For pharma & biotech, what's the value of a valuation?

When a client approaches us about conducting a valuation for them, our first question is always: why? If, for example, the reason is to help support them in a partnering negotiation, we proceed directly to the detail. However, when the driving force behind the request is solely to support fundraising efforts, our antennae go up, and we have an earnest discussion with the client as to whether a valuation would actually help them in that cause. The answer is still typically yes, but the reason might surprise you. In that scenario, its utility stems almost entirely from the exercise of creating credible revenue and cost forecasts based on realistic assumptions and demonstrating transparency which investors value.

Investors don’t believe your valuations

In our nearly fifteen years of conducting valuations, rarely have we seen experienced investors pay much attention to valuation figures provided by the companies they are considering a stake in. If they are interested, they will have their own valuation ideas. This is especially true for first-time funding rounds as their aim is to acquire as large of a share of the company’s equity as possible. So, if a company is seeking to raise a modest sum, say $5-10m, the pre-money value may be set at around the same level to ensure that the incoming investor acquires around 50% of the shares or more (of course they may use other mechanisms to enforce their control of the company, notably by the Investor Consent provisions of the Shareholder’s Agreement, which is something to be mindful of too). The value of a company will also be somewhat dependent on the stage of development, the quality of data that supports the value proposition, the development plan and milestones to be achieved and the quality of the team assembled. If this is a first or second round of financing and the company is in the pre-clinical stage, why go through the trouble and expense of undertaking a formal valuation exercise? If the valuation is necessary then conducting it correctly is crucial for the endeavor to bear fruit.

Valuation Methodologies

There are essentially four methods used to value a company, with only slight differences between public versus private, as outlined below.  

Methodology Details

Public companies: For public companies it is relatively easy to arrive at a valuation, as one can see their value represented by their stock price multiplied by the number of shares in the company; the market capitalization.

However, one can also estimate value based on comparable company valuations using Enterprise Value as a multiple of revenues or EBITDA. Enterprise Value is equal to the market capitalization plus debt minus cash. It is important to choose several companies that are at a similar stage of development and have similar sales or earning to compare valuations. This comparison is based on the fact that companies at similar stages of development, with similar sales and earnings, have market valuations that tend to move in lock step, but may vary individually based on the specifics of their business or progress.

A second type of comparative valuation can be obtained from companies in a similar field and stage of development that have undergone M&As or IPOs. As these are exits that investors are particularly interested in, such comparisons can give a reasonable estimate of your company value if you were to IPO or be acquired.

It is important to realize that comparison estimates of value can only really be applied to your company as it stands today, and does not take into account its value in the future.

For most innovative companies it is the future value of their company that is attractive to investors. This can be estimated by forecasting the company’s revenues, the cost of development and cost of providing a product or service, and the investment made in people, plant and equipment. By creating a profit and loss statement and extending it to the cash generated from the operation, one can estimate thecash flow of the company. However, it is very important to realize that the value of your company is based on the quality of the assumptions. Any future cash flows must be discounted to represent the future value of money and the risk and probability of success of the project; hence the term, discounted cash flow, and risk-adjusted net present value.

Private Companies: For private companies, one can use the similar valuation methods as those used by Public Companies.

Instead of a market reported stock price or market capitalization, one can utilizing the last post-money value of an investment made in the company. If substantial and significant value creating data has been generated since the last round of financing, a premium can be added to arrive at an adjusted valuation.

If the company has revenues or profits, then one can use the second technique of sales and earnings multiples of comparative companies (The companies chosen must be in a similar field and at a similar stage of evolution with regard to sales and earnings.

If the company is at an earlier stage and has no revenue or profits, one can still use the comparison to similar companies that have undergone mergers and acquisitions or IPOs.

However, most development stage companies will want to capture their future potential value in their valuation. In this case it is important to create a discounted cash flow, and to utilize a realistic discount rate (or Weighted Average Cost of Capital, WACC), and apply a realistic risk adjustment, (hence risk-adjusted Net Present Value, rNPV).

Creating a Believable Valuation

To arrive at an estimate of valuation it is typical to use median valuations from the last market capitalization, from the comparative methods (and usually at least 4-5 comparative companies), and to look at a range of rNPV values based on a variety of possible future assumptions (a sensitivity analyses). These estimates can then be used to create a blended valuation.

Blended Valuations

It is typical to state the valuation of a company as a range of values, and a median value of the different methods utilized. Typically, the rNPV value will be higher than the values calculated by the other methods, but to prevent overemphasis of what might happen in the future, the blended method is most typically used by most investment banks and investment houses. This involves taking the modified last investment valuation, the median multiples valuation, the median IPO and M&A comparisons valuations, and the median rNPV valuation, and then express the valuation as a valuation range and median of these values (=blended valuation).

The act of creating a valuation is itself value-adding

A risk-adjusted net present value (rNPV) is simply an arithmetical consequence of a set of assumptions. The fundamental building block is a realistic target product profile (TPP) which comprehensively defines the product being developed (as a destination, not a route map). The scope of a TPP depends on the stage of development amongst other factors, but must always contain details of the precise target:

• Indication
• Population
• Efficacy
• Safety and Tolerability
• Dosing and Administration
• Access, Health Outcomes and Pricing
• Manufacturing
• Anticipated Approval Date
• IP and life cycle management

Each of these parameters can then be translated into quantitative assumptions regarding the projected number of patients to be treated and the price level which can then feed into a revenue forecast. Although not always in the TPP, it is also essential to understand the competitive environment and likely standards of care during the course of development and crucially at the time of product launch to anchor the sales forecast in the best reality that is feasible.

The other side of the rNPV calculation are the costs: preclinical, clinical, regulatory, CMC, launch planning and commercialization. This allows you to estimate your profitability (net profit after tax). To estimate your operating cash flow = net profit + depreciation and amortization – change in capital expenditures – changes in working capital. Each of these needs to be documented to a level of detail suited to the stage of product development, and these assumptions directly inform the cost forecast. To arrive at a realistic rNPV value it is important to run iterations to look at different scenarios and to be as realistic as possible with your discount rate, your risk assessment or probability of success, as these parameters will have a significant impact on your value.

Additionally, there is the sensitivity analysis - development of relevant downside scenarios that reflect adequately the key risk in the program. Demonstrating that you have a handle on major uncertainties, that you have defined go/no-go decision points and that you are viewing the project with a healthy degree of realism is invaluable in building credibility. We generally use Monte Carlo analysis as a robust sensitivity tool and this may add further value, as outlined in our past white paper "What's Wrong with NPV Valuations?".

There is more to a valuation exercise than what is summarized above, but the message is that the act of documenting these key assumptions provides clarity and a necessary consensus in the management team which is not only important to inform a valuation but more critically serves to ensure that the overall development plan is commercially feasible and rooted in realistic inputs.

Investors respond to the assumptions, not the valuation

Demonstrating to investors that you have a well-thought-out plan, building not only on sound science but also firm commercial foundations is crucial to build credibility. So while they may not care about the rNPV number itself, they will appreciate the diligence that goes into the valuation and the assumptions you used to produce it.

Additional Valuation Articles & White Papers 

• What's wrong with NPV valuations?

• Valuing Pharmaceutical Assets: When to Use NPV vs rNPV

• Pharmaceutical Probability of Success

• What Happens to Pharma Valuations as Interest Rates Rise?

• Pipeline asset valuation: garbage in – garbage out

• Pharma Valuations: When to Use Incidence and/or Prevalence