CSI-Replidyne: A Reverse Merger Mystery Maybe Grissom Can Solve

Those public biotech companies unlucky enough to see their drug development hopes dashed when clinical failure rears its ugly head have a few choices when it comes to the question of what to do with their leftover cash.

Option 1. They can push ahead with earlier-stage development projects and hope they're luckier the second--or third, or fourth--time around. Option 2. They can liquidate and give the money back to their shareholders and turn out the lights in the labs and the boardroom. Option 3. They can start looking for a merger partner.

There are about fifty seven million VC-backed biotech and medical device companies that would like to suggest Option 3 is the way to go.

So when the antibiotic developer Replidyne began evaluating its strategic alternatives following the failure of its Phase III faropenem compound you can be sure there was a long line of suitors hoping to access the biotech's $40 million and Nasdaq listing. That queue, said CEO Kenneth Collins on a conference call this week, was 120 companies long.

One hundred and twenty! And apparently Replidyne's board so tired of the biotech scene that they picked the medical device play Cardiovascular Systems to settle down with. The Pink Sheet Daily's in-depth coverage of the deal is here.

RDYN shares promptly fell about 20% to a 52-week low, below $1. Some analysts were upset that the deal, essentially valuing Replidyne at cash, didn't ascribe any worth to the firm's pipeline, but management had clearly given up on Option 1. Why any other company would therefore put any value on Replidyne's pipeline is beyond us.

But we are confused as to why more public boards don't opt for Option 2. The track record of reverse mergers over the past four years has been woeful.

In September, START-UP analyzed 28 biotech reverse mergers initiated since the beginning of 2005, as part of our private biotech M&A review. For those deals where we could find a shareprice six months post-closing (presumably when a lock-up would expire), only five firms kept their heads above water. The average decline at six months was –18.8%. When to-date performance was reviewed as START-UP went to press in early September, the news was worse: an average decline of –41.0%.

So why do companies like Replidyne participate? One last roll of the dice? Replidyne's investors will get 17% of the combined company in this case.

And granted this is a bit of an unusual situation in that Cardiovascular Systems actually generates revenue (its minimally invasive catheter system for the treatment of peripheral arterial disease launched in Sept 2007). We're on record as actually believing that CSI could pull off its planned IPO! But had Replidyne' s backers wanted to invest in a shell--or a catheter--they probably could have done so elsewhere. So why not liquidate and return the cash?

For cash-hungry private companies, unable to tap public markets for an IPO, and with their own VCs largely unwilling to provide further funding, the rationale for these reverse mergers is clearer -- unlike the Replidynes of the world, they haven't failed yet.

But the underperformance of reverse mergers (even compared to companies that are newly public thanks to an IPO or the biotech space in general) seems to have little to do with quality. There are plenty of exciting biotechs with top-tier management and promising pipelines that have reversed into a public shell only to struggle, valuation-wise. See Infinity Pharmaceuticals or Micromet, for example.

So have at us. Are we missing the point? There were 119 other companies interested in Replidyne. So with IPOs off the menu surely we'll see more reverse mergers in the coming months. Unless VCs tamp down their valuation expectations and begin selling their companies outright for whatever they can get.

image from flickr user Great Beyond used under a creative commons license