Not all companies are valued equal

Biotech companies are having one of their worst stock-market runs in years (The?SPDR S&P Biotech ETF, an equal-weighted index of biotech stocks, fell 19.7% in the first quarter of this year, compared with a 5% decline in the S&P 500.), as rising interest rates, scientific setbacks and a slowdown in big pharma buyouts batter the sector, leading also to a decrease in valuations in the private market.

Venture capitalists are searching for innovative ideas, excellent management skills, and great business models to make their investment the next huge success. Start-ups in the areas of financial technology, the Internet of Things, digital health, and synthetic biology are trending at the moment

Determining the financial value of the company becomes an inevitable question for founders and investors when agreeing on giving away a specific percentage of the founders’ start-up for a specific amount of investment. Assessing the value of an early-stage growth company is not easy, mainly due to the short financial history, uncertain growth potential, and little comparability to listed companies or past transactions. The variables mentioned above pose an issue for Investors and Founders when meeting at a negotiation table: Which is the value of the company?

Before getting deeper into different valuation methods, how can we define them?

The valuation is the expectation of potential revenues from the company in a defined timeframe.

Are all companies valued the same way? and the straightforward answer is a big NO. We will concentrate this newsletter on Biotech, the industry is characterized as immature and highly uncertain, with little to no revenue for at least 4 to 5 years, fails in the primary business phase, and only a little percentage of start-ups survive. The main assets lie in intangibles such as IP, and brand name, increasing the risk and adding to the fact that despite increased understanding of the function and therapeutic capacity of proteins and monoclonal antibodies it has been acknowledged that it may be difficult to anticipate the effects of product and process changes on subsequent clinical performance. Uncertainty surrounding the risk and reward of investments in biopharmaceutical companies poses a challenge to those interested in funding such enterprises.

Valuation Methods:

There are no absolutes in valuation; the circumstances of the valuation and its purpose will influence the value. The market is sophisticated and changes in value are linked more closely to changes in expectation than to absolute performance. Valuation levels are linked to the return on invested capital and growth. Further, high discount rates reflecting high uncertainty and risk reduce the valuation too much in order to conduct business efficiently. If low valuations are obtained for biotechnology companies, the risk of them not obtaining sufficient funding to maintain a product pipeline will occur and promising development projects might not get spotted.

Traditional valuation methods tend to focus on mature businesses and the tools used for the valuation of mature having positive revenues. The most frequently used valuation methods are the Discounted cash flow (DCF) and Multiples Methods. At the end of the article, We′ll see another method called Real Options Valuation, which if used correctly could give us the most accurate value for biotech companies.

DCF:

The DCF approach is based on the concept that investment adds value if it generates a return on investment above the return that can be earned on investments of similar risks. The value of companies is based on the expected cash flow discounted at a rate that reflects the riskiness of the cash flow.

Discounted cash flow method fails also to reflect the ability to respond to changes in technology and market, it simply assumes that the project is forecasted concerning its duration, cost and possible revenue generation once and it gives no room for management’s flexibility.

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For start-ups, however, the intrinsic valuation applied in the DCF method cannot be used due to several reasons:

• No history: Young companies with a limited history mostly only have one or two years of data available. The basis of a DCF is to forecast the growth, but with no information from the past, this growth forecast becomes very subjective (Damodaran, 2009).
• Little or no revenue: In the first years, most start-ups generate significantly operating losses and negative cash flows, which are mainly associated with the cost of setting up the business. Establishing a useful operating pattern and thereby growth rate for the DCF is therefore impossible, especially since small changes in the input parameters can lead to significant changes in the overall values (Kotova, 2014).
• Binary business model (The Live or Die model): A lot of uncertainty regarding the future of the business exists, with up to 56% of businesses failing in the first three years (Knaup & Piazza, 2007). The DCF mostly only takes one scenario into account, which does not fit the binary business model of start-ups. Therefore, the valuation method used for start-ups has to be as flexible as possible, allowing the investor to take different scenarios into account.
• Timing: The DCF approach is very sensitive to the time to market of start-up companies. High-tech or pharmaceutical development projects have long time horizons of up to 30 years. With the valuation of the DCF approach, none of these projects would be started due to the high uncertainty and long period without positive cash flows (van Schootbrugge & Wong, 2013). The DCF approach fails to include value generated in the far future and therefore is not suitable for start-up companies.
• Rigid model: Van Schootbrugge and Wong (2013) reveal that the DCF approach does not include enough flexibility for optional expansion strategies. In case a start-up learns from it initial mistakes, the market strategy can be significantly changed and investment reallocated to other products which have proven to be successful.

Multiples methods

All multiple methods derive the theoretical justification from discounted cash flow models. In principle, the multiples capture the market’s view of the balance between the value of future cash flows deriving from the existing business plus other future growth opportunities and the corresponding risks.

Two basic categories of multiples exist (Vernimmen, 2014):

• Price multiples: These multiples are used to calculate the market capitalization of a company directly. The most common multiples are the price-to-earnings ratio (Equity value/PER) or the price-to-book ratio (Equity value/PBR).
• Enterprise multiples: These multiples don’t consider the capital structure of a company and are used to calculate the entire value of the company, the enterprise value (EV). The most popular multiples are the EBIT multiple (EV/EBIT), Sales multiple (EV/Sales) or EBITDA multiples (EV/EBITDA).

The following factors explain why the valuation of start-up companies using multiples will be equally difficult:

• Comparable companies: Relative valuation techniques are used to value a company with publicly traded comparable companies of equal size in a similar industry. Start-up companies should therefore be compared with other small companies, which are usually not publicly traded.
• Common measures: Such as EBITDA, EBIT or P/E ratios are mostly negative, thus, multiples for negative measures will not result in a meaningful valuation.
• Probability of survival: Start-up companies have a high probability of failure, adding more risk to the transaction. When comparing large public companies with start-ups for multiple valuations, this risk needs to be taken into account. Start-up companies should therefore be valued substantially lower since they have a smaller chance of surviving compared to bigger companies with an established product portfolio.

Real options

As most valuation methods mentioned above have proven to be too rigid and not really applicable to start-ups, the ideal valuation technique is supposed to be flexible enough to adjust for the uncertainties in start-ups, but at the same time value the potential the start-up may have in future. Therefore, instead of using shortcuts in the valuation, investors should rather use a well-reasoned, systematic approach to value start-up companies. The real options approach embeds the option to expand, defer, reallocate or contract an investment and allows more flexibility successfully complementing traditional approaches, such as the discounted cash flow model, which does not account for volatility or investment timing of cash flows (Baduns, 2013).

The strategic value of real options is highlighted in the table by Leslie and Michaels (1997), who claimed that by managing real options proactively the following advantages can be obtained:

Furthermore, the real options approach decreases the probability of overlooking a future profitable investment opportunity. Lin and Herbst (2003) have shown that using real options is especially useful for valuing start-ups with pending patents that are associated with high growth. Since start-up companies operate with a higher degree of uncertainty compared to mature companies, the management tends to change their decisions during the development stages (Banerjee, 2003). Therefore, the flexibility allowed in the real options valuation is necessary to account for the change of plans, as Banerjee (2003) has proven the importance of real options for big R&D investments, which are still uncertain. It is widely accepted that the development of a drug by a corporation can be thought of as a series of decisions about whether to continue or discard a particular project. Having an?opportunity to invest means that firms have the potential for a profitable return on investment as well as the scope to minimize loss by abandoning a project (Fig.1). Real options allow companies to quantify the value that is added to a project by having the potential to invest, and the potential to abandon, the project. Furthermore, real option could be applied to the evaluation of a portfolio of projects?or to rank projects within a portfolio.

Fig.1: The decision process that might currently be employed in an ROV analysis

As might have figured out already, valuation methods have several assumptions that need to be in place in order to figure out the value of a company and we need to be very careful when we apply them to not come to a false conclusion.

Knowing the true value of your company is often a deciding factor if selling the business becomes a possibility. It also helps to show company income and valuation growth over the course of the previous five years. Potential buyers like to see that a company has seen regular, consistent growth as it ages. If you are looking for funding, you are more likely to gain the attention of potential investors when they can see that their funds will carry the company to the next level, increase its value, and improve its ROI, your absolute value can be used as a starting point for any investment negotiation.

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