Why is valuation important for life sciences companies?
Updated: May 23, 2020
In this series we set out to shed light on the mysteries surrounding biotechnology companies and how to value them.
Leadership teams from biotech companies often ask corporate finance advisors the question “why is valuation an important tool in their organisation’s journey?”.
Valuation provides a perspective on the market price of a life sciences company or therapeutic treatment. It is essential because it is the principal tool used as part of the process in licensing a product or selling a stake in a company. It frames the value expectations of the licensee and licensor and gives a starting point for negotiations.
Milestone events requiring valuation include licensing deals, capital raisings, M&A transactions, IPOs, capital budgeting, and option grants.
Licensees financially model deal value more frequently than licensors (82% vs. 70% respectively) and it’s recommended that licensors also do the same in order to avoid letting the other side have an edge in negotiations due to information asymmetry. In other words, biotechnology companies should seek to level the playing field by having clear sight of their value and knowing the valuation expectations of investors.
In terms of deal modelling specifics, there are two main elements:
(1) Calculation of the actual return of the project to the investor or licensee. This involves considering the deal terms offered by pharma which includes investment & costs such as milestone stone payments and license fees, as well as revenues from product sales. Subsequently, the implied IRR of the deal is calculated.
(2) Estimation of the required return of the investor or licensee. One should always try to estimate the required IRR for investors. Venture investors and big pharma companies are typically looking for a 25% IRR/year but this varies depending on the risk related with the transaction.
The valuation exercise provides benchmarks to evaluate the actual and required returns of a product or company. In negotiations, biotech companies are advised that to achieve extra value, they must be able to pocket the difference between the actual and required returns. For instance, if the required IRR for pharma is 25%, the licensee should keep bargaining to try to get the pharma’s return down to 25%. This will often require getting the upfront payments to be higher.
In closing, the most important reason for a life sciences company to have an idea of value is that it gives an edge in negotiation with potential investors or licensees. It is recommended to be armed with as much information on valuation as possible, and thus pocket the difference between actual and required returns.
 Licensing Executives Society – Global “Life Sciences” Royalty Rates & Deal Terms Survey (2018)