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Valuing start-up and early stage biotechnology companies is particularly difficult. In particular, early stage biotech and pharma companies have high sunk costs (i.e. fixed costs that cannot be recovered) and at the same time few or no sources of revenue at all. As a result most or all their Profit & Loss (P&L) items such as EBIT and Net Income have a negative sign. This restricts the ability to value these types of companies through a Comparable Multiples Method (CMM) or Comparable Transactions Method (CTM). Therefore, DCF and Venture Capital Method (see: A Simple VC Investment Model: What every Biotech Entrepreneur should know) of major importance. This article will focus on how DCF and NPV can be applied to value an early-stage biotech company.
In order to value a company using the Discounted Cash Flow (DCF) method the following variables shall be taken into account:
- R&D Cost by Phase: This can be provided by the Management of the company (as estimates). For the purpose of this analysis the figures provided by Bogdan and Villiger.
- Attrition Rates: Probability of approval by phase – Assumed based on past studies/cases
- Discount Rate: Discount rate of the project can be assumed to be the same as the discount rate of the company, if the company has one project or very few similar ones (i.e. same therapeutic area – same risk etc.) Discount rate (and more specifically, beta) decreases each time a drug passes to the next phase of clinical trials because the project becomes less riskier as the product gets closer to the market. The discount rate is estimated through the Capital Asset Pricing Model (CAPM).
- Post-approval revenues and costs: In order to value the company sales forecasts are needed. That is particularly hard and risky to do because of the uncertainty of the market, the economy, the regulation or even tax policies in general in 6-7 years from now. However, revenues and costs are necessary to estimate future free cash flows of the firm or the project.
- P&L and Balance Sheet items: Items such as Cost of Goods Sold (COGS), Selling, General and Administrative (SGA) costs, EBIT margin, CAPEX and Working Capital will be assumed as a % of sales based on comparable companies (high growth, medium growth and maturity companies).
- Free Cash Flow calculation (1/2): If revenue projections have already been obtained (from the company’s management) the next step is to estimate operating expenses that lead to EBIT. By assuming an appropriate tax rate, estimating CAPEX (capital expenditure on fixed assets), change in Working Capital and Depreciation & Amortization (using the relevant method, e.g. straight line) Free Cash Flow to the Firm (FCFF) can be calculated by using the following formula: FCFF = EBIT*(1-T) + (Depr’n & Amortisation) – CAPEX – Change in Working Capital
- Free Cash Flow calculation (2/2): If revenue projections have not been provided by the management of the company then there are two alternatives. The first one is the market method and the second is the comparable method. The former suggests that the market forecasts and statistics should be found (e.g. if the product is a cancer drug then forecasts for the oncology market need to be found – it would be even more relevant if forecasts of the subsector can be reproduced i.e. if the product is monoclonal antibody cancer drug, then research the monoclonal antibody cancer market). Then estimate the therapeutic area’s statistics (potential number of patients targeted for the treatment based on disease prevalence) estimate pricing (search for comparable products to see prices and look for social insurance reimbursement percentages) and of course examine market access and penetration issues that may arise and perform quantitative (by looking at past products) and qualitative analysis (ask doctors whether they would prescribe that drug or not, do questionnaires, focus groups etc.) based on this information.
Using the assumptions outlined and those discussed above, the following steps were taken to come out with the results:
STEP 1: Comparable Companies (COGS, SG&A, EBIT Margin, WACC)
STEP 2: R&D Costs by Phase
STEP 3: Discount Rate by Phase
STEP 4: Discounted Cash Flow Results
Initial Sales that result in an NPV = 0 have been used (i.e. USD 132 mn.). Sensitivity analysis has been applied to observe how initial sales shape NPV of the project (see Step 5).
STEP 5: NPV of the Project
STEP 6: Sensitivity Analysis – Effect of Initial Sales and CAGR on DCF and NPV
Figure 6 depicts the exponential effect of sales CAGR on DCF Valuation for different initial sales values while initial sales follow a linear relationship with DCF valuation for different CAGR. For a minimum initial sales of USD 25 mn. the product needs a CAGR of 35% for a positive NPV, while for the minimum CAGR of 15% initial sales should be at least USD 200 mn. in order for NPV to be positive.
There are various financial modelling difficulties (subjectivity, unreliable forecasts, risk) in DCF but these can be reduced if the company to be valued has already secured a licensing agreement of its product(s) with a big pharma company. Then a Comparable Licensing Deals Valuation can be applied, in which the appraisal is based on licensing and royalties revenue development and how costs are distributed between the licensor and the licensee, what is the risk and value shared etc.
For VC-backed early-stage biotech/pharma companies there is also the Venture Capital Method which can be more accurate as it is based on investors’ requirements (return, exit strategy etc.). If the investment fails the company is in trouble while the investors moves on to another company and expect that their return on investments to the next company will cover the cost of the failure (+ profit) from the previous investment.
Of course there can be a combination of the methods outlined above, i.e. a VC firm will probably invest in a company that has already proven its ability to potentially develop successful products, i.e. a company that has already out-licensed one of its products. Such company will probably have less strict terms by the VCs as opposed to a company that has not secured any deal. In that case, model-wise, a valuation model should be considered that will incorporate VC investments as well as licensing deals.