Valuation Of Start-Up Life Science Companies

Valuation of a start-up life science company that offers little more than the promise of success in the future can be very difficult. Stellar results in the basic research laboratory rarely directly result in a cure of disease.  Considering biotech, the drug development process requires many years to determine whether all the effort will translate into monetary returns for a company. Although valuation of the start-up may appear to be more guesswork than proven algorithm, the investment community has a generally accepted approach to valuing biotech companies that are years away from product approval. The generally accepted approach to valuation relies on discounted cash flow (DCF) analysis, which I will explain below.

Valuation of Portfolio
Biotech companies are often valued as a collection of one or more experimental drugs, each drug representing a potential market opportunity. The idea is to treat each promising drug independently within a portfolio. Using DCF analysis of all the promising drugs in the portfolio, one can determine the value of a company.

That is, using DCF one determines the forecasted free cash flow of each drug to establish each drug’s present value. Then the net present value of each drug, along with any cash assets, are added to determine the net value of the company.

Start-up biotech companies often have several drugs in their developmental pipeline. Not all drugs should be included in the valuation. In general, only those drugs in phase I, II, or III are included for valuation. A drug candidate that is in the discovery or non-clinical stage is not a good bet, with less than a 1% chance of reaching the market. Therefore drugs in the non-clinical stage are usually assigned zero value by professional investors.

Sales Revenue Forecasting
The most difficult and most important estimate needed in valuation is that of the sales forecast. Here a determination of expected peak sales is estimated based on the assumption that the drug candidate successfully progresses through clinical trials to FDA approval. The forecast of sales is typically for the first 10 years of the drug’s life.

To forecast sales, start by making assumptions about the drug’s market potential. Use information provided by market research reports to determine the size of the patient group that will use the drug for a given indication. Data are utilized only for those markets were patients will pay market price for the drugs, usually those markets in industrialized countries.

 
To determine a drug’s potential market penetration one must consider many factors. If the candidate is entering a competitive drug market, with limited advantage offered by the candidate drug in terms of increased efficacy or reduced side effects, the drug will probably not gain substantial market share in its product category. In this case an assumption that it will capture 10%, or less, of that total market should be used. In contradistinction, if no other drug addresses the same needs, an assumption of 50% market share or more is reasonable.

Cost of Sales
Once a sales market size has been established, an estimated sales price needs to be determined. Estimating the price tag of a drug that addresses an unmet need will involve some guesswork. However, when a drug competes with existing product one can refer to the competition. For example, according to reports, Roche’s  HIV-inhibitor drug, Fuzeon, costs just over $20,000/year per patient. Multiplying $20,000 by the estimated number of patients gives you estimated annual peak sales.

For many biotech start-ups however this figure is  misleading because the company won’t necessarily receive all of this sales revenue. Most small biotech firms have little capital and therefore do not have the costly sales and marketing divisions capable of selling high volumes of drugs. Start-ups usually license promising drugs to bigger pharmaceutical companies that help pay for development and become responsible for making sales. The biotech in return normally receives royalty on future sales. The royalty rate for drugs currently in Phase I of clinical trials is normally a percentage in the single digits, and as the drug candidate moves through the development process, royalty rates become progressively higher. Interestingly, because of the high failure rate at phase II, proof of efficacy, many drug candidates will not be licensed to big pharma until the candidate has completed phase II.

An estimate of the peak annual sales revenues for a hypothetical biotech drug in a market with little competition and a potential market size of 2 million patients, an estimated sales price of $20,000 per year and a royalty rate of 10% is given below.

Potential Market Size- 2 million patients

Market Penetration Rate -Competition Low-50%

Estimated Market Size-1,000,000 patients

Sales Price-$20,000 per year

Peak Sales-$20 billion per year

Royalty Rate-10%

Peak Annual Sales Revenues-$2 billion

Drug patents last about 10 years, and therefore in the hypothetical example above, we assume that sales revenues from the drug will increase over five years until they hit their peak. Thereafter, peak sales plateau for the remaining life of the patent.

Estimating Costs
Future cash flows estimates for a drug candidate need to consider the costs of discovery and bringing the drug to market.

First, there are operating costs associated with the discovery phase, including efforts to discover the drug’s targets and molecular basis, followed by lab and animal tests. A very large proportion of the costs can be those of running clinical trials. These expenses include the cost of formulating and manufacturing the drug, recruiting, treating and caring for the subjects, and other administrative expenses. Expenses increase in each development phase as the number of patients increases substantially in the progressive phases. Ongoing capital investment continues in items such as laboratory equipment and facilities. Taxation and the cost of working capital also need to be considered. Investors often expect operating and capital costs to represent no less than 30% of the drug’s royalty-based sales.

Deducting the drug’s operating costs, taxes, net investment and working capital requirements from sales revenues of the drug yields the amount of free cash flow generated by the drug if it becomes commercial.

Factoring Risk
Our forecast of free cash flow assumes that the drug is approved by regulators. However, approval has a low probability. Therefore, depending on the drug’s stage of development, a probability factor is applied to account for the candidate’s probability of success.

As the candidate proceeds through the development process, the risk decreases with each major milestone. Rough estimates suggest that drug candidates entering Phase I clinical trials have a 15% probability of becoming a marketable product. For those in Phase II, the odds of success rise to over 30%, and for Phase III, they climb to 60%. Once clinical trials are complete the drug candidate has a 90% chance of success. These improvements in the odds of successful approval translate directly into increased stock value.

Multiplying the candidate’s estimated free cash flow by the stage-appropriate probability of success, a forecast is attained of free cash flows that accounts for development risk.

Next is to discount the drug’s expected 10-year free cash flows to determine what the candidates are worth today. Risk has already been factored by applying the clinical trial probability of success. Therefore one need not include development risk in the discount rate. A normal means of calculating the discount rate, such as the weighted average cost of capital (WACC) approach, can be used to calculate the drug candidate’s final discounted cash flow valuation.

Calculate the Firm’s Worth
To calculate the value of the biotech firm one simply needs to add up the DCF for each drug candidate to estimate a total value for the firm’s drug portfolio, or total value of the company.

DCF Value Drug A + DCF Value Drug B + DCF Drug C = Total Firm Value

Conclusion
Valuation of start-up biotech companies is not entirely a nebulous estimation. Intelligent investors can conceive solid stock valuation estimates if they utilize DCF analysis and amass an understanding of the industry and how major developmental milestones can impact the value of a biotech firm.