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Dealing with Uncle Sam - Alluring contracts with government frequently make for risky business

Inside Bay Area
By David Morrill, Business Writer

TWO YEARS AGO VaxGen Inc. thought it had struck a gold mine. The Brisbane-based biotechnology company was awarded an $877.5 million government contract to supply 75 million doses of anthrax vaccine for civilian use.

But VaxGen quickly learned that the road to government riches is daunting. Last month, the company announced that the original 2006 delivery date for the vaccine — and payment for it — would be delayed by up to two years.

CPU Technology Inc. of Pleasanton won government contracts potentially worth more than $245 million to replace several outdated radar processing systems with its own improved technology. That was about five years ago, and just now CPU Tech is starting to see some return on the deal.

"A lot can happen from the time you get the contract until you even begin to break even," CPU Tech Chief Executive Edward King said. "The government's priorities can change, and they can pull the plug on the contract at any time."

As those two examples show, technology and biotech companies that contract with the government can receive big rewards, but they face risks as well.

The rewards: huge contracts that can be paid off with no risk of bankruptcy; a long-term relationship with the largest contractor in the United States; and the chance to build a reputation in a high-profile arena.

The risks: Turning a profit usually takes several years, and the government can change the terms of the contract or even cancel it.

VaxGen, a spinoff of South San Francisco biotech giant Genentech Inc., saw its anthrax vaccine contract as a chance to redeem itself a year after a much anticipated AIDS vaccine turned out to be ineffective.

But after its coup in winning the largest single piece awarded under the Project BioShield Act of 2004, the giddiness has simmered down.

After the government asked for additional testing without providing additional financial support, VaxGen officials said last month that delivery of anthrax vaccine doses will be delayed until 2008.

And because VaxGen won't get a single cent until the doses are delivered, the contract that company officials once thought would help the company to soar suddenly could be its undoing.

Essentially all of the company's future revenue is dependent on its relationship with the government.

"Because we don't get paid until we deliver the product, we are continuing to take the risk," said Lance Ignon, a vice president with VaxGen.

VaxGen shares trade over-the-counter and have lost half their value in the past year.

If the company fails to deliver the vaccines, the government could say VaxGen defaulted on the contract and seek another way to add to the vaccine stockpile. VaxGen, meanwhile, will burn through its cash, and analysts say without a payday at the end it could be difficult for the company to recover.

"We are a science-driven company, but developing biodefense products is more about politics than science," Ignon said. "It's particularly frustrating because when all is said and done. We believe we have a pretty credible product."

Because the government is a ruling power, many companies have trouble adjusting to the major differences between it and a contract with a commercial business.

One big difference, experts say, is that the government can make modifications, such as changing how many doses of a virus it needs, and thecontractor can only comply.

Also, if at some point the government decides it no longer needs the product or service, it has the right to cancel the contract. Even though the contractor, in this case, would likely be reimbursed for costs incurred, the opportunity to make a profit would be gone.

Some contracts, such as those given to defense companies like Lockheed Martin Corp., are typically pay-as-they-go contracts. The advantage of this is that the company takes a limited risk if the contractor defaults, but the profit margins are reduced as well.

Many smaller technology and biotech companies choose to take the risk themselves because they have the confidence in the product or service they can offer. By being paid upon delivery, traditional commercial investment methods are used to raise the capital to complete the project. Therefore, at the end, the margins can be larger as well.

But companies that put too much weight on their relationship with the government, especially if the payout comes upon delivery, often are playing with fire.

"I would not be able to advise any company to stake its entire claim into a relationship with the government," said Sharon Seiler, an analyst with Punk, Ziegel & Co.

Also, the time it takes for a company to sign a contract with a government agency and actually see a return on investment is usually several years. Therefore, companies that don't have an alternative source for cash flow often struggle to fulfill their contractual obligations.

The companies that are most successful in dealing with the government are the patient ones.

"The only way to really work with the government is to have a great deal of patience and to really believe what you're doing is destined to go somewhere and be something — even when world events change," CPU Tech's King said……

Or…. If options A) or B) don’t wet your whistle – skip to option C). Create a domestic terrorist attack – whip everyone in a frenzy, take your generic product and now make it a premium product –double, triple – what the hell - quadruple the cost – and call it a day!

The hope for CPU Tech is that the government eventually will decide to use its technology for other complex computer systems, and CPU Tech could teach and sell rights to other companies to do what it does.

Unlike other sectors where companies can deliver services or products to the government either immediately or within a year, researching a new vaccine or technology can take many years. (Does not apply if you chose option C above)

Therefore, the perfect situation for a biotechnology or technology company to get involved with a government contract is when it also can target the private sector at the same time.

This way, if the government contract is modified or dropped completely, the amount of time and money spent on research and development won't go to waste.

Doug Farry — an attorney with McKenna Long & Aldridge LLP who assists biotech companies that work with the government — believes that for the right companies government contracts can provide tremendous opportunities.

"Are there different challenges in dealing with the government? Of course," said Farry, who served five years as senior policy adviser to House Majority Leader Dick Armey (R-Texas). "But at the same time, if you're a company that is able to reliably develop something of significance, they can be a great customer."

Business Writer David Morrill can be reached at (925) 416-4805 or dmorrill@angnewspapers.com.

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