There is usually a big disparity between investors and entrepreneurs regarding the valuation of an early-stage biotech company. How can both sides navigate this negotiation and reach a fair agreement?
Many entrepreneurs in biotech might be puzzled when they get a low pre-money valuation for a product with high potential. Even when a product in development can potentially tap into a million-dollar market, most investors rather focus on their returns. Consequently, they price the company to maximize returns and take a controlling stake.
Faced with this situation, how can an entrepreneur negotiate a fair price?
Let’s start with an example. Take an immuno-oncology company with an intrinsic value of €90M that expects to raise €10M from investors in Series A soon. It’s unlikely that the new investors accept such a high valuation. If they did, the post-money valuation would be €100M and their stake would be 10%. Most funds won’t invest with such a low ownership stake, though of course some may, with certain conditions. On the other hand, the pre-money valuation might not be correct if the management of young companies fails to perform a consistency check.
Challenging the forecast of entrepreneurs
Here is a real-world example. The management of a company with €6M revenues expects to have two commercialize two products in the pipeline. To understand the viability of their assumptions, the management forwarded us a 5-year forecast that included the predicted revenues for both assets.
These are the main points entrepreneurs raised that could be challenged by a potential investor. (The numbers are changed for confidentiality.)
Big market delusion
Most of the entrepreneurs claim to have access to a billion-dollar market through their technology and products. However, a patent does not prevent other entrepreneurs from developing superior products with a different mechanism of action. This would mean the market share and revenues of the product may be lower than expected.
Here, a potential investor must dive into understanding the wider context. How does the product compare with others, be it in similar, earlier or later stages. This can provide a more realistic vision on the market share the product can actually capture.
Say the market share of the two products is expected to be 25% and 36% respectively after 5 years. To evaluate if the estimation is realistic, it is essential to compare it to the market share of the biggest competitor currently dominating that market. If the predicted market share is similar or higher, can the management explain how their product can overtake their biggest competitor so fast and so easily? Unless the technology brings critical benefits over competitors or is truly revolutionary, the forecast might be inflated.
Growth is never free. To grow, the company needs to reinvest back its revenues in the form of capital expenditure and working capital. The company claimed to be less risky because it had low capital expenditure. However, low risk and low reinvestment are not consistent with a company expecting a high rate of growth.
Return on invested capital
Say the forecast for the return on invested capital (ROIC) for the two products is 40% and 156% respectively in the fifth year. But the average ROIC in the industry is 28%. Can the management explain why the values are so high?
In this case, one must ask if those figures are sustainable and for how long. Whether the product deserves a price premium, if it is cost-competitive and if it generates capital efficiency.
High gross margins
The management may claim to have superior technology that reduces the cost of producing the goods sold, and hence increases the gross margins. The question here is, will the cost of materials decrease faster than the price?
Let’s say the revenues of the two products are expected to grow at a 5-year compound annual growth of 170% and 210%. In comparison, the compound annual growth of other similar companies in the same industry is 14%. Can the management justify and maintain such a high growth over time?
Challenging the assumptions of investors
Understanding how investors price a company or asset is essential to negotiate a valuation. A professional VC fund would take into account the amount of money the company is raising, its target ownership (typically 30 to 40%), and whether there is any competition. Then, the VC may price the company using a rule of thumb. For example, if the company is less than two years old, they might set a limit establishing that the value cannot exceed €1M or €2M. Another method consists of reverse engineering, where the investor calculates the value based on the desired stake and return.
But the most classical approach is to base the valuation on the projection of revenues and earnings assuming a 5-year exit. The investor will usually multiply revenue figures with multiples like the price-to-earnings ratio, and finally discount it at a very high rate to get a reduced value.
Let’s make one point very clear. Before the company thinks of negotiating hard, it is important to understand the limits of its science. Unless the technology behind the assets is truly highly innovative, entrepreneurs may not have good chances of persuading investors, especially when they desperately need money.
For a successful negotiation with investors, entrepreneurs will typically have to address the following factors.
Science and technology
This is the central point of negotiation. An entrepreneur will have to argue in favor of the potential of their technology as a product, and its advantages over similar products either on the market or in development.
A consistency check is fundamental to understand if the initial projections of revenues and market share are realistic or not. While the growth can be very high at the beginning, where there are zero or little revenues, it must stabilize or converge to the industry standard as the company reaches a steady mature state.
Return on invested capital
To make a consistent forecast, the entrepreneurs should calculate the return on invested capital (ROIC) until their company reaches a steady state. The ROIC should exceed the cost of capital to create value and implies the company will have sustainable competitive advantages. However, this also invites competition, and to claim that the company will have sustainable competitive advantages at the early stage can be a red flag.
During the early stages of a company, a safe way of estimating its valuation is to compare it with that of other similar companies in the field. However, these comparable companies should be publicly listed companies that are similar in cash flow, growth and risk, and not just companies in the same industry or sector.
As an example, Novartis cannot be included in the comparable samples of a mid-cap publicly listed company that is developing an oncology drug. The risks, growth, and cash flows of a big pharma like Novartis will be very different from those of a mid-cap biotech company.
Some investors might use rates as high as 30 or 40% to discount the value of a company. Frequently, they justify these rates based on the fact that the risk is very high. However, if you are developing a new drug, the risk of failure is already taken into account when considering the probabilities of success at each phase, meaning that the risk is being counted twice.
Discount rates only capture continuous risk, not discrete risk such as the possibility of failing a clinical trial. If the investor does not agree on this, the company can request to use their discount rates without considering the probability of failure along the way.
Some companies may not reach such a deep level of discussion regarding valuation, but it is important to be prepared for every possible situation. Considering these pointers in price negotiation, an entrepreneur might be wondering who would be willing to pay the highest price, or to base the price on the fundamentals of the assets. It’s usually going to be the strategic partner, a publicly listed pharmaceutical or biotech company.
Saurabh Mishra is the founder of the life sciences consultancy firm Farmantra. His principal expertise is the valuation of technology, products, and companies, as well as the development of new market entry and growth strategies of life science companies in Asia, Europe, and the US. He is also an independent expert at European Commission to evaluate projects for Horizon 2020.