“Navigating the Valuation Maze: Unravelling the Complexities of Biotech Start-Up Valuation” — Challenges & Strategies

Generally, the valuation of a start-up is difficult because of the negative earnings, lack of accurate financial information, probability of low survival, difficulties in finding comparable organisations, and uncertainties in predicting the future growth and revenue. These issues get compounded if one need doing valuation of an early biotech company with no revenues because in addition to the common problems of valuing a start-up as stated above, biotech firm valuation has additional problems and uncertainties. Development of drug is highly expensive and a failure in successfully passing any stage of clinical trials causes the loss of millions of dollars and can reduce the valuation of the company in a very short span of time. The estimation for the cost of bringing a new molecular entity to the market varies and it can range from $314 million to $2.8 billion. These estimations neither consider the admin, and overhead costs nor the post-marketing costs that includes marketing. Imputing those values and adjusting for the inflation, one can surmise that the current and the future costs would be higher than the predicted. One of the striking features of the biotech valuation is that the de-risking or successfully passing structured clinical phases increases the value of the company exponentially however, the success of the trial is dependent on multiple factors.

To understand how a biotech or pharma industry is different from other industry sectors, this thesis briefly describes the structured development phases of drug development. The key cost drivers of drug development are discussed which includes the probability of the successful transitions from one clinical phase to another (success rate), the duration (cycle time) and costs for each phase, therapeutic area, whether the drug is orphan or not, size of the firm and the cost of capital. For instance, the average cost of bringing an antineoplastic and immunomodulatory drug to the market is $4.45 billion whilst the cost of bringing an orphan drug to the market is half the cost of the non-orphan drugthough this estimate changes if the orphan drug is for oncological indications. Most importantly the key factor that affects the successful launch of the medicine is the probability of the transition states from one phase to another. The attrition rate is very high in the phase 2 of the clinical trials, as most of the drugs worked in the pre-clinical models do not show effectiveness in this phase. The likelihood of approval varies depending on the disease indications and it is recommended to de-risk this issue by working on different indications to increase the chance of success. Not surprisingly, it is estimated that for a successful launch of one product, the company need having at least in average 8 to 9 molecules entering the clinical phase every year. In average the industry brings 1 NME (New molecule entity) in every 6 years and only the most successful firms could bring a single NME every year. No firm has managed to bring two or three NME a year and hence the NME share captured declines irrespective of the huge spending in R&D. In the case of early biotech companies, the cost of bringing a medicine to the market is very high compared to the large pharmaceutical companies because of the pharma’s extensive resources and abilities. Irrespective of its financial and resource abilities, due to the high attrition rates and to strategize new business development, large pharmaceutical companies need to acquire early-phase companies with innovative technologies or in-license their products. For early companies, they may have to out-license their product to a medium sized biotech companies for conducting clinical trials. It may be possible that the medium size companies out-license that product to a large pharma in return of milestone payments, royalties. It is often that many of the innovative or early staged companies are spin-off from academic universities and they also get involved in participation rate, royalties, milestones, upfront payments, and license. In essence, the valuation of a biotechnology firms can be very complex when multiple licensing contracts, discount rates, call back options exist between different firms and including those factors builds more assumption and can make the prediction of future free cash flows more uncertain. Upfront payments can be derived however royal stacking, milestone payments across different organisation are contingent on future milestone achievements and hence cannot be predicted. Many of these contracts become binding and share values only in the future contingent on the success. Moreover, the accurate valuation becomes difficult because of the inherent difficulty in valuing intangible assets, as this may often not found on the balance sheet. Intangibles can be divided into multiple categories, market, technology, customer based, goodwill etc and some of the methods commonly used for valuing intangibles are market based, cost based and income-based approaches. Market based approaches are difficult as the company can possess a unique patented technology, finding a comparator in the market is not easy besides the issues of finding correct multiples due to the negative revenues. Moreover, intangibles are not sold of its own but a part of the company, differentiating that information for a separate valuation is not possible. Cost based approaches lean on the assumption on what cost it takes to create a company from the scratch. The two methods that descend from the cost-based approaches are the replacement method and the value-based balance sheet method. The replacement method estimates what it would cost to re-create the same company in its current life cycle phase, whilst the value-based balance sheet method considers the assets, liabilities, and risk profile of the company to estimate its value. Both the method does not consider the course of the history that shapes in building the company nor its future growth and opportunities. Incomes based valuation models the future earnings from intangible assets and are then discounted to the present value, which is of more relevant approach. For many of the companies, the technologies are internally built. These intangible assets produce large value to the company. The technology offers the company a competitive advantage (For instance, proprietary vector platform that can transduce specific type of cells with high specificity and low toxicity) it possess the ability to generate future revenues and reduces the costs of product development through economies of scope. Patented proprietary technologies that may have a feed rate of producing assets are highly valuable and differentiated from others however a straightforward valuation is difficult though this can be imputed with caution. Taking into accounts of all these factors are important in the future for a well –reasoned valuation of the early biotech companies.

Valuation of biotech companies

Limitations using traditional techniques such as relative methods for the valuation

The uncertainties in the probability of the success in the different phases of the clinical trials is further funnelled into cascade of other uncertainties such as future revenue, cash flows (CF), therefore valuing using relative methods does not offer a viable solution in valuing early-stage biotech companies with negative earnings. In addition to that, most value of the early-stage company is captured in its success rate of its assets and the intangible value of the assets which are rarely showed on the balance sheet. The success rate of bringing an asset is contingent on different factors however a forward P/E ratio is sometimes used because the company have valuable assets in their pipeline. Equity multiples values are not suitable to apply because of the negative cash flows. Some of the common measures such as EBITDA, EBIT are negative, so the book value is small in relation to the invested capital and hence it is not possible to use relative valuation methods for early-stage biotech companies.

Usually P/E is used for the valuation taking the last twelve-month (LTM) historical data however in the case of start-ups, forward P/E is used with the assumption that in a certain future year, the company will make steady revenues and can be valued with a P/E value to calculate the multiples for future earnings. This is complicated because it is hard to find similar start-ups to calculate the industry averages (mean, median) to build a low end and high-end values besides the uncertainties in choosing the forward years and then discounting it back. In some cases, revenue multiples are used however depending on which year one would pick can change the valuations drastically.

Venture capital and First Chicago method

Another option is venture capital method of valuations of early start-ups. The venture capital method values the company by calculating the net present value (NPV) of the cash flows (considering only the successful scenario) for a fixed period that generally matches to the period when the venture capitalist (VC) decides to exit the company. The terminal value is calculated using the relative valuation methods that is based on multiples such as P/E. A high discount rate that is used that matches to the rate of return demanded by the VC for investing early in the company or in the start-up. The required equity share of the VC for the invested capital is empirically determined by dividing the increase in the capital with the NPV of the post-money value of the company during the exit. The latter is determined by adding the NPV of the pre-money value with the money invested by the VC. A modification of the VC method of valuation is the first Chicago method (FCM). The VC method considers only the successful scenario for the valuation whilst the FCM model considers multiple scenarios such as best-case, the most likely and the worst-case scenarios.The LCM method use a lower discount rate and a probability for each scenario to occur is adjusted to calculate the NPV of the cash flows in contrast to the VC method. For each scenario, two elements are considered, one considers the final NPV of the company when it is sold and the other one considers the NPV before the divestment. The cost of divestment is calculated using market multiples. For this current case study, both the VC and FCM model may not be suitable as this is beyond the scope of the thesis. The common methods of valuing a biotech company are 1. risk adjusted discounted cash flow and 2. real option method.

Risk adjusted discounted cash flow (rDCF) valuation

In the case of biotech firms, the future cash flow is contingent on whether the asset in the pipeline successfully passes individual clinical phases. This risk must be adjusted to calculate the probability of the future cash flows. The time value of the cash is accounted to the present by the discount rate. In contrary to the usual discounted cash flow methods, which only includes the time value of the money and the possibility, for biotech firms, one need to additionally include the likelihood or the probability of the possible occurrence of the cash flow. The risk adjusted DCF valuation calculation is sum of the net cash flows for all the years which is then adjusted for the risk by a probability factor or success rate. This net amount is discounted by a discount factor and the sum of the discounted amounts gives the risk adjusted NPV (net present value) of all the cash flows.

Important parameters that need to be considered when using DCF for valuation

It would be difficult to impute a growth rate for forecasting since many of the early biotech companies have negative cash flows and operating loss. Since a slight change in growth rate can change the value of the company, the model must be taken very cautiously. It will not be useful to forecast for a longer period using DCF, given many of biotech companies holds patents and proprietary licenses where the projects and revenues can be long up to 20 years.Moreover, DCF doesn’t consider the strategic decisions of the management to defer or expand or reallocate projects as can be done in real valuation methods that will be discussed in the next sections. For simplicity, many analysts tend to use the historical data from the market index for calculating the beta however one need to be cautious that many biotech firms hold a limited portfolios which are in the different phases of clinical trials compared to the large pharma which diversify the risk by having a large portfolio of assets and hence the beta estimation from regression against the market index may not be always accurate. A good estimate of terminal value is also dependent on the successful market authorisation of the assets. Since the patents of the drug expires in a limited period, calculating terminal value at perpetuity might not be suitable however the terminal value can be calculated till the expiry of the patent. If the company has a certain innovative technology that can produce multiple assets in the pipeline, a terminal value of the technology at perpetuity is usually calculated. In this case, feed rate of assets the technology can produce and account that number into the future cash flows for a more reliable valuation.

Modified discount cash flow method

In the modified DCF model multiple adjustments are made for valuing the start-up or early-stage companies with no revenues. Either a top down or a bottom approach can be used for estimating the future cash flows and the discount rate is adjusted to account for the industry specific risks. The terminal value (TV) can be calculated either by a perpetuity method or calculated for the limited time horizon when the cash flows are expected to end. The modified DCM model also consider the survival probability (a scenario of healthy growth and a scenario of default) as well as the value of the key people in the management, for instance the founders. Other method such as the score card method as well as the risk factor summation methods are also used for pre-revenue stage. Generally, this pre-revenue-based methods are based on certain strong assumptions about the time it takes the company to reach a desired revenue amount.

Real value option approach

The real value option is an extension of the financial option created by Black and Scholes. The DCF approach uses a very strict approach in predicting the future cash flow, but it does not take into the consideration that the management can make different decisions during the project such as the option to defer, expand or re-allocate the investments. In the case of biotech companies, the collection of new data during the phases of clinical trials can add or defer the value to the project. Having the flexibility to change the timing and scope of the investment by the management offers the opportunity for better decision making. Real value options provide a rationalised way of doing valuation for a biotech company given the uncertainties in the success rate of the project and the cash flows. Using real value options, a complete market capitalisation can be forecasted as there is a leverage for these companies to capitalise additional values such as their distinct technologies, licenses (both in and out licensing).

According to Villiger and Bogdan,there are 6 categories of real options for a project a company can employ.

1. Option to grow — This option let the company to exercise the possibility to implement a staged investment to grow or to expand.

2. Options to defer — If the investment cannot be recovered and if the outcome of the project is very uncertain, option to defer is triggered.

3. Option to expand or contract — This depends on the market conditions.

4. Option to abandon or license — This would reduce further losses and recover selling some of the assets that includes technology.

5. Option to switch — This depends on the strategy, cost, and the revenues.

6. Option to stage investments — This is commonly applied for biotech companies where investments are staged depending on the reaching of milestones. For instance, a successful completing a phase II trial would trigger the staged investment of the next rounds. This also applied to the licensed agreement with other companies and institutions.

In essence, real options allow to capture the uncertainties in the projects and allows the management to mitigate the risk in contrary to DCF method which is not flexible to capture different uncertainties however a risk adjusted DCF serve the same purpose of real options provided the risk is correctly captured when imputing the values.

In literature, there are multiple methods that are available to value an option, however tree method is commonly used. To build a binomial tree, the time to maturity is divided into time steps. For the valuation of a biotech company, a recombinant binomial tree can be used that merges back into a common node. The option value can be back traced from the last leaves to the root and the tree gives the value and state for every leave. With comparison to the DCF model, real value option offers the flexibility to estimate the peak sales based on the volatility of the project, however certain parameters are important to consider when valuing real options. The size of the cash flow is based on the probable estimation of how well the drug would do in the market. As a rule of thumb, it is advised to use the historical median sales data for a specific disease condition in case the compiled data contains the outlier sales of blockbuster data there by potentially avoiding any skews. To estimate the growth rate for calculating the future sales, it is best to keep the average success rate for the drug of interest. The timing of cash flow is also uncertain and herein this case, the historical data of average sales curve is advised to use. When it comes to discount rate, it is dependent on whether the asset is developed in house or licensed, in the latter case, the discount rate changes.

Common types of option pricing models — Call options and Put options

An option let the holder the right to buy or sell an asset at a strike price, which is a pre-fixed price before the expiration of the asset however the exercise to buy or sell is not an obligation. The holder would lose the value he paid for the right if he did not exercise the options. In a call option, if the asset is valued higher than the strike price, the buyer makes profit and if the asset price is lower, he would only pay the price of the right however do not commit to exercise the option to buy. In the case of put option, the right gives the option to sell at a strike price and if the value of the asset is lower than the strike price, the put option holder makes the profit. Interestingly the holder yields a higher return for both call and put options if the variance of the asset is higher and the duration of the expiry of the asset is longer. Other parameters that need to be taken into consideration are the interest rate and the strike price. The higher interest rate increases the value of the call options whilst the lower interest rate decreases the value of the put options.

Conclusion

The two commonly used methods for valuing a biotech company are risk adjusted discounted cash flow method and real option method though the former is commonly used. The essay describes the limitations of the valuing using relative methods using multiples due to the negative earnings and discuss the merits and de-merits of both the DCF and the real option method. The latter allows the management the flexibility to make rationalised decisions about the projects from the collection of new data, which is the case for companies that are conducting clinical trials of their assets. Simulations are generally used for the risk estimation of the assets in the pipeline and for valuing projects for multiple indications in the pipeline multidimensional tree approaches with different conditional probabilities can be used. The limitation of the risk adjusted DCF for the valuation of an early biotech company is that it is not possible to model all the uncertainties and the risks associated with the pay-off of the project during the period of the forecast and hence the forecast is very static. The calculation for the discount rate is generally a problematic issue for many start-ups and often a firm specific risk is considered than the uniform market risk used in CAPM (Capital asset pricing model).The modified DCF model estimates the discount rate considering the industry specific risk, risk with or without diversification expecting the cost of equity will finally get close to the market beta.

In essence, some salient features to consider when valuing a biotech company are.

a) Majority of the biotech do not have revenues in the early stages. There is a negative cash flow to the firm before a drug is approved in the market and hence the comparative valuation is not useful.

b) The drug development is a long process, and it can take in average 8 to 10 years. The journey of taking the drug to the market is a structured phases with distinct outcomes. Any negative outcome in one of the phases can fail the project and the cost is irreversible. Some of the major costs are the R&D expenses and the expenses related with conducting clinical phases which varies in different phases with different probability of success.

c) The risk is binary and any positive results in any of the phases in the clinical trials will cause a high increase in the valuation of the company. The probability of the success follows a Bayesian stat with a base rate and new evidence modifying the base rate. Unlike any other industries, one of the characteristics of the biotech firm is that this de-risking in each individual phases of the clinical trials drives value.

d) The pricing structure of the drug differs depending on its class. For instance, there are first-in class, targeted specifically for rare diseases or one-off or multiple treatment paradigms that are applied in a specific time windows such as for the gene therapies or a different class of a drug for a certain family of indication that has existing drug from an another class in the market and hence a reliable estimation of the pricing can be tricky before the market approval and pricing negotiations with the payers and with the national agencies.

e) Discount rate differs depending on the success rate of the assets passing the different phases of the clinical trials.

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