Companies in the Life Sciences industry require valuations for various reasons: transactions (raising investment funds, compensating employees, licensing intellectual property, etc.), tax purposes, financial reporting, or litigation purposes. Due to the innovative nature of the industry, there are many start-up Life Sciences companies that are focused on research and development but have not yet started generating positive cash flow. Generally speaking, the earlier the stage of a company, the less useful traditional valuation methods will be. On August 22, 2012, RubinBrown presented a seminar on valuation issues unique to Life Sciences companies, and the following article highlights a few of the topics covered.
There are three main approaches to valuing a company: the income approach, the market approach, and the asset approach. The income approach determines the value of a business based on its expected earnings, or cash flow. With the market approach, the value of a business is determined by comparing the subject company to publicly traded shares of similar companies, or to similar businesses which have recently been sold. The market approach can be difficult to apply to Life Sciences companies, as many of these companies provide innovative solutions for which there are no suitable comparable companies or transactions in the market. In using the asset approach, the value of a business is determined by considering the value of its assets and liabilities. 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 the future cash flow the company is expected to generate.
The two methods used to determine value under the income approach are the direct capitalization method and the discounted cash flow 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 usually the case with early stage companies. Under the discounted cash flow method, the value of a business is determined by discounting future expected cash flow to present value using a cost of capital. The two inputs driving a discounted cash flow model are the projected cash flow and the discount rate, which is based on the timing and risk of receiving future cash flow.
Projected Cash Flow
Projected cash flow takes into account the company’s projected revenues, profitability, and required reinvestment. The required reinvestment is the capital that the company must invest to be able to earn the future cash flow; for example, purchasing new equipment or building.
Life Sciences companies are typically early stage, and are often pre-revenue or pre-profitability. It can be difficult to project future cash flow with any certainty without a track record of historical cash flow on which to base the projections. One solution is to create a decision tree, which uses a probability weighted scenario analysis to value a company. The following decision tree provides an example of a probability weighted valuation:
In the example above, the joint probability is calculated by multiplying prior probabilities. For example, the first joint probability is calculated as 90%*75%*20% = 14%. The sum of all joint probabilities is 100%. The “Valuations of Future Cash Flow” are calculated in four separate discounted cash flow models (not shown) and then multiplied by their respective joint probabilities to determine the probability weighted value of the company of $217 million. As illustrated, the three main determinants of the hypothetical company’s cash flow are (1) whether or not they successfully complete clinical trials, (2) whether the product receives immediate or delayed FDA approval, and (3) whether the product receives high or low market adoption. The decision tree allows us to consider these various scenarios, which is especially helpful when valuing early stage companies that have not yet started generating positive cash flow. Another benefit of the decision tree is that the valuation can be updated over time as the company reaches certain milestones or as market conditions change.
Cost of Capital
Another tricky aspect of valuing early stage companies is determining an appropriate cost of capital, which is the rate of return that the market requires in order to attract funds to a particular investment. A company’s weighted average cost of capital (“WACC”) is calculated by determining the company’s cost of equity, after-tax cost of debt, and optimal capital structure. Specifically, WACC = re*we + rd*wd*(1-T), where re is the cost of equity, we is the percentage of equity in the capital structure, rd is the cost of debt, wd is the percentage of debt in the capital structure, and T is the corporate tax rate. The WACC captures systematic risk, industry risk, and company specific risk.
Pepperdine University publishes the Pepperdine Private Cost of Capital Survey biannually, which surveys market participants for required rates of return in various investment categories throughout the United States. The table below includes data from 68 respondents to the bank debt survey, 74 respondents to the mezzanine debt survey, 152 respondents to the angel investor survey, 213 respondents to the venture capital survey, and 327 respondents to the private equity survey. In addition, the latter portion of the table includes public equity data from 1926 through 2011 published by Morningstar.
The table above reveals five characteristics of risk that impact cost of capital:
- Debt has a lower required rate of return than equity, as debt holders receive priority in payment over equity holders. Equity investors bear more risk and therefore require a higher rate of return to be compensated for that additional risk.
- The size of a company affects the required rate of return. Generally, the smaller the company, the higher the required rate of return.
- The life cycle stage of a company also affects the required rate of return. Early stage companies have higher required rates of return than later stage companies, as the early stage companies do not have a proven track record and are therefore riskier investments.
- Stocks with high volatility (as measured by standard deviation) have higher rates of return. Volatility is an indication of risk, and high risk investments have higher required rates of return.
- Public equity markets have exhibited a lower rate of return than private equity investments.
Many Life Sciences companies are in the early stage of the business life cycle. As previously mentioned, the earlier the stage of a company, the less useful traditional valuation methods will be. Factors that determine the valuation methods used and impact the valuation inputs include a company’s life cycle stage, size, and financial structure.
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