Valuation-what you need to know, Nature Biotech, August 2004, Patrik Frei, Benoit Leleux
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Valuing a company has always been more art than science.At the best of times,it is a tricky and difficult task,especially for early-stage,biotech companies.The so-called pre-money valuation (which takes place before a company is financed) dictates how equity is divided among a company’s inv-estors and entrepreneurs.Those entrepre-neurs foolhardy enough to ignore the need for a proper valuation before they begin seeking capital not only may find them-selves at a disadvantage in negotiations with investors,but also may have no way of recti-fying a situation if the company valuation is suboptimal.In contrast,those who prepare a thorough valuation of their venture often gain a strong negotiating position,even in a buyer’s market.Every startup should thus enter financing negotiations with a clear understanding of its value drivers to obtain a fair and full valuation.In this article,we provide a basic outline of how to conduct a proper valuation exercise and present two common methods used to value an early-stage biotech company.
Gauging value
A company’s value lies in its potential to generate a stream of profits in the future.All valuation exercises are thus based on envisioning a company’s future,relying almost entirely on educated guesses.Value is based on assumptions as to what a com-pany’s future may look like,what important milestones will have to be met and strategic decisions taken.These assumptions are grounded in three fundamental factors:
first,the state of the market targeted by the company;second,the principle elements of a company’s science and technology;and third,the ability of management to deliver on the business plan.An intrinsic part of the envisioning process is thus the ability to question a company’s fundamental economic,technological and managerial hypotheses,as well as the likelihood of a company delivering on its promises.
There is no gold standard when it comes to valuation:it is and will remain a subjec-tive task.Consequently, a company can have as many values as there are people doing the valuation.Even so,we would rec-ommend that every valuation start with a systematic and rigorous testing of a com-pany’s economic,technological and mana-gerial hypotheses in combination with the following two key approaches:
?primary valuation,which is based on such fundamental information as pro-jected future free cash flow (FCF) and costs of capital;
?secondary valuation,which is based on comparable information,where valua-tion is done by analogy to other similar companies.
With a good understanding of the above two approaches,an entrepreneur is already well equipped to tackle the negotiations that will ultimately determine the deal valuation.
Fundamental valuation
The most common approaches to primary valuation in the corporate finance literature are generically referred to as the discounted cash flow (DCF) methods,whereby a com-pany is valued at the present value of the future cash flows it will be able to generate.These methods are conceptually robust but can prove difficult to implement in high-uncertainty environments,such as those of early-stage biotech firms.Typical problems include highly uncertain and distant positive cash flows,a business model based on many assumptions and a difficult risk profile.Although the DCF methods commonly applied in such contexts could be construed as technical overkill (given the variable qual-ity of assumptions made about the future performance of a biotech company and the lack of tangible results on which to base cal-culations),they can still generate valuable insights into the value drivers of a company (even though the final number generated may be of questionable value).
Corporate finance theory indicates that the value of any asset is equal to the present value of its future cash flows.Therefore,in principle,all that is needed is (i) to esti-mate the expected future cash flows of the business,and (ii) to discount back to the present all these future cash flows,using a discount rate consistent with the level of risk in the project.In practice though,problems
Patrik Frei is at Venture Valuation,Zurich,
Switzerland (https://www.wendangku.net/doc/ca14175308.html,),a valuation boutique specializing in independent,third-party valuations.
patrik.frei@venturevaluation.ch
Beno?t Leleux is at IMD,Lausanne,Switzerland (http:www.imd.ch).
Valuation—what you need to know
Patrik Frei & Beno?t Leleux
The basics of determining valuation will help you to understand what criteria matter most for investors.
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emerge at every step of this process.First,projecting performance for several years into the future is a process seen by many as too speculative to be useful.Second,selecting a forecasting horizon for the future cash flows (5 years,10 years or 20 years) is purely arbi-trary and leaves open the question of the residual value of the business at the end of that horizon.Third,obtaining an appropri-ate discount rate for an early-stage,privately held company presents difficulties.
Projecting cash flows into the future is never an easy endeavor,especially for smaller,high-growth life science firms.The key data used for valuation is the FCF.According to Copeland,Koller and Murrin 1,“[FCF] is a company’s true operating cash flow.”In other words,the FCF refers to the cash flows free of (or before) all financing charges related to the corporate debts.These cash flows include all necessary fixed asset investments and working capital needs,as both are normally needed for a viable busi-ness.The FCF is estimated through the financial projections of the business plan.Depending on the available information and the time frame needed for a steady revenue flow,a forecast period of 5 or 10 years is most commonly used.
The easiest approach to determining the most appropriate discount rate in a DCF exercise is one that would use the stage of development of the company,which can be determined by the drug development stage of products in the pipeline as proxies for risk (see Table 1).For example,a company that is generating leads without further developed products would be considered a seed stage company and a discount rate of between 70%–100% would be used.Although con-
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ceptually a bit loose,the method is surpris-ingly reliable.Several factors typically influ-ence the risk profile of a biotech company (Table 2).Once identified,the risk factors can then be used to determine the discount rate within the ranges provided in Table 1.The discount rate to be used in a DCF calcu-lation depends on the degree to which a company fulfils each of the criteria.As the discount rate is critical in determining value,it is appropriate to spend time in meticu-lously assessing each criterion and to investi-gate the sensitivity of the results to the various parameters.The full DCF approach is illustrated in Box 1.
Comparable valuation
The comparable method is also known as a ‘secondary’valuation method because it uses the market value of comparable companies or transactions as reference points.The method relies on available key figures,such as earnings,sales,number of employees,number of PhDs or R&D expenditures,to estimate value.
In a sense,secondary valuation makes the assumption that these comparable compa-nies have been properly valued,and can serve as benchmarks when assessing a com-pany.For example,if a comparable public company is valued at $1,000 with R&D expenditures of $500,for a price/R&D ratio of 2,then the private company to be valued with R&D costs of $200 would,by analogy,be worth an estimated $400.An example of comparable valuation is provided in Box 2.Cautionary remarks
Humility and realism are the two key attrib-utes of the prospective company valuator.Humility is needed to recognize that the exercise is primarily about envisioning the future,and that the exercise is fraught with uncertainty.Realism will help to understand that the inherent uncertainties do not con-stitute an excuse for sloppy estimates of the valuation components.Whether the valua-tion is done explicitly (as in the DCF meth-ods) or implicitly (as in the comparable methods),either method will give an accu-rate valuation if carried out by experienced valuators.
Although the valuation methods described here are routinely used by investors,we offer three important cautionary remarks to help the newcomer to watch for typical pitfalls.First,investors often refer to pre- and post-money valuations:pre-money is the value before the investment is included;post-money is the value including the new investment.Thus,pre-money value + invest-
ment = post-money value.Investors rou-tinely play with different figures and com-pany data.Numbers are their daily business and they may try to use them to their advan-tage.
Second,don’t enter into negotiations without having completed your homework.Management needs to master the figures and numbers and have clearly laid out its expec-tations about pre- and post-money value and the corresponding value of its shares.Only with preparation and a good under-standing of valuation drivers can manage-ment establish itself as a credible partner in front of investors.
And third,valuation is not everything.The investment contracts that accompany investments can easily take away everything that was given in a rich valuation,by impos-ing drastic restrictions on the future conduct
and wealth of the founders.Similarly,a com-pany must feel comfortable with its investors because they will share the same bed,figura-tively,for a long time to come.It would thus be foolish to maximize the short-term share price if it is at the cost of the long-term value creation potential of the company.N ever lose track of the fact that a financing round is just a means to an end,not the end itself!
This story was reprinted with some modification from the Building a Business section of the Bioentrepreneur web portal (https://www.wendangku.net/doc/ca14175308.html,/bioent), 21 June 2004, doi:10.1038/bioent814.
1.Copeland, T. , Koller, T. & Murin, J. Valuation:
Measuring and Managing the Value of Companies .(John Wiley & Sons, New York, 2000).
2.Frei, P . & Leleux, B. Valuating the company. in
Starting a Business in the Life Sciences—from Idea to Market . (Luessen, H. (ed.).) 42–55 (Edition Cantor Verlag, Aulendorf, Germany, 2003).
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