Short ONVO. Implications of Organovo Lawsuit

July 31, 2013 | RP

I last wrote about Organovo Holdings (ONVO) on July 24th. Since my last article, there have been several new developments which further reinforce the short thesis on the stock. The stock has continued to fall as expected.

First, the S3 registration statement for up to $100 million of new shares and/or warrants has now become effective. Some individuals had previously taken comfort that no offering would be impending because the S3 was not yet effective. It is now the case that Organovo is free to issue up to $100 million of equity securities at any time.

Second, I have uncovered an undisclosed legal action against Organovo by their own investment banker, Spencer Trask Ventures (“STV”). The initial arbitration filing was submitted on June 27th, when STV demanded compensation which is now valued at around $28 million. Under the terms of the original Placement Agency Agreement, Organovo had agreed to binding arbitration. However, on June 28th, Organovo filed in New York Civil Supreme Court to attempt to fight the arbitration.

There have now been a flurry of arguments and counterarguments in New York Civil Supreme Court during the month of June and July.

One issue is that this may prove to be a significant financial issue for Organovo. But as a totally separate issue, this is already a significant disclosure problem for Organovo.

None of this has been disclosed to investors, including in theS3 registration statement which just became effective a few days ago.

Preliminary points

Before getting into these issues, there are a few preliminary points that deserve to be made.

Following my article, Seeking Alpha contributor Jason Napodanowrote a forceful rebuttal to my article. It was his 4th bullish article on Organovo in less than 1 year.

In his article, Mr. Napodano makes it clear that the points in my article are either entirely irrelevant or else downright inaccurate. The author supports these statements with a mix of facts, opinions and anonymous postings from a Yahoo message board.

There are now three main issues which investors need to resolve for themselves.

  1. How much (if any) of the 32 million share overhang is currently depressing the share price?
  2. How much (if any) equity is Organovo likely to issue under the recent S3 registration statement?
  3. How much (if any) revenue is Organovo likely to generate in the next 1, 5 and 10 years?

Clearly I disagree with Mr. Napodano on each of these points.

A substantial overhang pressing on the share price from the 32million shares from 2012 is evidenced by the fact thatOrganovo still filed a subsequent prospectus on these shares.Once the overhang is fully removed, there will not be additionalprospectuses.

Organovo is likely to complete a very large financing under the$100 million S3 sooner rather than later. It has been less thanone year since the company deliberately reduced the exerciseprice of the existing $1.00 warrants to just 80 cents in order toget money in the door at that price. We can also see from theSTV lawsuit that Organovo tried to incentivize STV to exerciseby reducing the strike price to just 60 cents. This means thatOrganovo was attempting to issue new shares at a price of just60 cents as recently as February / March.

For revenue, Organovo may have some prospects with liver cellmodules at sometime in 2014. But we have been given noindication of the certainty or the amounts which may beinvolved. The key point here is that the hype surroundingOrganovo is in connection with the 3D printing of humanorgans. Not even the most bullish authors expect to seemanufactured human organ revenues any time in theforeseeable future. Instead, we will continue to see smallamounts of revenue from grants and research collaborations. Historically these have typically been in the range of six figureamounts.

In the meantime, we can see that Organovo has beensuccessful in two areas:

– selling stock to investors at $1.00 (or below)

– elevating its share price to above $6.00

The company has recently been sporting a fully diluted marketcap of nearly half a billion dollars, despite the following financial metrics:

– lifetime revenues of just a few million dollars (coming fromgrants and research)

– non cash assets (including all intellectual property) of lessthan $2 million

Metrics like these do not justify a market cap anywhere nearhalf a billion dollars.

A very small but vocal minority of readers continues to posttheir emotional comments below these articles. However amuch larger (and silent) majority chooses to express theirviews by selling their stock rather than typing up rabidcomments.

Prior to my article, the stock was hitting $7.70 in pre markettrading. Following my article the stock fell to $6.50.

It is now the case that all investors have the benefit of fullinformation from these various articles and comments and theshare price continues to slide rather than recover any lostground. Following his article on Organovo, Mr. Napodano left asubsequent comment stating that he believes that “fair value”for the stock is around $4.00-5.00 – an additional decline of asmuch as 20% from the current level. In the near term, I wouldagree with this statement, which is why I continue to be shortthe stock. Although any potential equity offering couldpotentially push the share price even lower.

An undisclosed legal action

In its past financings, Organovo used the services of SpencerTrask Ventures for raising what now totals roughly $28 millionin proceeds from stock and warrants. As of March, Organovohad $15 million in cash remaining.

The lead individual involved was Adam K Stern, a ManagingDirector with STV. Mr. Stern also became a Director ofOrganovo.

According to the terms of the Private Placement Agreement, Organovo would pay to STV a cash fee equal to 10% of theproceeds along with “agent warrants” ($1.00 strike price, 5 yearmaturity) equal to 20% of the stock issuable to investors. There was also an 18 month “tail” provision allowing foradditional fees to be payable to STV based on subsequentcapital raises. A key point of contention in the current lawsuit isthat it was agreed that STV would be appointed as an exclusiveWarrant Solicitation Agent at least 20 days prior to any noticeof redemption. Organovo agreed to not contact any of theinvestors introduced on STV’s proprietary investor list.

In 2012, Organovo Director Stern left Spencer Trask and wentto Aegis Capital. Shortly thereafter, the arbitration suit statesthat Organovo began the warrant solicitation to raise newmoney from STV customers. But instead of using (or evennotifying) STV, Organovo used Mr. Stern’s new firm, Aegis.

In total, Organovo raised $14.8 million through the warrantexercises. In fact, Organovo lowered the exercise price onwarrants to just 80 cents in order to raise new money at thatlevel.

STV did not find out about any of this until it became publicinformation through Organovo filings.

STV and Organovo are now in a protracted legal battle in whichSTV is demanding the disgorgement (and payment) of $14.8million along with $1.3 million in cash fees and the issuance of2.9 million warrants owed. The warrants alone would currentlybe worth around $12 million. Total consideration is thereforenow in the area of $28 million.

During 2013, and after the warrant transactions conducted viaAegis, Organovo and STV began negotiating a Warrant Agreement which would arrange for payment of compensationto STV. A second draft of the Warrant Agreement was also provided.

On March 1st, Spencer Trask’s attorneys sent an email toOrganovo CEO Keith Murphy rescinding the proposedagreement. A copy of the rescind email can be found here.

Following the rescinding, Organovo still sent small payments toSTV, however these payments totaled just $115,000, instead ofthe much larger sum demanded by STV.

Section 13 of the Placement Agency Agreement states (in ALLCAPS) that any “dispute, claim or controversy” which arises withrespect to this agreement will be submitted to JudicialArbitration and Mediation Services Inc. (“JAMS”) in the State of New York.

STV filed for arbitration on June 27th.

The next day, on June 28th, Organovo filed to fight the movefor arbitration, stating that the Warrant Solicitation Agreementvoided both the compensation earned by STV as well as theneed for arbitration.

As is often the case, many dirty secrets get spilled out inlawsuits. Organovo reveals that it had already agreed to pay toSTV $23 million in exchange for helping Organovo raise just$15 million in proceeds. The need to pay such a fee isstaggering in and of itself.

The lawsuits also reveal that Organovo was willing to lower thestrike price on STV’s warrants to just 60 cents, in order to raiseequity at that level. This was not in the distant past. This was inFebruary / March.

Both of these facts speak loudly to the fact that Organovo hasalways been eager to issue equity at just about any price, nomatter how low. The company has virtually no non-cash assetsand continues to generate only minimal and non-commercialrevenues. So getting money at any price may well be the beststrategy.

But it also reconfirms my suspicion that if the company is eagerto issue substantial equity for just pennies, then it will likely bea very large issuer of equity with the price sitting at just over$5.00. A normal discount for an equity offering like this wouldbe around 20%, meaning that an offering would likely takeplace at around $4.00. The stock price would then reactaccordingly.

Investors now need to ask themselves two very importantquestions:

First, how much of the $28 million in demanded compensationwill Organovo end up paying to Spencer Trask ?

Second, why are investors hearing about a potential $28million legal liability from me, rather than from Organovo in an8K or S3 legal disclosure ?

Reverse mergers in perspective

Commercializing a new product or service in the real world is anarduous and time consuming task. Successes are rare andoften take decades to make themselves evident.

Reverse merger stock promotions, in sharp contrast, are fareasier. It is very simple to achieve 8 and 9 figure fortunes inthe space of just a year or two.

Step one is to acquire the busted shell of a defunct company. Step two is to complete a reverse merger and inject sometoken amount of assets. Step three is to change the name. Step four is to heavily promote the story.

A few years ago, when China was hot, it was possible to create$500 million dollars by simply creating a reverse merger withthe “China” in the name. Hundreds of these companies wereuplisted to the NYSE and NASDAQ. Before that, when solar washot, there were numerous half billion dollar companies createdjust by having some hint of a solar business. Prior to thatadding “.com” to a companies name would often create similarvaluations for reverse mergers. But in the end, when thesecompanies failed to produce profits, we saw them ultimatelyplunge to the pennies.

As noted in “Get Rich or Die Tryin’”, there are two kinds ofinvestors in these promotions. The “Get Rich” crowd gets inearly at very low prices.

It is important to note that the Get Rich crowd has no intentionof waiting for the product to be an ultimate commercial success. Instead, they cash out when the promotion of the stock andthe story hits a peak.

Many authors (such as Mr. Napodano) have clearly expressedtheir views that the early investors in Organovo have alreadysold their stock – well before any commercial success is evenclose. They had no intention of waiting around for real worldsuccess because they were simply playing a stock promotion -not a product.

I agree that these investors will sell well beforecommercialization. But I also believe that they would be smartenough to wait for the price and liquidity which is provided bythe uplisting. This is why I believe that they are selling now.

Early investors cannot sell unless someone else is doing thebuying. Likewise, investors who buy these stocks should beaware that every time they buy, it is the result of someone elsebeing eager to sell. This is where the Die Tryin’ crowd comes in.

It is well known that institutions tend to steer clear of reversemerger promotions. As a result, reverse mergers rely heavilyon promotion to retail investors.

For example, Organovo has made ample use of a service called

Retail investors can often take comfort from various sources of ”validation” which may not be appropriate.

For example, some investors believe that an uplisting to theNASDAQ or the NYSE is reflective of some sort of judgment onthe investment merits of a stock. This is quite clearly not thecase.

In recent years, there were hundreds of Chinese reversemergers which uplisted to the NYSE and the NASDAQ. It wasultimately uncovered that many of these companies wereempty shell frauds with virtually no assets or employees. Mostof these companies were delisted to the pink sheets just asquickly.

The only point I am trying to make is that an uplisting willimprove liquidity, but does not have any implication for theinvestment merits of a company. Note: I am not making anysuggestion that Organovo is a fraud.

Likewise, many investors assume that obtaining a researchgrant is also validation of the long term potential of acompany. Sometimes this can be the case. But we can also seethat the list of non-productive research grants is very long and very large.

Examples include a $3 million federal grant to study the gameWorld of Warcraft and a $2.6 million program to teach Chineseprostitutes to drink responsibly.

My point is not to suggest that Organovo’s grants are withoutmerit. Instead, my point is to suggest that obtaining a fewmillion in grant money is a very common occurrence for manycreative ventures in the US.

So far, Organovo has not achieved any meaningful degree ofcommercial success. But the stock promotion has beenextremely successful.

Despite minimal assets and revenues, the company has beenable to briefly exceed half a billion dollars in market cap. Therecent rise briefly put the value of CEO Keith Murphy’s stock atnearly $40 million in a very short time since coming public.

Fortunes like this often take decades to achieve when one isdependent upon the actual commercial success of a product. But with reverse merger stocks, they often take just a year ortwo.

Ultimately, Organovo may end up being the reverse mergerthat transforms the nature of medicine as we know it. If so, itwill end up being worth many billions of dollars.

On the other hand, if Organovo fails, someone will come along, acquire the defunct shell and start over with a new billion dollarreverse merger idea. The name will be changed and so on.

Fortunately we are all able to come to our own investmentconclusions with respect to these divergent potential outcomesand we are all able to act accordingly.

I am short Organovo.