It's not easy being green – or a precommercial drug developer. In fact, that existence has been a relatively painful one since funding for the industry suddenly dried up in 2022. It hurts more considering the era of easy money persisted for so long up until the well ran dry.

To navigate the frustratingly viscous financial landscape, Recursion Pharmaceuticals and Exscientia have announced plans to combine into a single, technology-enabled drug discovery entity.

Whether the combination succeeds will depend on a confluence of factors spanning financial, technical, and competitive metrics. The merger has the potential to be messy, especially if the new Recursion fails to define a coherent development strategy for the technology platform and pipeline.

"AI drug discovery" carries no more meaning for investors than any other tool used in the lab, nor does it equate to a strategic direction in drug development.

Transaction Details

The proposed business combination will be an all-stock transaction.

• Recursion shareholders will own roughly 74% of the combined entity, which will be named "Recursion" and will retain the stock ticker "RXRX."
• Exscientia shareholders will trade each share of Exscientia for 0.7729 shares of Recursion.

There's not a fixed price for the transaction. The market will get a say in how much or little to value the combined business between now and the close of the transaction.

Instead, investors might find it easier to focus on what happens when the dust settles:

• The new Recursion would have roughly 378.881 million shares outstanding.
• If the combined entity had a market cap of roughly $3 billion, then each share would be worth $7.91 apiece.
• Although the combined company would boast a larger pipeline and roster of collaborations (making it more valuable), it will also have redundant expenses (making it less valuable).
• At the end of June 2024, Recursion and Exscientia had a combined cash balance of approximately $825 million. By the time the transaction closes in early 2025, the combined cash balance might dwindle to just $575 million.

Investors are reminded that the proposed merger might be terminated. The merger terms show a lopsided balance of power.

• If Exscientia terminates the merger, then it must pay Recursion $6.88 million.
• If Recursion terminates the merger, then it must pay Exscientia $58.77 million.

The larger company in a proposed merger or acquisition often offers better terms to the smaller company, as the latter has less managerial bandwidth to devote to merger paperwork. But this is an interesting divergence. Exscientia is a stronger standalone company despite being smaller, while Recursion has more to gain.

Finally, investors are reminded that the proposed merger might be blocked by regulatory bodies. The transaction value is low enough to avoid triggering antitrust concerns, but the United Kingdom's Competition and Markets Authority (CMA) is a unique little butterfly. The CMA, akin to the U.S. Federal Trade Commission (FTC), has taken an aggressive protectionist stance to mergers and acquisitions involving its homegrown businesses.

I have a contact at the CMA. As a complete coincidence, I was the journalist who broke the news that the CMA would recommend blocking Illumina's acquisition of PacBio (to protect the U.K.'s Oxford Nanopore) – at The Motley Fool of all places. I actually got scolded by editors because "while commendable, this isn't the type of work we do." I now have my own platform, so that won't be a limitation.

If there's wind of the CMA throwing a wrench into the Recursion and Exscientia combination, and I can discuss it publicly, then members will be the first to know.

What Does the Merger Mean for the Pipeline?

Oh boy.

There are two primary strategies in drug development:

• Develop first-in-class drug candidates. These target unique and often unvalidated disease drivers, such as a new protein that sorta-kinda-maybe plays a role. Examples include Recursion and Coherus BioSciences.
• Develop best-in-class drug candidates. These target well-validated disease drivers, but aim to do so with better convenience, efficacy, safety, or all the above compared to existing treatments. Examples include Exscientia and Relay Therapeutics.

A first-in-class strategy is generally riskier. Drug developers using this approach need to prove the hypothesis for a new therapeutic modality or disease target is correct and works better than existing and better-validated treatments already on the market. The upside is there's a small chance to discover the "next big thing." Imagine being one of the first to market a TNF alpha inhibitor (like Humira), a GLP-1 agonist (like Zepbound or Wegovy), or a PD-1/L1 inhibitor (like Keytruda).

A girl can dream.

She can also adopt a best-in-class strategy, which is much more de-risked. Drug developers using this approach let their competitors discover what works and doesn't for new drug classes, then tries to optimize for the "what works" part.

The proposed merger scrambles these paths. Exscientia adopted a best-in-class strategy that balanced risk with reward while wisely monetizing R&D through collaborations with Sanofi, Bristol Myers Squibb, and Merck. Arrowhead Pharmaceuticals pioneered this approach and is now well-positioned for long-term value creation.

Recursion adopted a first-in-class strategy that favors higher risk, higher reward assets. To be fair, the company's unique computational approach is the best-positioned to pursue this strategy across the global landscape. It's just a bit of a mess right now.

The most mature pipeline programs weren't developed with the existing platform. They're also in underwhelming and disparate therapeutic areas, which likely won't justify the expensive buildout of commercial infrastructure. The first programs to test the computational component of the technology platform (needed to model a potentially significant improvement in drug development probability of success) are a couple years behind.

From that perspective, the proposed merger is essentially combining three pipelines. It gets worse. The "focus" spans solid tumors, liquid tumors, fibrotic diseases, precancerous lesions, rare diseases, and infectious diseases. Recursion would almost certainly need to simplify, either by terminating programs or divesting of licensing them.

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It gets better. The combined company would have an interesting combination therapy opportunity.

Both Recursion and Exscientia are developing next-gen CDK inhibitor treatments for hormone-positive solid tumors, except Recursion's inhibits a secret target that only mimics the CDK12 protein. That suggests the two assets could be studied in combination because they might be the industry's only pairing with an acceptable toxicity profile. That could have top 25 bestselling drug potential – if both work.

Maybe the combination of a first-in-class, best-in-class pipeline could be worth it after all.

Forecast & Modeling Insights

(No change.)

I'm going to take more time to gather information. Both companies will continue to have separate models.

Margin of Safety & Allocation

Recursion is considered a Growth (Speculative) position. The current modeled fair valuation for the company based on my 2024 model is below:

• Market close August 7: $6.37 per share
• Modeled Fair Valuation: $6.53 per share
• Allocation Range: Up to 5%

Recursion reported 281.109 million shares outstanding as of July 31, 2024. The modeled fair valuation above assumes 295.164 million shares outstanding, which is equivalent to 5% dilution. It does not account for the proposed merger with Exscientia.

Exscientia is considered a Growth (Speculative) position. The current modeled fair valuation for the company based on my 2024 model is below:

• Market close August 7: $4.50 per share
• Modeled Fair Valuation: $6.03 per share
• Allocation Range: Up to 5%

Exscientia reported 129.5 million shares outstanding as of March 2024. The modeled fair valuation above assumes 139.150 million shares outstanding, which is equivalent to 10% dilution. It does not account for the proposed merger with Recursion.

Further Reading

• August 2024 press release announcing the proposed merger
• August 2024 regulatory filing discussing the proposed merger in more detail
• August 2024 press release announcing Recursion's Q2 2024 business update
• May 2024 research note analyzing Exscientia's Q1 2024 business update