Valuation--what you need to know

Finance/Funding Published online: 21 June 2004, doi:10.1038/bioent814 Valuation—what you need to know Patrik Frei1 & Benoît Leleux 2 Patrik Frei is at Venture Valuation, Zurich, Switzerland (http://www.venturevaluation.com ), a valuation boutique specializing in independent, third-party valuations. e-m ail: patrik.frei@venturevaluation.ch Benoît Leleux is at IMD, Lausanne, Switzerland (http://www.im d.ch). The basics of determining valuation will help you to understand what criteria matter most for investors. Valuing a company has alw ays been more art than science. At the best of times, it is a tricky and difficult task, especially for early-stage, biotech companies. The so-called pre-money valuation (w hich takes place before a company is financed) dictates how equity is divided among a company's investors and entrepreneurs. Those entrepreneurs foolhardy enough to ignore the need for a proper valuation before they begin seeking capital not only may find themselves at a disadvantage in negotiations w ith investors, but also may have no w ay of rectifying a situation if the company valuation is suboptimal. In contrast, those w ho prepare a thorough valuation of their venture often gain a strong negotiating position, even in a buyer's market. Every startup should thus enter financing negotiations w ith a clear understanding of its value drivers to obtain a fair and full valuation. In this article, w e provide a basic outline of how to conduct a proper valuation exercise and present tw o common methods used to value an early-stage biotech company. Gauging value A company's value lies in its potential to generate a stream of profits in the future. All valuation exercises are thus based on envisioning a company's future, relying almost entirely on educated guesses. Value is based on assumptions as to w hat a company's future may look like, w hat important milestones w ill have to be met and strategic decisions taken. These assumptions are grounded in three fundamental factors: first, the state of the market targeted by the company; second, the principle elements of a company's science and technology; and third, the ability of management to deliver on the business plan. An intrinsic part of the envisioning process is thus the ability to question a company's fundamental economic, technological and managerial hypotheses, as w ell as the likelihood of a company delivering on its promises. There is no gold standard w hen it comes to valuation: it is and w ill remain a subjective task. Consequently, a company can have as many values as there are people doing the valuation. Even so, w e w ould recommend that every valuation start w ith a systematic and rigorous testing of a company's economic, technological and managerial hypotheses in combination w ith the follow ing tw o key approaches: primary valuation, w hich is based on such fundamental information as projected future free cash flow (FCF) and costs of capital; secondary valuation, w hich is based on comparable information, w here valuation is done by analogy to other similar companies. W ith a good understanding of the above tw o approaches, an entrepreneur is already w ell equipped to tackle the negotiations that w ill ultimately determine the deal valuation. Fundamental valuation The most common approaches to primary valuation in the corporate finance literature are generically referred to as the discounted cash flow (DCF) methods, w hereby a company is valued at the present value of the future cash flow s it w ill be able to generate. These methods are conceptually robust but can prove difficult to implement in high-uncertainty environments, such as those of early-stage biotech firms. Typical problems include highly uncertain and distant positive cash flow s, a business model based on many assumptions and a difficult risk profile. Although the DCF methods commonly applied in such contexts could be construed as technical overkill (given the variable quality of assumptions made about the future performance of a biotech company and the lack of tangible results on w hich to base calculations), they can still generate valuable insights into the value drivers of a company (even though the final number generated may be of questionable value). Corporate finance theory indicates that the value of any asset is equal to the present value of its future cash flow s. Therefore, in principle, all that is needed is (i) to estimate the expected future cash flow s of the business, and (ii) to discount back to the present all these future cash flow s, using a discount rate consistent w ith the level of risk in the project. In practice though, problems emerge at every step of this process. First, projecting performance for several years into the future is a process seen by many as too speculative to be useful. Second, selecting a forecasting horizon for the future cash flow s (5 years, 10 years or 20 years) is purely arbitrary and leaves open the question of the residual value of the business at the end of that horizon. Third, obtaining an appropriate discount rate for an earlystage, privately held company presents difficulties. Projecting cash flow s into the future is never an easy endeavor, especially for smaller, high-grow th life science firms. The key data used for valuation is the FCF. According to Copeland, Koller and Murrin 1 , "[FCF] is a company's true operating cash flow ." In other w ords, the FCF refers to the cash flow s free of (or before) all financing charges related to the corporate debts. These cash flow s include all necessary fixed asset investments and w orking capital needs, as both are normally needed for a viable business. The FCF is estimated through the financial projections of the business plan. Depending on the available information and the time frame needed for a steady revenue flow , a forecast period of 5 or 10 years is most commonly used. The easiest approach to determining the most appropriate discount rate in a DCF exercise is one that w ould use the stage of development of the company, w hich can be determined by the drug development stage of products in the pipeline as proxies for risk (see Table 1). For example, a company that is generating leads w ithout further developed products w ould be considered a seed stage company and a discount rate of betw een 70%–100% w ould be used. Although conceptually a bit loose, the method is surprisingly reliable. Several factors typically influence the risk profile of a biotech company (Table 2). Once identified, the risk factors can then be used to determine the discount rate w ithin the ranges provided in Table 1. The discount rate to be used in a DCF calculation depends on the degree to w hich a company fulfils each of the criteria. As the discount rate is critical in determining value, it is appropriate to spend time in meticulously assessing each criterion and to investigate the sensitivity of the results to the various parameters. The full DCF approach is illustrated in Box 1. Table 1: Discount rates to be used depending on stage of product developmenta Company stage Discount rate (%) Drug development stage Seed stage 70–100 Generating leads Startup stage 50–70 Optimizing leads/preclinical First stage 40–60 Phase 1 clinical trial Second stage 35–50 Phase 2 clinical trial Later stage 25–40 Phase 3 clinical trial The discount rate presented incorporates the overall 'risk profile' of the company investigated, a profile driven jointly by technological, market and business (management/organization) risks.Source: reference 2. a a The discount rate presented incorporates the overall 'risk profile' of the company investigated, a profile driven jointly by technological, market and business (management/organization) risks.Source: reference 2. Comparable valuation The comparable method is also know n as a 'secondary' valuation method because it uses the market value of comparable companies or transactions as reference points. The method relies on available key figures, such as Iearnings, sales, number of employees, number of PhDs or R&D expenditures, to estimate value. n a sense, secondary valuation makes the assumption that these comparable companies have been properly valued, and can serve as benchmarks w hen assessing a company. For example, if a comparable public company is valued at $1,000 w ith R&D expenditures of $500, for a price/R&D ratio of 2, then the private company to be valued w ith R&D costs of $200 w ould, by analogy, be w orth an estimated $400. An example of comparable valuation is provided in Box 2. Cautionary remarks Humility and realism are the tw o key attributes of the prospective company valuator. Humility is needed to recognize that the exercise is primarily about envisioning the future, and that the exercise is fraught w ith uncertainty. Realism w ill help to understand that the inherent uncertainties do not constitute an excuse for sloppy estimates of the valuation components. W hether the valuation is done explicitly (as in the DCF methods) or implicitly (as in the comparable methods), either method w ill give an accurate valuation if carried out by experienced valuators. Although the valuation methods described here are routinely used by investors, w e offer three important cautionary remarks to help the new comer to w atch for typical pitfalls. First, investors often refer to pre- and post-money valuations: pre-money is the value before the investment is included; post-money is the value including the new investment. Thus, pre-money value + investment = postmoney value. Investors routinely play w ith different figures and company data. Numbers are their daily business and they may try to use them to their advantage. Second, don't enter into negotiations w ithout having completed your homew ork. Management needs to master the figures and numbers and have clearly laid out its expectations about pre- and post-money value and the corresponding value of its shares. Only w ith preparation and a good understanding of valuation drivers can management establish itself as a credible partner in front of investors. And third, valuation is not everything. The investment contracts that accompany investments can easily take aw ay everything that w as given in a rich valuation, by imposing drastic restrictions on the future conduct and w ealth of the founders. Similarly, a company must feel comfortable w ith its investors because they w ill share the same bed, figuratively, for a long time to come. It w ould thus be foolish to maximize the short-term share price if it is at the cost of the long-term value creation potential of the company. Never lose track of the fact that a financing round is just a means to an end, not the end itself! Table 2: Reduce the risk profile: what are the driving factors that influence the value of a biotech company? Management Management team ˙Historical track record/experience ˙Varied skill sets ˙Financial incentives to keep them in place Individual members Market Product ˙Revolutionary rather than just evolutionary ˙High consumer demand Technology Intellectual property ˙Freedom to operate ˙Ease of scalability Stage of technology Business model ˙Much experience ˙Makes sense ˙Ready to commercialize Technological partnerships & alliances ˙Entrepreneurial attitudes ˙Broad customer base ˙High probability of partnering ˙Good business judgment ˙Ease of distribution ˙Diverse collaboration ˙Great motivation/commitment Industry structure Management of future innovation ˙Strong patent protection Directors/scientific board ˙Few substitutes ˙Robust pipeline ˙Highly respected in community ˙Little rivalry among existing competitors ˙High chance of second generation product development ˙Independent thinkers ˙Low barriers of entry ˙Low bargaining power of suppliers ˙Low bargaining power of buyers ˙Proactive involvement Box 1: Example of DCF model for determining valuation Table 3 shows the expected FCFs in the next 5 years for a fictitious biotech company. The analysis of the management shows some weaknesses in business development but the overall experience level of the team is excellent, coupled with strong boards of directors and advisors. The market targeted shows high growth rates but also high competitiveness. The science and technology of the company is sound and solid, with strong intellectual property protection and a filled pipeline for the future. The most advanced product in the company's pipeline is in phase 1 clinical trials. This assessment and referring to Table 1 for the stage of the company, a discount rate of about 42% seems appropriate, at the low end of the range for the first stage due to the favorable factors above. Table 3: Calculation of pre-money value of a fictional biotech FCF ($ millions) 2004 2005 2006 2007 2008 Continuing value (CV = FCF for 2009/[discount rate − perpetual growth rate]) Pre-money valuation −1,400 −600 2,100 5,500 11,000 Present value (FCF/(1 + Discount rate)^[years from present]) ($ millions) −1,400/(1.42)1 = −986 −600/(1.42)2 = −298 2,100/(1.42)3 = 733 5,500/(1.42)4 = 1,353 11,000/(1.42)5 = 1,905 41,667 41,667/(1.42)5 = 7,217 58,267 9,925 The continuing value (CV) of the company (that is, the value in 2008 of all cash flows in 2009 and beyond) is calculated with a normalized FCF of $12,500 for 2009, estimated by extrapolating from the 2008 FCF of $11,000 (FCF for 2008 is calculated based on the projections in the business plan) on the basis of the established growth trend and a perpetual growth rate of the cash flows beyond 2009 of 12%. The growth rate is estimated based on the long-term industry growth rate of the market in which the company is active. On the basis of the equation shown in Table 3 (present value = FCF/[discount rate – perpetual growth rate]), the CV in 2008 in this example is $41,667 (that is, $12,500/[(42% – 12%]). Readers should note that even though the assumption of a 12% perpetual growth may sound a little optimistic, the large discount rate of 42% applied (because of the early stage of product development) essentially guarantees that very distant cash flows have very little impact on the value of the company today. The premoney value of the fictitious biotech company is the present value of the first five years of cash flows plus the present value of the continuing value, which is equal to $9,924 (see Table 3). PV = FCFt/(1 + discount rate)t + CV (with t = years from present). Box 2: Simplified example of comparable valuation A comparable valuation for a fictitious biotech company is based upon a financial investment into a comparable company that took place, for the example, two months before the present. Table 4 shows the input data for the comparable company and the fictitious company to be valued. Table 4: Parameters of a company and fictitious biotech company deemed comparable for a secondary valuation Parameter Comparable company Company to be valuated Past 12 months' revenues Employees $3 million $4 million 15 17 Past 12 months' R&D $5 million $8 million Value $10 million ? Based on the information in Table 4, ratios (including price/revenue, price/employee and price/R&D) can be calculated (see Table 5) and used to estimate the value of the company of interest. These ratios are used because they have a direct or indirect impact on the valuation. It would seem to make more sense to use earnings or cash flows as the ultimate basis of comparisons across firms. Unfortunately, most early-stage companies, as development entities, tend to burn more cash than they generate, and usually have negative earnings as well. Comparing losses or cash burns would obviously lead to nonsensical valuations (would a comparable company burning twice as much cash as the company being valued deserve double or half the valuation?). The amount spent on R&D, the number of people working for a company and the level of revenues that can be generated already are seen as better indicators of future performance. Table 5: Calculation of a comparable valuation for a company Calculati on Value/revenues 3-Oct Value/employee 15-Oct s Value/R&D 5-Oct a Ratio Company to be valuated ($ million) Value ($ million) = 3.3 × 4 = 13.2 = 0.66a × 17 = 11.3 = 2 8 = 16 13.5 × Average value 0.66 represents a value of $660,000 per employee, or $0.66 million With all three ratios weighted equally, the resulting (mean) value of the company is $13.5 million, with a spread between $11.3 million and $16 million. References Copeland, T., Koller, T. & Murin, J. Valuation: Measuring and Managing the Value of Companies (John W iley & Sons, New York, 2000). Frei, P. & Leleux, B. Valuating the company. in Starting a Business in the Life Sciences—from Idea to Market. (Luessen, H. (ed.).) 42–55 (Edition Cantor Verlag, Aulendorf, Germany, 2003). © 2019 Nature is part of Springer Nature. All Rights Reserved. partner of AGO RA, HINARI, O ARE, INASP, O RCID, CrossRef, CO UNTER and CO PE