How to value a biotechnology company
By Jeremy Webster, CA, CBV, ASA, and Trevor Philippon, CA, CBV
The major risk to be quantified in the valuation of a biotechnology company is the risk of successfully completing clinical trials. In order to accurately asses the value of a biotech company, it is crucial to have an understanding of the clinical development process for human therapeutics — the costs, timing and other risks of undertaking clinical trials.
Through the process of clinical development, the compounds identified by scientists are approved for human use (for specific purposes) by regulatory authorities. Each country has a regulatory authority, such as the Food and Drug Administration (FDA) in the U.S. and the Health Protection Branch (HPB) in Canada. Clinical development risk is the largest business risk facing biotech companies.
Generally, a biotechnology company is a collection of one or more market opportunities or products. Therefore to value a company, each one of the products must be valued. The value of the company is then determined by adding up the value of all the products and the company’s other assets and liabilities. Sometimes companies indicate that they have a “platform” technology with a large number of possible products or services. Management must decide where to allocate their resources and therefore which opportunities to pursue.
There are two major stages of a product’s life:
Research & Development stage
The cash flow for each of these two periods can be estimated separately. It is quite usual for a valuation analysis to start with the second time period component. By starting with the second component, the analyst can quantify the eventual market opportunity. This is how many companies begin their analysis when determining whether it makes economic sense to even contemplate starting the clinical trial process. This is the payoff! This is the opportunity sought. This is the reason to invest. The opportunity needs to be there to justify the investment to be made in clinical trials. Certain companies have iminimum market opportunity sizes before they will even begin to consider whether to pursue an opportunity.
Therefore, this is how we begin our analysis.
Step one - Start with the commercialization stage
To determine the value from market launch to the end of the product life, estimates of the following are made:
the forecast cash flow from market launch until the end of the product life.
the discount rate to apply the cash flows.
the net present value as at the market launch date is then determined by applying the discount rate to the forecasted cash flows.
The forecasted cash flow from market launch to product expiry (product life) requires a quantification of:
cost of sales
Step two – Value back through the R&D stage
The expected future cash flow during the development stages until market launch is made up substantially of the costs of pre-clinical trial research & development and conducting the clinical trials related to the specific indication. Therefore, the valuator must make an estimate of the:
of each of the stages of the pre-clinical and clinical trials.
A detailed understanding of the clinical trial process is critical. See the Appendix to this article for an outline the clinical trial process. Understanding all the parameters and risks associated with the clinical trial process is a major task of the valuator. Key documents that articulate a clinical trial plan include the “Investigator’s Brochure” including the “Protocol.”
Detailed build-up of the budgeted trial costs
A bottom-up estimate of the cost of clinical trials is used to determine how much cash is needed. A complete detailed budget should be prepared by management and reviewed by the valuator for reasonableness, as part of the assessment of the forecast.
The costs of a clinical trial include:
investigator and clinician costs
close out and reporting results
co-ordination with regulatory authorities
Other administrative costs must also be included in the budget, such as the premises, equipment, management salaries, intellectual property and legal fees. These are some of the more typical other costs incurred during the development process.
Overall, it is helpful to consult a number of different members of the management team in reviewing management’s forecast. Key personnel include the director of clinical trials, the chief scientific officer, the chief financial officer and the president.
Timing of the clinical trials is a function of the length of time required to conduct the trials and the amount of time it takes to get the relevant publications and necessary regulatory approvals. The length of time that a trial takes is a function of: number of patients, speed of recruitment, natural disease progression and amount of time it takes for the therapeutic to show efficacy versus natural disease progression.
Estimates of trial timing can be determined through a review of the clinical trial protocol and discussions with participating clinicians. Estimates provided can be compared to trials of similar indications at similar stages of development. The Appendix to this article provides some general guidance.
One of the major risks in the development of biotechnology is the clinical development process. Each stage of a clinical trial is a step along the journey to obtaining market approval from the regulatory authorities. By assessing the probabilities of achieving success at each stage of the clinical development of a therapeutic, the specific risk can be quantified directly in the valuation model. For each of the stages of development, there is a probability of that stage being successful and unsuccessful.
For an example of how to apply a decision tree to the clinical development process, see the complete article in Life Sciences Quarterly, Q2 & Q3, 2004.
Sources for determining probabilities of success for each stage
The primary source for analyzing the probability of successfully moving through each of the stages of the clinical trials is discussions with the management of the company and designers of the trial.
In addition, to help put this analysis in a context, there are a number of publications that show analyses of probabilities of achieving success through each of the clinical trial stages.
Determining net present value
Once all of the above analysis is complete, the valuation is a simple matter of taking the net present value at market launch and then discounting it back through the decision tree and deducting the present value of the clinical trial costs as you go. Because the biggest risk has been directly quantified using the clinical trial probability of success, we use a more typical discount rate.
Reasonableness check on conclusions
As a reasonableness check on the value conclusion, it is helpful to apply one or more market approaches to value. In order for the market approach to be useful, the comparable deals should be as similar as possible to the subject of the valuation. Factors to consider in determining similarity include: stage of clinical development, disease target, status of intellectual property and other products in development. The following is a very brief summary of four market approaches that are used by biotechnology analysts:
Comparable Licensing Transactions – the present value of the up-front payments, milestone payments and expected royalties is calculated as an estimate of value.
Comparable Venture Capital Transactions – implied pre-money valuations are calculated based on dollars invested and percentage of company received by VC fund.
Mergers & Acquisitions – implied valuations of acquired companies.
Stock Market – implied technology values – market cap less net assets.
At Deloitte, we have found that the decision tree discounted cash flow method is often used as it reflects how the managers and investors in biotechnology companies assess their investments and manage their business.