After answering the question about why valuation is important for life science companies [in Part 1 of series], it’s time to see in detail how to value these companies.
For many advisors and investors not actively involved in life sciences, biotech companies represent a murky area. The main question raised by these individuals is how do we value drug discovery companies whose development programs only have a small chance of success and potentially generate payoffs occurring a long time in the future?
The main valuation methodologies used to value life sciences companies are summarised as follows:
Net Present Value (NPV)
The NPV method employs an increased discount rate to account for the risk of failure during research and development.
However, the method fails to reflect the decreasing risk over time as a new drug advances through the development process because a given discount rate can only represent the overall risk associated with an individual stage of development. [1]
Risk-Adjusted NPV (rNPV)
This method takes technical risk outside the discount rate which results in a lower overall discount rate.
Technical risk is instead accounted for via the adjustment of cash flows at each stage of development by the probability of the drug candidate successfully reaching launch from the respective stage. [2]
Real Options Analysis
Real options methodology aims to address the impact of economic uncertainty on project value by applying financial options theory to the drug development process.
However, a lot of work remains in developing a practical application of the real options theory; difficulties also exist with accurately estimating the volatility parameter because the market data needed to estimate it is typically not available; and, many of the options are not necessarily being exercisable in practice. [3]
Monte Carlo
Monte Carlo methodology simulates adjustments to multiple inputs (e.g. market size, expenditures, pricing and time to market) considering a statistical probability distribution for each input to produce an overall probability distribution of possible NPV outcomes.
However, the value derived depends on the choices of scenarios and the associated probabilities of occurrence, which are largely subjective. Furthermore, although the methods are useful for assessing the spread of values for a project, they still do not assist in yielding a more reliable single value. [4]
Market Comparables & Comparable Transactions
This methodology operates under the premise that similar drugs will possess similar values.
However, it’s difficult to find a large enough pool of suitable comparables involving a similar product with similar market potential & at a similar stage in development. Also, many transactions are undisclosed and limit full understanding of early stage and private deals. [5]
So, which is the preferred valuation method? Big pharma (licensees) predominantly use rNPV to value and structure deals regarding drug development projects. In fact, pharmaceuticals with more than USD $250M in sales use rNPV & NPV as their primary valuation methods 83% of the time [6].
Conversely, life sciences companies (licensors) with less than $250M in sales are more likely to use non-NPV/rNPV methods. Their most favourable form of valuation involves looking towards comparable companies & transactions. Similarly to the principal that was recommended in our previous article regarding the avoidance of information asymmetry, it’s suggested that licensors also consider rNPV to avoid letting the other side have an edge in negotiation. The flipside is also true whereby licensees are encouraged to have a clear sight of value through the eyes of licensors by considering comparable companies & transactions.
To sum up, the preferred methods of valuing a drug development project are Risk-Adjusted NPV for licensees and comparable companies & transactions for licensors. It is recommended that licensors and licensees each consider the valuation methodologies used by the other side in a transaction so as to more accurately calculate value expectations.
[1] J. Stasior, B. Machinist & M. Esposito - Valuing Pharmaceutical Assets: When to Use NPV vs rNPV (2018)
[2, 4] Mayer Brown - Pharma & Biotech - Drug Development: Valuing the pipeline – a UK study (2009)
[3] A. R. Enevoldsen & A. V. Nordbæk - Real options valuation of a biotech project using fuzzy numbers (2011)
[5] Gryphon Analytics – Pharma & Biotech Development & Valuation (2013)
[6] Licensing Executives Society – Global “Life Sciences” Royalty Rates & Deal Terms Survey (2018)