Valuation Methodologies for Life Science Companies

By Channing Hamlet and David H. Crean, Ph.D.

Managing Directors, Objective Capital Partners

Overview

There are several methods used to determine the valuation of companies and assets in the life science industry (ShareVault, Mayhew, Bogdan and Villiger, Pullan). Companies in the pharmaceutical, biotechnology and medical device fields, and the products they set out to develop, present particularly challenging to valuation exercises for numerous reasons. These include long development times to reach the market, risk associated with preclinical and clinical development and the significant capital needed to complete the lengthy approval process required by regulatory authorities around the world. Identifying the appropriate methods of valuation to be used in the assessment is important. Valuation experts must be inclusive of the key value drivers, assumptions and the dynamics of the market potential for a company’s intended product that is being developed. Ultimately, the valuation exercise serves as an appropriate surrogate marker for making good investment decisions, portfolio management choices, preparation for partnering or M&A activities, negotiation of ownership interests and increasing shareholder value.

Pre-revenue life science company valuations are viewed much differently than valuation on a company possessing positive cash flows and EBITDA.

Understanding Uncertainties, Assumptions and Key Value Drivers

Since many companies in the life sciences space are pre-revenue, the process of determining valuation of these companies is a much different exercise than determining the value of a company possessing positive cash flows and EBITDA. Valuation professionals often use a company’s past financial performance such as revenue, profitability, and cash flow as benchmarks and indicators of future performance. When dealing with life science valuations, you must determine, predict and make decisions about the future market potential of a product (or series of products) well into the future that could take as much as up to 5-10 years to develop before being launched in the marketplace. Valuations and decision-making thus will be highly influenced by assumptions made in modeling the value, key value drivers and their dynamics such as:

• Target profile of the product (TPP), the intended labeling being pursued and the likely risks and benefits of the intended product;
• Probabilities of technical success for progressing the product throughout a lengthy and highly regulated development pathway involving numerous preclinical and clinical studies and decision points (Clinical Development Success Rates; DiMasi, Hay et al)
• Patient populations, which appear to becoming more and more segmented and diverse;
• Competitive landscape with generics and new products entering the market;
• Market penetration rates
• Sales, marketing and promotional efforts and their effectiveness to drive uptake or expansion into new markets or patient segments;
• Treatment patterns used by prescribers and physicians in numerous markets and specialties (dosing, patient compliance, persistence and retention); and
• Pricing strategies, third party reimbursement and government regulations

Valuations on early stage life science companies, such as those companies that are still in discovery stages, pre-IND stages or developing products before being tested first-in-man, often present additional challenges to valuation exercises relative to the later stage, more mature and predictable companies. Some of the additional challenges with the valuation of early stage companies include:

• Very short (if any at all) financial track record, and even if generating revenue, it is often relatively recent, highly variable, and insufficient to generate profits and positive cash flow; 
• Rapidly changing conditions and high degrees of uncertainty, e.g., the acceptance or rejection of intellectual property protections and very low success rates on R&D efforts;
• High WACC and discount rates (typically 30-50% WACC versus 10-15% for mature pharmaceutical companies); and
• Lack of sufficient capital to execute business plans per timelines.

Life Science Valuation Techniques

Life science valuation techniques can be grouped into cost-based, market-based, income-based and option-based method. Each approach has its advantages and disadvantages. Thus, it is important that the method chosen for any given valuation is appropriate given the purpose and parameters.

Cost-Based Method

This valuation method, sometimes also called asset-based method, focuses on the costs associated with developing or acquiring an asset (or company) and are based on the premise than an investor would pay no more for an asset necessary to reproduce it (economic principle of substitution). The approach views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of the assets and liabilities. The difference is the business value. The valuation method is backward-looking and does not account for future benefits that may be derived from the asset. A classic cost-based business valuation method is the Treasury Method. In addition to business value calculation, this method lets you determine the value of business goodwill.

The cost-based method is predominantly restricted to use in valuation methodologies for accounting purposes and are commonly known as book values. The parameters used in the valuation method are accumulated costs incurred including research funding costs, legal, intellectual property, administration fees and non-recoverable taxes. Depending on the age of the asset, these costs may be subject to depreciation, inflation and exchange-rate fluctuations.

Market-Based Method

Market-based valuation methods focus mainly on comparative company data from both the public and private sector within the same or similar industry. The market value is the value a buyer will pay to a seller in an open and honest transaction, and market-based methods determine the value of an asset compared with similar assets. Market-based methods such as comparables, precedent transactions and benchmarking are straightforward and can be useful in cross checking other valuation methodologies. The challenge with life science valuations using this method is identifying the appropriate choice of comparable companies or assets. Given the complexities and uncertainties that we described earlier in this article, it is rare to find two companies or assets sufficiently alike to be directly comparable.

If publicly available, comparable parameters that can be used to value life science companies and assets include the value of milestone payments, earn-outs and royalty payments associated with similar structures and transactions. However, most of these contingency payments are not disclosed and may have to be estimated from best available knowledge or experience. This is relatively straightforward in the case of companies with a single asset but becomes more complex and challenging where firms have multiple assets where the relative contributions of the individual assets to the overall valuation need to be determined.

For this type of valuation, it is essential that the valuation inputs and parameters to be used represent current and relevant comparative data relating to similar businesses. There are many good sources for getting access to comparable data including S&P’s Capital IQ (www.capitaliq.com), PitchBook (pitchbook.com) and Recombinant Capital (recap.com), now a part of Thomson Reuters. Most valuation experts have access to these subscription-based data sources. A review of public filings, such as 8-K’s, 10-K’s and 10-Q’s, is also quite useful for valuation exercises. 

The Precedent Guideline Transaction Method for market-based assessments values a business based on pricing multiples derived from the sale of companies that are like the subject company. Figure 1 demonstrates an illustrative example of precedent transactions for a mid-later stage biotechnology company that operates in the cardiovascular space. As you can see from the illustrative example, the steps taken in using the Guideline Transaction Method include finding transactions involving the purchase of comparable companies, selecting the transactions that closely mirror a company’s operations and which occurred in similar industry and economic conditions, and then, applying the indicated pricing multiples from the representative transactions.

Figure 1. Precedent Transactions for an Illustrative Life Science Company with a Cardiovascular Asset in Mid-late Stage Clinical Development

Once a population of guideline transactions is identified, some valuation experts also need to analyze transaction subsets that focus on specific groups of transactions such as companies of similar size, companies with similar margins, and transactions that have occurred most recently. It should be noted that the calculated transaction multiples are typically based on the enterprise value of the purchased companies. Enterprise value incorporates all a company’s operating assets, except for cash, and includes working capital, fixed assets and intangible assets. Because enterprise value indicates the value of a company’s equity and interest-bearing debt (excluding cash), one must subtract debt and add cash to the calculated enterprise value to arrive at the company’s equity value.

The Public Comparable Company Method is founded on the concept that companies within similar industries or similar positions within their industries will have similar valuations or characteristics upon which a valuation can be based – whether that company is public or private. Figure 2 demonstrates an illustrative example of comparable companies that operate in the genetic and molecular diagnostic testing space. Some typical metrics to examine include key operating statistics such as growth rates, profit margins, EV/Revenue, EV/EBITDA, EV/EBIT and Price-Earnings ratios.

It is vital to understand the subject company’s market, product lines, plans and growth to identify comparable public companies. One difficulty in creating a set of guideline public companies is that larger companies often have multiple lines of business. When trying to value a smaller business, it may only compete against one of these lines and be difficult to compare metrics due to this.

Figure 2. Public Comparable Analysis of Companies in the Genetic and Molecular Diagnostic Space

Income-Based Method

The income-based approach seeks to identify the future economic benefits to be generated by a company and to compare them with a required rate of return. This numerator/denominator relationship can be applied through several different methods such as discounted cash flows (DCF’s), capitalized cash flows or excess cash flows.

The first step in the valuation process, performed internally or externally, is to determine the future cash flows or “projections”. Typically, these projections come from company management. DCF techniques identify the likely future investment and revenue cash flows associated with an asset, which are then discounted per financial theory to give a net present value (NPV) for the asset. Risk-adjusted NPV techniques are designed specifically account for the technical risks of drug development by adjusting cash flow forecasts based on the success rates of development phases, whereas scenario analysis and decision-tree analysis techniques attempt to model the effects of variations in key technical and market parameters on the value of an asset, and allow the possibility of project failure or abandonment to be included in the valuation approach. Figure 3 demonstrates the equation used to risk adjust the cash flows considering stage of development. The risk adjusted model must not only take into consideration business risk (i.e., discount rate) but also development risk (i.e., probability of clinical development and regulatory success) and the risk of ever achieving revenues and cash flows upon approval of the product and its launch in the marketplace.

Figure 3. Risk-adjusted Equation for Cash Flows and Net Present Value

where n= the number of years in the projected forecast; t= year and t=1 (today); C=cash flow; R= probability of success; and r= discount rate.

An important point to make is that the projections should be reviewed for reasonableness. The projections are typically performed for the upcoming five years. Revenues and expenses should be projected forward from current results. In the case of life science assets, the forecast period is based on the product and cash flow life cycles and typically lasts from market approval until patent term expiry. The resulting amount should be appropriately tax affected to determine what the free cash flows of the entity will be. Other adjustments that should be considered are cash related items such as CAPEX, depreciation and amortization.

The rate of return, or discount rate, for more developed companies is often determined through a Build-Up Method or Capital Asset Pricing Method (CAPM). The discount rate represents the opportunity cost of capital to the company or investors in the project, and can be determined using weighted average cost of capital (WACC) or expected return on investment hurdle rates. While this type of approach works for a company with more history, a new company or one just beginning to generate income and free cash flows poses a different challenge. The rate of return for companies that are younger can vary quite a bit. Amounts from 30%-50% are often used for companies that are early-mid stage. Taking the free cash flows and applying a discount rate will result in the present value of future cash flows. The sum of these for the years projected, based on the reasonable adjusted projections, provides one half of the value to be calculated.

Not many companies will simply end at five years. The valuation needs to also take into account the additional years of cash flows to be obtained. These cash flows can often be even more significant than the five years already detailed out. The terminal value, as this next amount is known, is generated by applying a long-term growth rate to the company’s free cash flows and discounting this total back to a present value as was done with the first five years’ projections. When calculating the terminal value, the growth rate should consider the stage of the company and how it is likely to grow in the future. The sum of the present values of the five-year projected free cash flows and the terminal value provides the total enterprise value from the income-based approach.

The advantages of using this widely recognized method include flexibility in addressing companies of many different stages and natures and simulates a market price even if there is no active market. The disadvantages are that it relies on hypothetical projections and utilizes a discount rate with many variables in determining the appropriate value.

Option-Based Method

This method takes a view of future earnings to estimate the value of an asset, but they also place value on the right, but not the obligation, to decide under fixed terms at a fixed point in the future. Options methods such as Black-Scholes model and binomial lattices are used in valuations of financial assets, and are increasingly finding applicability in life science valuations where options to abandon and options to expand can be used to represent the “stage-gate” mentality of life science R&D projects. Future articles will be written to provide more on these methods. Although real options have strong theoretical applicability for valuation of life science assets, they are somewhat conceptually challenging and tend to rely on numerous assumptions, and are thus difficult to model in practice.

Final Comments

The valuation methods discussed above represent some of the most commonly used by business valuation professionals to generate an opinion of value on a life science company and its assets. Although considerable time and effort is involved in preparing formal business valuations, the results may or may not reflect the “real world” value of a specific company or is assets if it were formally offered for sale or reflected in a partnering deal. Much of the valuation exercise depends on assumptions made.

Consulting a professional investment banker and valuation expert can best help you assess the true value. These professionals will assess your company’s strengths and weaknesses and employ some of the commonly used valuations methods used by business valuators. They will also leverage their insight into the current marketplace to help determine financing availability and assess many other factors to determine the company’s potential value in the market place.

If you have questions about which valuation methods reflects the value of your company or assets, please contact us. Objective Capital Partners has significant experience in providing independent, defensible business valuations for strategic advisory, partnering, M&A, tax reporting and compliance purposes for life science companies. A background of the firm's Business Valuation services can be obtained here.

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Objective Capital is a mergers and acquisitions (M&A) advisory and investment banking firm focused on transactions for companies with enterprise values up to $500 million.  Channing Hamlet is a Managing Director for the firm and leads Objective Capital’s valuation practice. Mr. Hamlet holds FINRA Series 7, 63 and 79 licenses and is a Registered Representative of BA Securities LLC, Member FINRA SIPC. David H. Crean, Ph.D is a Managing Director at Objective Capital Partners where he leads the firm’s life science investment banking transactions. Dr. Crean has in excess of 20 years of life sciences R&D and corporate development transactional experience in the pharmaceutical industry where he was responsible for leading mergers, acquisitions, licensing and collaborations, and establishing corporate strategy. Dr. Crean holds FINRA Series 79 and Series 63 licenses and is a Registered Representative of BA Securities LLC, Member FINRA SIPC. More information on Objective Capital and its valuation practice can be found at https://objectivecp.com/services/business-valuation/.

This article is for informational purposes only and does not constitute an offer, invitation or recommendation to buy, sell, subscribe for or issue any securities. While the information provided herein is believed to be accurate and reliable, Objective Capital Partners and BA Securities, LLC make no representations or warranties, expressed or implied, as to the accuracy or completeness of such information. All information contained herein is preliminary, limited and subject to completion, correction or amendment. It should not be construed as investment, legal, or tax advice and may not be reproduced or distributed to any person.