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Focus on Life Sciences & Technology: Considerations for the Valuation of Early Stage Entities – Part 3

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Part 3 of the series covers specific valuation approaches that can be utilized for early stage companies.
October 5, 2015

Part 1 discussed the type of questions that should be answered to help frame the valuation. Identifying the purpose, perspective and audience will help establish the type of valuation. In Part 2, challenges inherent in early stage valuations were identified and some ideas for getting past these challenges were discussed. In Part 3, specific valuation approaches that can be utilized for early stage companies are covered.

Once you’ve answered the questions discussed in Part 1: What is the purpose of the valuation? Whose perspective matters? Who is the intended audience?; and, you’ve considered the challenges discussed in Part 2, you should be in position to identify what approaches will be most appropriate for valuing the early stage entity.

At a high level, valuation professionals will typically consider approaches that fall into one of two camps – traditional approaches and alternative approaches.

Three primary methods classify as traditional approaches: the income approach, the market approach and the cost approach. In addition to those three, some of the following alternative approaches are often utilized for earlier stage entities: the venture capital method, the David Berkus method, the scorecard valuation method and the risk factor summation method. In practice, some of the alternative approaches actually contain aspects of one or more of the traditional approaches.

Traditional Approaches

Often, if the purpose of the valuation is for compliance purposes and the intended audience is the IRS, the SEC or an audit firm, it is wise to utilize a traditional valuation approach. These methods are tried and true, and so long as they are properly executed and have an appropriate level of support and analysis, they are accepted by auditors, the IRS, and so on.

  • The Income Approach: The income approach determines the value of a business based on its expected earnings, or cash flow. The two primary methods under this approach are the discounted cash flow method and the direct capitalization method.

    The discounted cash flow method is used when a company’s future income stream is expected to differ from recent or current operating results, which is often the case for early stage and growth stage companies.

    The direct capitalization method is a simplified version of the discounted cash flow method, but is generally only appropriate for mature, stable companies that expect cash flow to grow at a relatively constant rate.

  • The Market Approach: Under the market approach, the value of a business is determined by comparing the subject company to “comparable” companies with observable valuations. The two common methods utilized in the market approach are the guideline public company method and the comparable company or guideline transaction method.

    Under the guideline public company method, the subject company is compared to similar publicly traded companies and observed valuation multiples are used as benchmarks for the subject company (with some potential adjustments).

    In the comparable company / guideline transaction method, observed valuations for companies that have been acquired or have recently raised capital (you can even use your own funding round) are used as the benchmark for the subject company (also with some potential adjustments).

  • The Asset Approach: The asset approach values a business by considering the net value of its assets and liabilities – essentially the company value is equal to the sum of its parts. This method is also called the cost approach, as it values a company based on the individual or component costs of its assets, rather than expected future cash flow of the company (if any).

Each of these approaches has its strengths and weaknesses. The income and market approaches are best utilized for companies that are expected to continue operating (often referred to as “going-concerns”). The asset approach, which often fails to account for the value of non-saleable intangible assets, is not as useful in valuing going concerns, and often is best utilized to assess potential liquidation value.

Also, while these approaches can be used for companies during all stages of their life cycle, given the numerous inputs and assumptions required for the income approaches and the difficulty in finding truly comparable companies under the market approach, they are generally less useful for the earliest stage entities (especially those that are pre-revenue). Have faith though. If you do not need a valuation for compliance purposes, there is enhanced flexibility offered through alternative valuation approaches. Here are several other approaches that can be used to provide indications of value for very early stage companies.

Alternative Approaches

  • The Venture Capital Method: This approach estimates an exit value at some point in the future and then solves for a value today by assuming an appropriate return on investment during the interim period. A quick example can illustrate this method best.

    Assume that a pre-revenue company is projected to generate $25 million in revenue by year five, and a review of comparable companies indicates a revenue multiplier of 1.5 times. Thus $25 million x 1.5 equals a $37.5 million valuation in year five (assuming relatively constant revenue multiples). Now, assume that for the level of risk and the investment horizon that a 10X return is appropriate. Based on this return assumption, the implied value today would be approximately $3.75 million ($37.5 million exit ÷ 10X return).

  • The David Berkus Method: Named after angel / VC investor Dave Berkus, this method looks at five factors, and depending on how the investment is scored on each factor, the value is increased by an amount (up to $0.5 million per factor, according to the latest from berkonomics.com). Thus, an early stage company can be valued at up to $2.5 million, if it is scored highly on all five factors.

    (Note: this may need to be adjusted for the current investment environment. For example, it was recently reported that the median seed stage valuation was about $3.95 million).

    The five factors are:
    1. Sound idea
    2. Prototype
    3. Management team
    4. Strategic relationships
    5. Product commercialization to-date (if any)

  • The Scorecard Valuation Method: This is also a factor-based method, in some ways similar to the David Berkus Method, but it also incorporates the market approach. This approach uses observed early stage company valuations as a benchmark for the subject interest valuation.

    Under this approach, you observe median or mean valuations for comparable early stage companies and then adjust the valuation up or down depending on how the subject investment stacks up with the comparable companies, as determined by a comparison against various factors. The factors for adjusting the valuation are each given respective weights that sums to 100%.

    These factors are:
    1. Management team
    2. Commercial opportunity
    3. Product / technology
    4. Competitive environment
    5. Strategic relationships and partnerships
    6. Need for additional investment

  • The Risk Factor Summation Method: Another factor-based model that utilizes a higher number of factors than the scorecard valuation and the David Berkus methods. In this method, 12 factors are utilized and, similar to the scorecard valuation method, comparable early stage company valuations are used to establish a baseline value from which to adjust the subject interest up or down depending on an evaluation of certain factors.

    The factors include:
    1. Management team
    2. Stage of business
    3. Political risk
    4. Manufacturing risk
    5. Sales and marketing risk
    6. Funding risk
    7. Competition risk
    8. Technology risk
    9. Litigation risk
    10. International risk
    11. Reputational risk
    12. Exit potential

Final Considerations

The following are some final considerations to keep in mind as you perform your valuation or engage another to do so:

  • Use multiple approaches as a sanity check: Use multiple approaches in valuing the subject interest and assess how consistent or disparate the results are. Consistent indications of value among different approaches provide a level of assurance on the reasonableness of the conclusions. If the results of the various approaches differ significantly, then you should recheck one or all of the models and approaches utilized to see what factors are driving the differences, and also to determine if the differences can be reconciled or explained.

  • Perform sensitivity analyses: Test the different assumptions and inputs used in performing the valuation. This will allow you to see how each assumption directly impacts the ultimate valuation and will help you identify the true value drivers.

  • Know the limitations of the work: Acknowledge the potential limitations of the work by recognizing what are assumptions versus empirically driven inputs. As the number of assumptions increases, and the support and justification for those assumptions decreases, the level of uncertainty within the valuation increases (i.e., “garbage in, garbage out”).

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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