

islet transplantation using a combination of three antirejection drugs. After a year, all seven

patients receiving the transplanted cells were still off insulin. This procedure became known as

the Edmonton protocol. However, other researchers at the Diabetes Research Institute in Miami

found that the effectiveness of this regimen faded over a period of several years. In addition the

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use of the immunosuppressants could have side effects such as deteriorating kidney function,

anemia and mouth ulcers. Islet transplants could cost up to $200,000 for one patient in the United

States in the first year. Anti-rejection drugs added another $30,000 annually after that.

The First Human Xeno Trials

Dr. Daniel Green had joined the John P. Robarts Research Institute at the University of

Western Ontario as the chair of xenotransplantation (transplanting of animal organs, tissues and

cells into human beings) in Dec 2000. Dr. Green was a Fellow of the Royal College of

Pathologists and had a Ph.D. from the University of Cambridge. Since 2000, Dr. Daniel Green

and Dr. Ramon Velasquez, a surgeon in Mexico City, had been collaborating on a clinical study.

Dr. Ramon Velasquez was a former student of Dr. Daniel Green in the early to mid 80’s while

Dr. Green was a Professor of Immunology at the University of Cambridge. The study involved

the four year follow-up of 12 patients in Mexico City affected by Type I diabetes into whom the

islets of Langerhans and Sertoli cells obtained from pigs were cotransplanted. The Sertoli cells

would protect both themselves and the islets of Langerhans cells from destruction by the immune

system. The purpose of this study was to determine whether this procedure would reduce the

insulin requirements of these patients. The study revealed that in the patients in the treatment

group, no complications had arisen and no infection was detected. Half of the patients showed a

significant reduction in insulin requirements compared with both their pre-transplant levels and

controls.

The Discovery of Sertoli Cells

While at the University of Tennessee Medical Center, Dr. Helena Wright discovered the

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existence of Sertoli cells which could protect themselves from destruction by the immune system

when transplanted into a foreign host. In addition, Sertoli cells could also protect and enhance

the growth of tissue co-transplanted with the Sertoli cells. This would make possible the

transplantation of a broad variety of cells without the repeated use of immunosuppressive drugs.

The University of Tennessee had technology transfer agreements with Dr. Wright. In 1996,

Biotech Venture Corporation (BVC) and the University of Tennessee founded Sertran Research

Incorporated (SRI) to commercialize these discoveries by Dr. Helena Wright. Dr. Wright was

appointed to the Scientific Advisory Board of SRI. SRI had exclusive worldwide rights to

commercialize a large patent portfolio protecting the use of Sertoli cells based on Dr. Wright’s

discoveries. BVC provided the initial venture funding for SRI. BVC was a Tucson, Arizona-

based technology investment and management company that provided early-stage venture

funding for promising biomedical companies and technologies.

The Founding of Xeno Technologies

James Malone had received a B.Sc. in Cell Physiology/Genetics from the University of

British Columbia in 1996. From 2001-2003 he worked for a biotech Venture Capital Company.

In 2003 he began the MBA program at the Ivey School of Business at the University of Western

Ontario. James was introduced to Dr. Green through a mutual acquaintance. After Dr. Green

talked about his work, James was immediately interested. He understood the business

possibilities of the research done by Dr. Green. To improve his experience in this area, in the

middle of 2003, James began developing a human islet transplantation program for the London

Health Sciences Centre. Subsequently, he reached an agreement with Dr. Green to create a

company based on the results of Dr. Green’s research. Dr. Velasquez was not interested in the

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business opportunity and consequently was not involved with the formation of the company. In

August 2003, James decided that the next step would be to seek FDA approval. In addition, he

would need to purchase the patents that involved the use of Sertoli cells from BVC. FDA

approval would proceed in stages. The first two stages would involve testing this technology on

animals and would cost between three to five million dollars. If the results were successful in

these two stages, then Xeno Technologies would apply to the FDA to begin human trials. The

problem was that it would be difficult to obtain initial financing given the limited amount of

testing that had already been completed.

Juan Torres was a billionaire Mexican financier that had provided $4 million for the work

of Dr. Ramon Velasquez and James believed that he would be most likely to provide such

financing. In February 2004, James visited Juan Torres in Mexico City. The purpose of this

meeting was to obtain seed funding for Xeno Technologies and to establish boundaries for the

negotiations with BVC. James was able to secure a letter of intent in which Torres agreed to

provide $3.5 million in cash for the xenotransplantation studies on animals. James and Dr. Green

would each have a 7.5% stake in the new company, Xeno Technologies. Torres would have a

stake of about 60-65% in Xeno Technologies depending on the negotiations with BVC, which

would receive the remaining equity in the firm.

Although the proposal was then made to BVC in February 2004, the offer was not

immediately accepted. BVC sought proposals from other interested parties in an attempt to

improve on the existing offer. BVC was not explicit on what would constitute an acceptable offer

and did not communicate with James while they were pursuing other proposals. Realizing that he

needed to force the decision, James arranged a meeting with BVC representatives, including the

chairman of the Board of BVC in Tucson, Arizona in December 2004. An agreement was

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reached in which BVC would receive 25% of the equity in Xeno Technologies in exchange for

the patents involving the Sertoli cells.

The Diabetes Market

In the United States the number of people with diabetes was estimated at 20.8 million in

2005. Type 2 diabetes accounted for about 90% of all cases of diabetes. Total costs of diabetes in

the US in 2002 were estimated at $132 billion with $92 billion of that amount being indirect

medical expenditures and the other $40 billion in indirect costs because of disability and

premature mortality1.

In 1997 the growth rate in the incidence of diabetes cases in the US was 3.5% per year. In

1999 and 2000 the growth rate was 6.5-7% per year. By 2002 the growth rate had increased to

8.5% per year. In 2002, sales of drugs for controlling Type 2 diabetes was approximately $9.3

billion in the US, France, Germany, Italy, Spain, the UK and Japan. This market2 was expected

to reach $20.5 billion in 2012 representing a sustained 10-year annual growth of 8% since 2002.

Alternative Sources of Financing

After he reached the conclusion that Torres was no longer interested in following through

on his commitments, James speculated that this had happened because Torres did not understand

the process of developing the technology in order to meet the regulatory requirements. No

penalties for withdrawing from the commitments in the letter of intent signed by Torres had been

established. James realized that he needed to act quickly in order to retain his credibility with

BVC. He would need to find another source of financing that would be willing to make a similar

offer to BVC. However, the small number of trials that had been done, the risks involved in

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xenotransplantation and the large sums of money that were needed would make it difficult to

find an alternative source of funding. The most likely sources of financing were the IPO process,

Venture Capitalists, Angel Investors or Corporate Venture Capitalists.

Initial Public Offering (IPO)

For the IPO process to be successful the firm should have either a well-established history of

steadily growing earnings or operate in a highly visible industry with strong growth potential. In

addition audited financials for several years are required by the Securities and Exchange

Commission. For the average IPO, estimated expenses for lawyers, accountants, paperwork and

miscellaneous expenses would range from $150,000 - $300,000. In addition the investment bank

would require a commission of up to 10%.

Venture capitalists (VCs)3,4

Venture capitalists typically are organized as limited partnerships in which the fund

managers are the general partners and the investors are the limited partners. The investors are

wealthy families or individuals and institutional investors such as insurance companies or

pension funds. In order to keep the limited liability status, these limited partners are not involved

in specific business decisions. Venture capitalists prefer to invest in startup and expansion

financing. The typical size of the investment is $2- $10 million. In addition to the capital

invested, the VCs provide advice to the venture’s top management. VCs require significant board

representation. This enables them to apply pressure to the entrepreneur to achieve the agreed

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objectives or face the possibility of being replaced. VCs require regular reports to which they pay

close attention.

Business angels (BAs)3,4

Business Angels are individuals who invest their own capital in new ventures. BAs are

often either self-made entrepreneur millionaires or retired senior executives of large companies.

The typical size of their investment is $50,000-$500,000. However some “super angels” are

willing to invest up to a few million dollars. BAs are interested in equity growth, but many are

also involved in venture capital investing because of the chance to be closely involved in a

venture where they have the opportunity to contribute by mentoring a promising young

entrepreneur and by providing access to their contacts in the industry. In addition some of these

Business Angels have a desire to “get back into the game”. As a result, BAs are inclined to invest

in businesses where they have knowledge and experience. More often they either invest in seed

stage deals in the hope that they will develop into ventures that will attract start-up financing

from VCs.

Corporate Alliances and Corporate venture capitalists (CVCs)3

Corporate venture capital is the investment of corporate funds in startup businesses.

Corporate venture capital investments are primarily made in ventures whose line of business is

closely linked to the parent’s existing business. Investing in startup technology companies is a

way for corporations to increase their innovativeness. Startup technology companies with greater

patent protection are more likely to reveal their breakthroughs to their corporate venture capital

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partners. Without this protection the startup companies may face the threat of their technology

being copied by their corporate partner. Other risks include the loss of control by the startup

company’s founders and a loss of the entrepreneurial culture. The advantages of the association

with the larger company include the provision of a source of capital, research and testing

facilities and access to personnel experienced in the FDA approval process. In addition, the

smaller company would be perceived as being more credible because of their alliance with the

larger company.

Private Placement

Under SEC Regulation D Rule 506 a private business may issue an unlimited amount of

securities with no dollar limit, to 35 sophisticated investors plus any number of “accredited

investors”. Accredited Investors are those who can provide assurances that they would not be

adversely impacted by the loss of their capital. Advertising and general solicitation are

prohibited. The securities are “restricted securities” which may not be readily resold.

James believed that Venture Capitalists wanted more control of the company than he

was willing to relinquish, offered very low valuations, and would not reach a conclusion in time

to keep BVC interested. There would be similar problems with Angel Investors and they would

be less likely to provide the large sum of money required. Another possibility would be to sell

the company to a larger public biotechnology or pharmaceutical company. A problem in this

case would be to convince the investors of the acquiring company of the effectiveness and

potential of the treatment. Given the short time in which to achieve his objectives, he wondered

what financing options he should now pursue and how the offer to BVC should be restructured.

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References

1. American Journal of Public Health March 2006

2. Chemical Market Reporter March 2004

3 “An Entrepreneur’s Guide to the Venture Capital Galaxy”, Academy of Management

Perspectives Aug 2006

4. “How to Raise Capital”, Jeffrey Timmons, Stephen Spinelli and Andrew Zacharakis, McGraw

Hill 2004

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