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The valuation of privately held biotechnology companies is generally very challenging because of the long development cycles and uncertainties of clinical testing and product registration outcomes even before market acceptance and competition is considered. Most companies do not have significant revenues or positive earnings, and their assets will generally consist of cash or short-term investments and intellectual property that is difficult to assess, meaning that it is difficult or impossible to apply most traditional valuation methods.
The use of a classic Discounted Cash Flow analysis for a biotechnology company with products in an early stage of development is not meaningful since projected future revenues will be contingent on the products successfully going through clinical trials and product registration where there is uncertainty and thus always less than 100% probability of success. Many analysts try to adjust for this by adding a high risk premium to the cost of capital used, but this approach is misleading.
Instead over the past two decades Risk-Adjusted Net Present Value or rNPV analysis emerged as a better tool. With rNPV analysis the expected future cash flows are calculated, by first estimating the future cash flows without risk and then applying a probability to that cash flow. For example if typical pharmaceutical development probabilities (Phase I = 71%, Phase II = 45%, Phase III = 64%, Product Registration = 93%) are applied the compound probability from Phase I to Product Approval will be 19%. Therefore any future net cash flows from when a product is in the market would be multiplied by this percentage to arrive at an expected net cash flow. These cash flows would then be discounted to present value using typically an industry based cost of capital representative of “systematic risk” rather than an estimated cost of capital for the company being valued.
However the rNPV method has also come under criticism for providing value estimates that are unrealistically precise and concrete as well as focused on average numbers. In the real world there is never a 90% product approval – it is either approved or not. Instead Monte Carlo Simulation has come to be more and more used with more powerful computers and better software to analyze these problems. With a Monte Carlo simulation thousands or millions of potential outcomes can be tested for the development and market introduction of a pharmaceutical product, providing a distribution of outcomes which can be further analyzed and often reveal a different picture. An average value provided by an rNPV analysis can be misleading because outcomes are more likely to be either a zero value or a high value, with the average value unlikely to occur in reality. For an introduction to Monte Carlo simulations visit www.probabilitymanagement.org.
To further incorporate the dynamic effects of a drug development process we can also utilize a Real Options analysis to extend an rNPV or Monte Carlo analysis. The Real Options analysis recognizes the inherent optionality in such a process, for example that a decision to undertake costs for a Phase II trial does not need to be made until the results from the Phase I trial are known. Projects that have a negative net present value in an rNPV analysis can therefore have a positive net present value when analyzed with a Real Options methodology. A Real Options analysis is often performed using a binomial lattice options technique although Monte Carlo simulation can also be used.
Windeye Partners performs business valuations for early stage biotechnology companies that plan to provide option or stock incentives to employees and need to comply with the U.S. tax code (i.e. Section 409A) and related AICPA rules. For an overview please see our 409A Valuations page.