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Focus on Life Sciences & Technology: Considerations for the valuation of early stage entities – Part 2

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In Part 1, we talked about what questions should be answered to help frame the valuation. Identifying the purpose, perspective, and audience will help you establish the type of valuation needed and the appropriate level of effort.
May 20, 2015

In Part 1, we talked about what questions should be answered to help frame the valuation. Identifying the purpose, perspective, and audience will help you establish the type of valuation needed and the appropriate level of effort.

  • What is the purpose of the valuation? A valuation performed for internal purposes will have more flexibility in the valuation approaches utilized and the level of due diligence and analysis required relative to a valuation for tax compliance or financial reporting.
  • Whose perspective matters? Differences in perspective can lead to very different value conclusions.
  • Who is the intended audience? The requirements and sophistication of the intended recipient will help determine the nature of the valuation needed. Once those questions are answered, you can move on to the analysis and approach.

Early stage valuations often present additional challenges relative to the valuation of more mature and predictable companies. Some of the challenges with the valuation of early stage companies include:

  • Lack of, or a very short, track record: Valuation professionals often use a company’s past financial performance, in particular, revenue, profitability, and cash flow, as benchmarks and indicators of future performance. Early stage companies often have a very short (if any at all) financial track record, and even if generating revenue, it is often relatively recent, highly variable, and insufficient to generate profits and positive cash flow.  
  • High level of uncertainty: Start-ups and emerging entities often operate with a high degree of uncertainty making it difficult to assess the prospects for commercialization of a company’s product or service.  
  • Rapidly changing conditions: Situations can change quickly, for better or worse, and this is especially true for early stage companies. The acceptance or rejection of intellectual property protections, success or failure on R&D efforts, or the ability or inability to raise needed capital can quickly change the landscape of an early stage company and significantly change its probability of success. Valuations are a snap shot, taken at a point in time. For this reason, early stage valuations can get stale very quickly.  

All of these characteristics of early stage companies are interrelated and present challenges in the valuation process. They make it difficult to establish and assess future prospects, to know what routes will be taken to execute on a company’s vision and strategy, and to identify what will create value for the company now and into the future. But there are steps that can be taken to mitigate these challenges:

  • Solid Business Plan: Creating a business plan, that includes a set of financial projections, can help mitigate the lack of a financial track record. It is critical to recognize that the key is not necessarily about being “right” with your business plan (nobody can predict the future), but to have a robust, well supported business plan. Make sure your business plan’s assumptions and inputs are 1) reasonable, 2) logical, and 3) supported. Talk to potential customers about your developing product or service.  Analyze preliminary sales efforts and results. Maintain the documentation supporting your business plan. Also, keeping your business plan up to date will not only help facilitate better valuations of your company, but has the added benefits of projecting cash flow needs (cash burn) and identifying needs for additional capital. Again, it is not about being right or creating some false sense of precision, but rather about developing your understanding of the market potential and supporting that understanding.
  • Make the process easy to repeat / re-iterate: If you are going to go through the effort, or are paying someone else to go through the effort of valuing your company, make sure you can re-up the analysis quickly and easily. As mentioned, conditions change rapidly. Give yourself the ability and flexibility to quickly revise or shift your business plan in response to changing conditions or your increased knowledge of the potential market.   
  • Perform sensitivity and scenario analyses: Understand the drivers of financial success (and disaster) and then test and change those assumptions to see how they can impact your business. Sometimes even small changes in assumptions / inputs can have large impacts on predictions and results. It behooves you to identify this before the fact rather than after the fact.      

By recognizing the challenges you can set up the analyses and valuation properly and minimize (or at least account for) the impacts of the challenges presented by early stage valuations. In Part 3, specific valuation approaches for valuing early stage companies will be identified and discussed.

RubinBrown has a dedicated Life Sciences and Technology Services Group specializing in serving life sciences and technology based companies, including: advising startup and early stage companies; performing valuations for internal purposes, financial reporting, and tax compliance; and consulting on IP value, management, and strategy.

 

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

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