Biotech Investing 101: Valuations and ROI
Investing in private companies is tricky business. Here’s what you need to know to make smart investment decisions.
There are only 3 questions that a prospective investor, regardless of industry or investment opportunity, needs to ask:
Let’s tackle the most difficult questions first: Why is the stock worth the market price and how will it appreciate over time the lifecycle of the drug development program (from preclinical research through FDA clinical trials and commercialization)?? The answers lie in the wonderful world of valuations.
When it comes to clinical-stage, pre-revenue biotech companies, the answer is not always clear. Unlike an operating company that is cash flow positive, clinical-stage biopharma companies are in the business of spending investor dollars to drive research and development and increase the theoretical purchase price of the company (i.e., the acquisition price). This prevents us from simply looking at a Price-to-Earnings or Price-to-Sales ratio to determine whether the enterprise is appropriately priced in the market. What we are going to have to perform requires a bit more nuance and some financial forecasting wizardry. Equities analysts use a technique called risk-adjusted discounted cash flow (rDCF) analysis to calculate the theoretical value of a company’s drug development pipeline.?
The general idea of rDCF analysis is that the value of a company’s drug development pipeline can be determined by summing the income generated from each drug over their patent lifetimes, and then accounting for the risk of failure.
In constructing our risk-adjusted discounted cash flow model, we must consider the following variables:
Discount rate
The discount rate is an interest rate used to account for the time-value of money and the opportunity cost of making one investment over another. The riskier the investment, the higher the discount rate. This implies that investors need a higher rate of return to justify placing their cash in an uncertain asset. For a brand-new company that is spending the majority of their capital on research and development, the discount rate is used to adjust the forecasted future cash flows that could be generated once the drug product is commercialized.?
Market capture and pricing
Unsurprisingly, market capture and drug pricing are the most influential components of an income-based approach to valuation. If the drug candidate is going to solve a previously untreatable disease, then assume that the vast majority of the market will be acquired. If there are competing technologies, then it is wise to segment the market. For example, patients that do not respond to the standard of care represent an untapped pool of customers. Perhaps the drug candidate does not have to compete directly with other treatment options. Arthur Cook's method of estimating drug revenues is a well-delineated methodology, as described in his book Forecasting for the Pharmaceutical Industry (2015).
The actual cost of the approved drug will be a function of the company's required internal rate of return (IRR) and the new therapy’s value-add over existing treatment options. The pricing will vary based upon who is actually paying for it - insurance, out-of-pocket patients, or Medicare. The price will also be influenced by the prices of alternative treatments.?
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Cost of Goods Sold and Administrative Expenses
This is relatively easy. Cost Of Goods Sold and Administrative expenses can be estimated as a percentage of revenue. I highly recommend The Pharmagellan Guide to Biotech Forecasting & Valuation (2016). According to a meta-analysis of 10-k filings from 35 small/mid-cap drug companies listed in the NASDAQ Biotechnology Index, median COGS and SG&A expenses were 15% and 34% of revenues, respectively. The cost of drug manufacturing is highly dependent on the type of drug (small molecule v. biologic), but costs continue to drop as manufacturing technology improves.?
Probability of clinical trial success
This is the boogeyman. Historically, 30% of trials fail in the preclinical/discovery stage, 40% fail in Phase 1, 64% fail in Phase 2, 37% fail in Phase 3, and 15% fail to get NDA approval by the FDA. Compound the probabilities… that’s less than a 1% approval rate of drugs that make it out of the lab. The outlook gets much better once a drug candidate completes the Phase 1 trial. A risk-adjusted NPV takes into account this risk of failure and adjusts the enterprise value by the compounded probabilities (depending on stage of development, of course). A more developed drug is a less risky drug and therefore a more valuable drug.
Economic life of the drug asset
This is an easy one. Patents and orphan drug status awards determine the period of exclusivity for a proprietary drug. It is important to look at the filing dates of the patents to make sure they are not set to expire when the drug is projected to complete clinical trials. Patents typically guarantee 15-20 years of protection from the date of grant. Innovators are constantly filing continuation patents to keep their intellectual property alive during the R&D process. Once exclusivity is lost and generics flood the market, you can expect the revenues to plummet. A terminal value can be assigned to capture the remaining value of the drug in perpetuity.
Return on investment
Private biotech companies do not have their stock listed on an exchange, so investments are tied up until there is a liquidity event. A liquidity event allows shareholders to cash out, and can take the form of a private acquisition/licensing deal or an Initial Public Offering (IPO). Many private biotechs have no intention of actually commercializing their drug assets, favoring the acquisition or licensing route due to capital constraints. Acquisition activity in the biotech industry is hot due to the expiration of Big Pharma’s patents. When a patent expires, generics flood the market and the value of the proprietary drug asset is significantly diminished. Big Pharma has adopted an acquisition strategy to stack their development pipelines with “de-risked” drug assets. Small, private biotechs de-risk their drug assets by completing the early phases of clinical trials (Phases 1 and 2), then Big Pharma swoops in and offers to buy the shareholders out.
The Result: Cytonics Case Study
Your income-based valuation approach should result in an exponential valuation curve. It’s easy to see why clinical-stage biotech companies live and die by clinical trial results. A positive data set can equate to a doubling in valuation overnight.?
Below is the valuation curve for Cytonics. This result was generated using the following (very) conservative assumptions: 1% market capture, 50% discount rate (risky!), and $1,500 cost per treatment (2 treatments per year). This is how we arrived at our current valuation of ~$60M. Our goal is to sell the company to Big Pharma in Phase 2/3, when we can justify a $200-$500M acquisition price.