A Simple VC Investment Model: What every Biotech Entrepreneur should know

Before reading this article, you can download the Excel version of the model from the link below:

VC Financing Model – Revised

All Entrepreneurs know that Venture Capitalists (VCs) want is two main things: (i) Return and (ii) Control. They want return because they have invested in a company that operates in one of the riskiest industries of the world and they want control to participate in the decision-making that may affect the future returns on their investments. What are the elements affecting their return on investment? How do these reflect to the valuation of the company after a series of investments?

Before contacting a VC (and you need to have a strategy even for that) you must make sure that you know what you need from them and if it is just capital, how much (a reasonable range) would you need and how would you allocate it (R&D and Marketing, or only R&D and then secure a marketing and distribution agreement with a large pharmaceutical company?). In brief, VCs want:

  • Initial Ownership: Percentage of stock owned by VCs based on their initial investment.
  • Dividend Provision: Future dividends model (no dividends, flat or cumulative?)
  • Exit Strategy: M&A or IPO
  • Liquidation Preferences: Return multiple (i.e. times their initial investment)
  • Type of Stock received: Usually investors required a convertible preferred stock. That is because, initially, they receive all their stock as preferred stock which means that in the case of bankruptcy the investors get paid first and then the rest of shareholders. This is a “shield” to make sure that in case their investment fails they will get back some money back. Therefore, convertible preferred stock reduces the overall risk of the investment. In case where their investment is successful, they have the right to convert all the preferred stock into common stock which can be sold to collect their investment returns.
  • Participation: If the company is sold (or if the equity raised through an IPO) more than its post-money valuation (i.e. premium) then the VCs can “participate” in that premium too.
  • Protective Covenants: usually a  non-competition covenant is applied – an employee is not allowed to work for a competitor for a specified period of time.
  • Board of Directors (BoD) Control: In order for VCs to have actual control on importance decisions made in the company they will certainly ask for board sits.
  • Rights of First Refusal: Rights of first refusal allows the VCs to prevent dilution of ownership in case of additional series of investments from other VCs. Full rights of first refusal means that VCs will maintain exactly the same ownership until exit.
  • Stock Repurchase Agreement: Restriction on stock repurchases from existing shareholders (mainly founders) to avoid concentration of shares in a single or very few shareholders.

Example

Biostrategy Analytics Corp. is a biotechnology company that with its own funds and Angel investors has succeeded in bringing a drug from research to phase I and seeks VC funding for testing the drug in clinical trials. On average an early-stage biotech company needs needs € 60 mn. in total (nominal value) throughout the clinical development period (6 – 9 years). Due to the huge amount of investment required, the company plans to receive three series of investments: Series A, Series B and Series C.

Table 1 presents the Series A model of investment:

Series A Financing

Table 1: Series A Financing

Highlighted in blue are the assumptions of the model, while in green are calculated values. Assuming the initial investment is € 10 mn. and the required ownership is 20%, this gives a post-money valuation of € 50 mn. and a pre-money valuation of € 40 mn. If there are 10 mn. outstanding shares then 2.5 mn. of convertible preferred stock resulting in 12.5 mn. of total shares. The price per share, assuming that all preferred stocks are converted to common stocks is:

Price (€) per Share: pre-money valuation / outstanding shares = € 40 mn. / 10 mn. = € 4

Since this is an investment in an early stage company the risk is very high and the VCs will ask for increased liquidation preferences (4x initial investment) and a participation of 40%. Therefore the required investment return (nominal, i.e. at exit) is:

Required Investment Return at Exit = (Liquidation Preferences)*(Initial Investment) + 40%*(Value at Exit – Post-money Valuation)

In Table 1, the required Investment Return is 4 € 10 mn. = € 40 mn. (participation not taken into account since there is no exit yet at series A).

An additional assumption is that the conversion ratio (if the preferred stock is converted into common stock) will be 1 in all series of investments.

Table 2 below presents the valuation of the company assuming there are three series of investments: A, B and C. As it can be seen the valuation of the company changes depending on the ownership the investors require and the amount of investment dedicated by each VC. Outstanding shares are cumulative (initial shares + shares issued in each Series of investments).

Table2: Series A - C

Table 2: Series A – C

Cells highlighted in red point to the factors that mostly affect the investment return to the VCs and what is left for the founders of the company. The post-money valuation of the company after series C has been estimated to be € 87.5 mn. It should be noted that full rights of first refusal have not been applied in this model.

In table 3, the ownership structure of the company (post-series C) is shown:

Ownership Structure

Table 3: Ownership Structure

The majority of the company’s equity (69%) has passed into the hands of the VCs while only 31% has remained to the founders. In case where full rights of first refusal were applied the company would dilute further. In addition, summing up the investors’ required return gives € 170 mn. (€ 70 mn. + € 60 mn. + € 40 mn.) which is approximately 2 times the post-money valuation of the company. Therefore, only in case where the company raises equity (through an IPO or sold to another company) at least double of its post-money valuation the VCs will get the required return. Entrepreneurs will receive return only if the company raises equity or sold more than double its post-money valuation, and they will only have a 10% participation of that (see Table 4, click on the figure to see numbers more clearly). That is the only pure profit for the Entrepreneur.

Exit Scenario

Table 4: Exit Scenario

In the IPO scenario it is assumed that the company raises € 200 mn. Together with participation, investors receive € 197 mn. and € 3 mn. are left for the entrepreneur. If the company raises € 3 mn. less, then the entrepreneur gets nothing.

In the M&A Scenario, it is assumed that the company is sold twice its post-money valuation. In that case the return for the entrepreneur is much lower, i.e. € 0.5 mn.

Assumptions and Limiting Factors of the Model

1) Time value of money has not been taken into account. This is mainly a static model rather than a dynamic one as it does not take into account the risk profile of the Company, how it changes and how it develops through times. It is rather a model examining the relationship between the value of the company and the investments to it at discrete time points (pre-money and post-money).

2) Full rights of first refusal were assumed non-existent.

3) All VC investments are assumed to be allocated for R&D, Personnel Costs and Other company operating or capital expenditures. Any potential net income is to be reinvested in the company.

In conclusion, every entrepreneur should know that when seeking investments, going the VC way it is like a long journey with many obstacles and when the destination is reached you might not be rewarded.

Valuation of Pharmaceutical and Biotechnology Companies: Comparable Transactions Method (Part 3)

In this article the Comparable Transactions Method (CTM) is discussed. In CTM the valuation of the company is based on the answering the following question: If the company was sold are there any similar transactions have taken place under similar conditions? Could these transactions be used in a comparative manner in the valuation of the company? The following steps can be followed to accurately value the target company using CTM:

Step 1: Analysis of the Target Company

As in CMM (see here) the data needed to be collected for the target company are:

  • Location: headquarters, countries of operation, location of subsidiaries.
  • Quoted Status: Publicly Listed or Private.
  • Product Pipeline: Number of products, breakdown of products’ type.
  • Revenue structure: breakdown of revenues by area.

Step 2: Characteristics of Comparable Transactions

The CT sample should fulfill the following criteria:

  • The target company shall have a similar business description if available.
  • When researching for acquisitions (comparable transactions) the SIC code should be the same or close to our company.
  • Comparable transactions should have been completed at most 3-4 years prior to the valuation date.

Step 3: Collection of Comparable Transactions Data

Two types of data need to be collected for CT valuation. These are:

  • Transaction Financials: Price to Sales, Enterprise Value to Sales, Price to Earnings After Tax (EAT), Enterprise Value to EBIT.
  • Financials of the Company to be Valued: Sales, EAT, EBIT, Net Debt (Debt – Cash).
  • Other: Target Ownership (Public or Private), Announcement Date of Transaction, Percentage bought by bidder in each comparable transaction.

Step 4: Analysis

Before estimating the average and the median of the transaction multiples a two-fold adjustment has to be made in the equity value of the target company in each comparable transaction:

  • Discount for Lack of Marketability: If the target company in the CT sample is a private company and the company to be valued is public (or vice versa) then the equity value of the target company has to be adjusted. This occurs because a private company does not have a comparable equity value with that of a public company and that is because a public company has better liquidity and better access to the capital markets.
  • Control Premium: For each transaction in the CT sample it must be known whether the bidder has acquired a majority or a minority of the target’s equity. If it is a majority stake then the bidder paid a control premium which should be subtracted to find a realistic transaction multiple.

Since, it is almost impossible to find the discount due to lack of marketability and the control premium for each transaction an industry average can be applied (based on the industry classification code named SIC Code).

Control premiums for past transactions can be found here. For example, the SIC Code for the pharmaceutical industry is 2834. In the link attached, 14 transactions took place in the pharmaceutical industry in the first quarter of 2012. Taking the average of the control premiums of the above sample (excluding outliers) a representative control premium can be found if you are valuing a pharmaceutical company in 2013 or 2012. Typical control premiums can range between 15% – 45%.

Marketability discount can be found by looking at recent Initial Public Offerings (IPO) of companies in the relevant industry and comparing the company’s equity value pre-IPO with the market value of equity in the post-IPO period. Marketability discount varies by industry and company size but it is typically between 20% – 40%.

Therefore:

Adjusted Equity Value When Valuing a Public Company = Equity Value * (1 + a*CP + b*MD) (i)

Adjusted Equity Value When Valuing a Private Company = Equity Value * (1 + a*CP – b*MD) (ii)

  • a = 0 if the bidder buys a minority stake
  • a = 1 if the bidder buys a majority stake
  • b = 0 if the target company is public
  • b = 1 if the target company is private

If net debt is also known for each target company in the CT sample the Adjusted Enterprise Value can be estimated by adding the Adjusted Equity Value with net debt. If net debt cannot be obtained then reported (e.g. annual report) EV measures can be used.

As a final step, the transaction multiples are calculated by dividing  Adjusted Enterprise Value and adjusted equity value with the target company’s sales and EBIT and EAT. By finding the average of these ratios (excluding outliers) and multiplying by the company’s parameters the final value of the company can be obtained.

Example: CT Valuation of Sanofi (As of 31.12.2005)

Sanofi is publicly listed therefore equation (i) applies in regards to adjusted equity value.

The following CT sample 13 comparable transactions were identified (click on the picture to see numbers more clearly). A control premium of 25% and a 25% marketability discount have been applied.

Comparable Transactions Sample

Comparable Transactions Sample

The CT sample above produced the following multiples:

Comparable Transactions Multiples

Comparable Transactions Multiples

Using the CT multiples above and the Sanofi-Aventis’ financial parameters as of 31.12.2005 the market value of equity of Sanofi-Aventis is derived as follows:

Market Value of Equity Estimation - CT Approach

Market Value of Equity Estimation – CT Approach

The last step to complete the valuation process is to provide a weight for each valuation approach. DCF approach resulted in € 91,925 mn. CMM resulted in € 92,954 mn. and CT in € 100,999 mn. (press here for previous articles on DCF and CMM)

The final step of valuation is to give weights to each valuation method in order to determine the central value of the company.

CMM and CT approach will both receive equal weight of 25% while DCF will receive a weight of 50%. Therefore, the weighted market value of equity is calculated as follows:

Valuation Synthesis

Valuation Synthesis

It can be seen that the total weighted value of € 94,451 mn. diverges 10% from the actual market capitalisation of Sanofi (€ 103,656 mn.). As mentioned in Part 1 & Part 2 there are various reasons for the difference in derived values from various valuation approaches and the actual market capitalisation of a company (including: potential investors’ speculation, M&A rumors, imperfect information, short-term investments on companies’ stocks as opposed to DCF which is based on long-term free cash flows etc.)

It should be noted that the value derived is the central value. This means that sensitivity analysis was not performed to provide with a range of values. In DCF one could slightly alter the growth to perpetuity and WACC to see the potential effects on Enterprise Values. That would provide a range of values and in fact the actual market capitalisation value would lie in that range. Therefore, the derived value can be considered close to the actual market capitalisation meaning that the stock as of 31.12.2005 was not overvalued or undervalued and investors’ expectations about Sanofi-Aventis were realistic with respect to Sanofi-Aventis actual financial performance.