Scientists doing research in a lab often focus on helping people who have specific diseases. While the goal is clear, the path to achieving that goal is filled with challenges. In particular, funding is of significant relevance for the companies backing the research. One path to funding is finding investors, which requires an accurate company valuation.
Valuing early-stage life sciences companies presents challenges that are unique to the industry. Companies in other industries often are valued based on operational projections such as revenues, expenses, and future cash flows. The most common valuation methodology for revenue-generating companies is discounted cash flow. However, early-stage life sciences companies are defined by uncertainty, such as potential success of regulatory approval, size of the market opportunity, competitive alternatives, and the reimbursement outlook of the product. Obtaining an accurate valuation is tremendously important as access to outside capital is integral to the success of research and development activities.
Specific key drivers determine a company’s value. An experienced management and scientific team with a track record of successfully developing, commercializing, and monetizing novel products can be integral to attracting significant funding. Being able to evaluate and communicate the size of the market opportunity is a requirement when pitching to potential investors. Additionally, understanding the stage of the lead asset and the breadth of the pipeline for alternative indications is critical, as is the ability to prioritize the primary focus of the company in the face of funding limitations. However, even if the company can clearly convey all of these factors, if management is not able to effectively protect the core sciences through patent protection and licensing agreements, it will be difficult for the company to succeed ultimately.
Valuation methods
As previously mentioned, valuing an early-stage life sciences company through a traditional discounted cash flow analysis is not an option. However, other valuation methods are commonly used.
- The risk-adjusted net present value method uses projected cash flows from development candidates and applies discounts for risk, also referred to as success rates, at various clinical development inflection points in the forecast such as phase 1, phase 2, phase 3, and Food and Drug Administration approval. Applying success rates in this manner offers a more intuitive way to adjust the forecast and account for risk.
- The market approach attempts to benchmark the company or its underlying clinical assets to other similar recently acquired companies or assets while adjusting for differences in stage of development and the specific market or patient population served.
- The venture capital method estimates the exit value at a future point, such as through an acquisition or IPO, and discounts the value to the current stage of the company. It incorporates investor return expectations and offers a way to simplify early-stage valuation, but it depends heavily on market multiples often applied many years in the future.
Other methods are available as well; the key is to apply the best approach for the company’s stage of development to arrive at the most accurate and reasonable value for the investors and management team.
Accounting and financial reporting
The company’s valuation also affects accounting and financial reporting. When the company has no contemporaneous equity financing, it must obtain a valuation to determine the estimated value of its common stock. One or more of the methods previously addressed may be used to value the company’s equity, and then certain allocation approaches are used to estimate the value of common stock in cases where there are multiple classes of stock. The valuation is one of the factors used to establish the exercise price of stock options granted to employees and to record compensation expense. In addition, it might affect the number of options management is allowed to grant. When preparing financial statements for the company, management will use other valuation models – such as the Black-Scholes option pricing model – to measure the related expense of options or other share-based compensation granted.
As the company matures and continues to develop its product, management and the board might decide to take an opportunity to exit and sell the company. Accurate valuations of the company and the deal structure are essential for leadership to negotiate effectively and determine that the consideration received is fair. The structure of the agreement will vary depending on the circumstances; however, frequently there will be an up-front payment (cash, stock, or a combination) and milestone payments in the form of an earnout based on future milestones. The earnout, or contingent consideration, typically allows for payments based on future success of product development, such as lump-sum payments tied to achieving certain milestones and royalties on future sales. Company leadership needs to understand the deal structure motivations of the acquirer and the financial statement implications of the agreement.
The acquirer will need to value the earnout for financial reporting purposes at the acquisition date and revalue it at future reporting periods until settlement. The earnout usually is valued using a specialized approach, such as a scenario-based method or Monte Carlo simulation, that differs from the methods previously noted. Additionally, the continued impact on the financial statements of remeasuring the earnout will affect future earnings of the acquirer.
Why valuations matter
Valuing early-stage life sciences companies can be complex. Because product development can take several years and be capital intensive, obtaining an accurate valuation is essential to align management’s, the shareholders’, and current and potential investors’ understanding of estimated value. For finance and accounting teams, a clear and supportable analysis is integral to financial reporting, and using appropriate valuation models will help guide internal decision-making.
Photo: Hong Li, Getty Images
Ron Melling, CPA, is a partner in Crowe’s Audit and Assurance group and leads the firm’s Life Sciences audit practice. He serves as audit partner to domestic and international privately held and private equity–backed companies, PCAOB engagements, and publicly traded organizations. Ron brings deep industry expertise across Crowe’s life sciences subsectors, including biotechnology and pharmaceuticals; medical devices, MedTech and durable medical equipment; CDMO, CRO, diagnostics, and laboratory services; and specialty pharmacy and nutraceuticals. He has served in Crowe’s national office advising on complex technical accounting matters and has extensive international experience working with foreign subsidiaries and professional service providers throughout Asia and Europe.
Tom Shoemaker, CPA, is a partner in the life sciences audit and assurance group at Crowe. He specializes in IPO offerings, secondary offerings, reverse mergers, SEC comment letters, and periodic SEC reporting requirements. Tom has more than 25 years of experience providing services related to life sciences working in the clinical stage through commercialization. He has a deep understanding of the technical accounting complexities associated with debt and equity financings, stock-based compensation and revenue recognition, and other topics.
Michael Taglieri, CFA, is a managing director in Crowe’s advisory group and member of the valuation services practice. Michael specializes in life science and technology industries, providing valuation advisory services to clients spanning from pre-revenue start-ups to late-stage, middle market companies for a variety of purposes including financial reporting, management planning, mergers and acquisitions, tax and regulatory compliance, restructuring and reorganization, and corporate strategy. His experience includes valuing businesses and business interests, financial instruments including equity, fixed income, and complex derivative securities, and intangible assets.
This post appears through the MedCity Influencers program. Anyone can publish their perspective on business and innovation in healthcare on MedCity News through MedCity Influencers. Click here to find out how.
