A company’s value lies in its potential to generate a stream of profits in the future and it is the criteria that matters most to the investors. Almost all valuation exercises are thus based on assumptions or educated guesses as to what a company’s future would be down the line meaning what important milestones to be achieved and what timely strategic decisions to be taken. These assumptions are grounded by 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.
Valuation is essential for the most crucial steps of a biotechnology company. The value of biotechnology companies is driven by anticipated future product and revenue streams, or by the impact that a technology platform is expected to have on the value of assets. The amount of money at stake justifies and requires a careful and thorough valuation. Biotechnology companies face the need for valuation at various stages: fund raising, license contracts, initial public offerings, and mergers and acquisitions. Quantitative financial evaluation of biotechnology investments is not an easy task. Biotechnology companies are typically dealing with innovative yet uncertain technologies and drug development candidates. The applications and the impact of a technology are often not clearly defined, and new drug development targets are not validated. However, financial evaluation and risk analysis are essential for investors as financial indicators and definite value propositions to fund biotechnology operations, and to the senior management of biotechnology companies needs to understand the risk and expected financial impact of their projects for prioritization and maximization of company value and while establishing technology partnerships and licensing agreements, the involved parties need to understand the financial value generated by a deal, and to ensure market-conformity and fair deal terms. The determinants of value in the biotechnology industry are expected cash inflows from marketed assets, R&D and market uncertainty, cost and speed of development, and strategic opportunities arising from technologies and projects.
Although, a company can have as many values as the number of different people evaluating it, every valuation starts with a systematic and rigorous testing of a company’s artistic hypotheses such as economic, technological and managerial abilities in combination with the following three scientific approaches:
Discounted Cash Flow or Net Present Value
The most common approach to primary valuation is the discounted cash flow (DCF) method, whereby a company is valued at the present value of the future cash flows it will be able to generate. The same approach is also called as net present value (NPV), or risk-adjusted net present value (rNPV) or expected net present value (eNPV). The idea underlying this method is to compare revenues and costs. If income exceeds expenses, then the project is profitable and the company should start or continue the project. But if, different cash flows do not occur at the same time or have the same likelihood, then adjust the cash flows for their time difference by discounting them and for their likelihood by multiplying with their probability to occur.
These methods are conceptually robust but can prove difficult to implement in high uncertainty environments, such as those of early-stage biotechnology firms. Typical problems include highly uncertain and distant positive cash flows, a business model based on many assumptions and a difficult risk profile of the company. Therefore, in principle, what is needed is to estimate the expected future cash flows of the business and 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 practical terms, there are some difficulties in implementing this approach as to projecting performance for several years into the future is a process considered as too speculative to be useful, then selecting a forecast for the future cash flows is purely arbitrary and questions the residual value of the business at the end of it, and obtaining an appropriate discount rate for an early-stage, privately held company presents difficulties too.
Comparable market data 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, and R&D expenditures, etc to estimate value. In a sense, secondary valuation makes the assumption that these comparable companies have been properly valued, and can serve as benchmarks when assessing a company.
A comparable valuation for a biotechnology company of interest is based upon a financial investment into a comparable company. Based on the information, the ratios such as price/revenue, price/employee and price/R&D can be calculated and used to estimate the value of the company of interest. These ratios are used because they have a direct or indirect impact on the valuation. It makes more sense to use earnings or cash flows as the ultimate basis of comparisons across firms. Unfortunately, most early-stage companies, as development entities, tend to burn more cash than they generate, and usually have negative earnings as well. Comparing losses or cash burns would obviously lead to speculative valuations. The amount spent on R&D, the number of employees for a company and the level of revenues that can be generated are seen as better indicators of future performance.
Real Options Pricing Model
Real options valuation is primarily based on the investments and financial options. An option is the right but not the obligation to buy or sell an asset at a prefixed price until a certain expiry date. Some investments can be modeled as options. For example, a company with Phase III trial compounds, where the results are expected in 30 months. If the results are positive, the company has the option to file a new drug application (NDA) and then launch the product. However, the company will do so only if the expected sales exceed the costs necessary to bring the drug to market. The costs of clinical Phase III correspond to the purchase of this option. Equally, with the costs of clinical Phase II the company buys the option to acquire the above-mentioned option after a successful trial. The investment for clinical Phase I is then the price for an option on an option on an option. In finance, these options on options are called iterated compound options, nested options or multi-stage options. The companies exercise the options only if the necessary investments (the costs of the subsequent phase or the launch costs) are less than the value the company gets in return. The launch costs are the option fee to launch the drug. In return, the company gets the sales revenues of the drug.
“Price is what you pay. Value is what you get.” -- Warren Buffett
Valuation is essential for the most crucial steps of a biotechnology company. The value of biotechnology companies is driven by anticipated future product and revenue streams, or by the impact that a technology platform is expected to have on the value of assets. The amount of money at stake justifies and requires a careful and thorough valuation. Biotechnology companies face the need for valuation at various stages: fund raising, license contracts, initial public offerings, and mergers and acquisitions. Quantitative financial evaluation of biotechnology investments is not an easy task. Biotechnology companies are typically dealing with innovative yet uncertain technologies and drug development candidates. The applications and the impact of a technology are often not clearly defined, and new drug development targets are not validated. However, financial evaluation and risk analysis are essential for investors as financial indicators and definite value propositions to fund biotechnology operations, and to the senior management of biotechnology companies needs to understand the risk and expected financial impact of their projects for prioritization and maximization of company value and while establishing technology partnerships and licensing agreements, the involved parties need to understand the financial value generated by a deal, and to ensure market-conformity and fair deal terms. The determinants of value in the biotechnology industry are expected cash inflows from marketed assets, R&D and market uncertainty, cost and speed of development, and strategic opportunities arising from technologies and projects.
Although, a company can have as many values as the number of different people evaluating it, every valuation starts with a systematic and rigorous testing of a company’s artistic hypotheses such as economic, technological and managerial abilities in combination with the following three scientific approaches:
Discounted Cash Flow or Net Present Value
The most common approach to primary valuation is the discounted cash flow (DCF) method, whereby a company is valued at the present value of the future cash flows it will be able to generate. The same approach is also called as net present value (NPV), or risk-adjusted net present value (rNPV) or expected net present value (eNPV). The idea underlying this method is to compare revenues and costs. If income exceeds expenses, then the project is profitable and the company should start or continue the project. But if, different cash flows do not occur at the same time or have the same likelihood, then adjust the cash flows for their time difference by discounting them and for their likelihood by multiplying with their probability to occur.
These methods are conceptually robust but can prove difficult to implement in high uncertainty environments, such as those of early-stage biotechnology firms. Typical problems include highly uncertain and distant positive cash flows, a business model based on many assumptions and a difficult risk profile of the company. Therefore, in principle, what is needed is to estimate the expected future cash flows of the business and 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 practical terms, there are some difficulties in implementing this approach as to projecting performance for several years into the future is a process considered as too speculative to be useful, then selecting a forecast for the future cash flows is purely arbitrary and questions the residual value of the business at the end of it, and obtaining an appropriate discount rate for an early-stage, privately held company presents difficulties too.
Comparable market data 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, and R&D expenditures, etc to estimate value. In a sense, secondary valuation makes the assumption that these comparable companies have been properly valued, and can serve as benchmarks when assessing a company.
A comparable valuation for a biotechnology company of interest is based upon a financial investment into a comparable company. Based on the information, the ratios such as price/revenue, price/employee and price/R&D can be calculated and used to estimate the value of the company of interest. These ratios are used because they have a direct or indirect impact on the valuation. It makes more sense to use earnings or cash flows as the ultimate basis of comparisons across firms. Unfortunately, most early-stage companies, as development entities, tend to burn more cash than they generate, and usually have negative earnings as well. Comparing losses or cash burns would obviously lead to speculative valuations. The amount spent on R&D, the number of employees for a company and the level of revenues that can be generated are seen as better indicators of future performance.
Real Options Pricing Model
Real options valuation is primarily based on the investments and financial options. An option is the right but not the obligation to buy or sell an asset at a prefixed price until a certain expiry date. Some investments can be modeled as options. For example, a company with Phase III trial compounds, where the results are expected in 30 months. If the results are positive, the company has the option to file a new drug application (NDA) and then launch the product. However, the company will do so only if the expected sales exceed the costs necessary to bring the drug to market. The costs of clinical Phase III correspond to the purchase of this option. Equally, with the costs of clinical Phase II the company buys the option to acquire the above-mentioned option after a successful trial. The investment for clinical Phase I is then the price for an option on an option on an option. In finance, these options on options are called iterated compound options, nested options or multi-stage options. The companies exercise the options only if the necessary investments (the costs of the subsequent phase or the launch costs) are less than the value the company gets in return. The launch costs are the option fee to launch the drug. In return, the company gets the sales revenues of the drug.
“Price is what you pay. Value is what you get.” -- Warren Buffett
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