Five Ways to Value Biotech Companies Investors Should Know

Biotech is the primary reason humans have defeated several life-threatening diseases, including the pandemic. Biotech plays a crucial role in our healthcare, from innovating new drugs to accelerating their development. As a sector, biotech holds a lot of promise. It has led to tremendous value, as most of the world's top revenue-generating drugs are derived from biotechnology, and 7 of the top 10 selling drugs are biologics. However, the journey of an early-stage biotech company is not easy. The entrepreneurs have to convince investors of their product's disruptive potential, and it takes many years to turn a profit. One of the challenges during the funding stages is to value the company accurately so the investors understand the opportunities and risks.

In the sections below, we explore the five popular valuation methods used for biotech companies. Each method signifies the quest for accurate valuation with the available company data; hence, they are all used in different scenarios.

#1. The Venture Capitalist Method

The Venture Capital (VC) Method is widely used to evaluate startups as they progress through standard funding rounds. This method is particularly applicable for companies following the typical trajectory of the Seed round, Series A round, Series B round, and eventual exit.

In most cases, the Lead VC determines the valuation, which other investors in the round then accept. Occasionally, two VCs might co-lead the round and jointly establish the valuation. The VC method values the company based on the total round size and standard percentage benchmarks.

The valuation benchmarks are determined as per the following:

Seed Stage:

·??Post-money valuation: 4x to 5x the round size

·??Investors typically purchase 20-25% of the company

For example, a high-growth potential company’s $7M Seed round might be fairly valued at $35M post-money, with investors acquiring 20% of the company.

Series A Stage:

·???Post-money valuation: 5x to 7x the round size

·???Investors typically purchase 15-20% of the company

Series B Stage:

·???Post-money valuation: 7x to 10x the round size

·????Investors typically purchase 10-15% of the company

This method generally provides a valuation within a factor of two of the correct value, assuming management is experienced, the company is progressing efficiently, and there are no major issues or irrational market exuberance. Within this range, the final valuation is influenced by company-specific factors and the negotiation skills of both the VC and management team.

#2. The Competitor Comparable Method

The Competitor Comparable Method offers a refined approach to startup valuation. It draws parallels with companies at similar stages and operating in the same market. This method provides a more contextual perspective, grounding the valuation in real-world examples rather than relying solely on theoretical calculations.

Steps in the Competitor Comparable Method:

1. Identify comparable companies: Find startups or established businesses that are similar in terms of industry, business model, target market, growth stage, and size.
2. Gather relevant financial data: Collect information on valuation metrics like revenue multiples, EBITDA multiples, or user/customer multiples for comparable companies.
3. Calculate average or median multiples: Determine the average or median multiples across the comparable set.
4. Apply multiples to your startup: Use these multiples to estimate your startup's value based on its financial metrics or key performance indicators.

Here are a few examples for better understanding:

1. Revenue multiple example: Suppose you have a SaaS startup with $2 million in annual recurring revenue (ARR). You identify five comparable SaaS companies with the following revenue multiples: Company A: 8x ARR Company B: 10x ARR Company C: 7x ARR Company D: 9x ARR Company E: 11x ARR

The median multiple is 9x ARR.

Applying this to your startup: Estimated valuation = $2 million ARR * 9 = $18 million

1. User multiple example: Imagine you have a social media app with 500,000 monthly active users (MAU). You find three comparable social media startups that were recently acquired: Company X: Valued at $50 million with 2 million MAU ($25 per user) Company Y: Valued at $30 million with 1 million MAU ($30 per user) Company Z: Valued at $80 million with 4 million MAU ($20 per user)

The average value per user is $25.

Applying this to your startup: Estimated valuation = 500,000 MAU * $25 = $12.5 million

1. EBITDA multiple example: Your e-commerce startup has an EBITDA of $1 million. You identify four comparable e-commerce companies with the following EBITDA multiples: Company P: 12x EBITDA Company Q: 15x EBITDA Company R: 10x EBITDA Company S: 14x EBITDA

The average multiple is 12.75x EBITDA.

Applying this to your startup: Estimated valuation = $1 million EBITDA * 12.75 = $12.75 million

However, finding truly comparable companies can be challenging. It's often part of management's role to educate investors on the nuances that make their company unique, potentially affecting its valuation. In some cases, management might suggest comparables at more advanced stages, in larger markets, or of higher quality than their own company. This strategy aims to position their startup favorably and potentially secure a higher valuation.

Conversely, lead VCs may engage in aggressive negotiations, pushing for valuations that align more closely with their investment goals. The process often resembles real estate transactions, where recent sales of similar properties heavily influence the value. Ultimately, the Competitor Comparable Method seeks to establish a fair valuation by anchoring it to tangible market data. While it's not an exact science, this approach can provide a realistic benchmark, helping investors and founders reach a mutually agreeable valuation. The key lies in selecting truly comparable companies and understanding the subtle differences that might justify variations in valuation.

#3. The Company Stage Market Analysis Method

The Company Stage Market Analysis Method offers a more data-driven approach to startup valuation by examining a broader set of comparable companies. This method provides valuable insights into current market trends and helps founders and investors make informed decisions.

For instance, when evaluating a high-quality Seed stage company in 2024, research data shows that the 75th percentile post-money valuations ranged from $30M to $40M between January and July, reaching $40M on July 7th. This information is a benchmark for what top-performing startups in this stage can expect.

The method also allows for sector-specific analysis. Research in the drug discovery and pharmaceutical sector indicates a 75th percentile post-money valuation of $30M based on 72 deals. This sector-specific insight can be crucial for startups operating in specialized industries.

By leveraging these data points, we can conclude that a disruptive company raising a Seed round in July or August 2024 could reasonably expect a post-money valuation of $30-40M. This range reflects the general market conditions and sector-specific trends, providing a solid foundation for valuation discussions between founders and potential investors.

#4. The Net Present Value (NPV) and risk-adjusted NPV (rNPV) method

The Net Present Value (NPV) and risk-adjusted NPV (rNPV) methods are fundamental approaches for valuing early-stage biotech companies. These methods involve estimating future investments and profits, which can be challenging for emerging companies. However, experienced management teams or venture capitalists may be able to provide reasonable projections.

In the traditional NPV method, future cash flows are discounted to present value using a discount rate that reflects the project's risk. For biotech companies, discount rates typically range from 15% for later-stage projects to 40% for earlier-stage ventures. This approach accounts for the time value of money and the inherent risks in drug development.

The rNPV method takes the analysis a step further by incorporating specific success probabilities at each drug development stage. For instance, peptide drugs in non-oncology applications have a 65% chance of advancing from Phase 1 to Phase 2, a 43% probability of moving from Phase 2 to Phase 3, and an overall 23-26% likelihood of achieving regulatory approval from Phase 1. By weighting future cash flows with these probabilities and using a standard 15% discount rate, the rNPV method provides a more nuanced valuation that accounts for the unique risks in biotech development.

When probability data is available, the rNPV method using a 15% discount rate is generally preferred over the NPV method with a higher discount rate. This approach offers a more accurate representation of a biotech company's value by explicitly factoring in the success rates at each development stage rather than relying solely on an inflated discount rate to account for risk.

#5. The Follow the Leader Method

The Follow the Leader Method is a common approach in priced funding rounds, where a single valuation needs to be established for all investors. This method simplifies the valuation process and ensures consistency across the investment round.

Typically, the Lead investor (or co-leads in some cases) sets the valuation. They negotiate with the company's management using one or more of the four previously discussed methods: the VC Method, Competitor Comparable Method, Company Stage Market Analysis Method, or NPV/rNPV Method. Once the Lead investor and management agree on a valuation, other investors in the round "follow the leader" and accept this established valuation.

This approach streamlines the investment process and reduces potential conflicts among investors. However, it's important to note that valuation isn't the only factor at play. There's often a delicate balance between valuation and control. Management might accept a lower valuation in exchange for more founder-friendly terms, such as maintaining a more significant equity stake or retaining more decision-making power.

Conversely, investors might agree to a higher valuation if they receive enhanced rights through mechanisms like "preference" or "participation." These provisions can provide additional protections or potential returns for investors, offsetting the risk associated with a higher valuation.

The Follow the Leader Method, combined with these potential trade-offs, illustrates the complex dynamics of startup funding rounds. It highlights the importance of not just the valuation figure itself but also the terms and conditions that accompany it.

Now, you are familiar with the standard ways of valuing a biotech company. Use any of the above methods to analyze if the company you are considering for investment is fairly priced, underpriced, or overpriced. Remember, your contribution to biotech powers human health, so play the longer game.

References:

https://arnab.co/a-comprehensive-guide-to-startup-valuation-methods/

https://www.statista.com/statistics/299138/top-selling-biotech-drugs-based-on-revenue/#:~:text=In%20that%20year%2C%20Keytruda%20generated,biotech%20drug%20based%20on%20sales.&text=AbbVie's%20Humira%20is%20among%20the,billion%20U.S.%20dollars%20in%202023.

https://www.dcatvci.org/features/pharma-pulse-top-selling-small-molecules-biologics/#:~:text=A%20recent%20analysis%20by%20Evaluate,BioNTech's%20mRNA%20COVID%2D19%20vaccine.