There is usually a disparity between the values investors and entrepreneurs ascribe to a company. This article discusses several aspects of value negotiation.
Many entrepreneurs in biotech might be puzzled when their product has high potential but the pre-money valuation is very low. The product might have million-dollar market exposure and the risk-adjusted value could be in the range of €80M to €100M, but based on discussions with the investors, the entrepreneurs might claim that the potential doesn’t matter to the majority of the investors. They are right: Most investors instead focus on returns and price the company to maximize them and take a controlling stake. How does an entrepreneur negotiate?
Let’s start with an example: assume the intrinsic value of an immuno-oncology company is €80M and it expects to raise €10M from investors in Series A soon. It’s unlikely that such high value would be accepted by the investors. If the funds were to accept the pre-money value of €80M, the post-money value would be €90M (€80 + €10) and their percent stake would be 11.11% (10/90). The funds won’t invest with such a low ownership stake, though of course some may with conditions. On the other hand, the pre-money valuation might be outrageous, as the management of young companies can fail to do a consistency check.
So how do investors and entrepreneurs see eye to eye when it comes to the value of a biotech?
Challenging the Forecasting of Entrepreneurs
Here is a real-world example to illustrate the following facets of the investigation. A company ABC has €6M in revenues and the management expects to have 2 products in the pipeline for commercialization. The revenues from each of them will grow at a 5-year compound annual growth rate (CAGR) of 170% and 210%. The management has provided a 5-year forecast to the fund that was forwarded to us to understand the viability of the assumptions. The numbers are changed for confidentiality. Following are the points an entrepreneur might raise:
- Big Market Delusion: Most of the entrepreneurs claim to have access to a billion-dollar market through their technology/products. However, a patent does not prohibit other entrepreneurs to develop superior products through a different mechanism of action, which could lead to overvaluation of the market as more entrants take shares of it for themselves. This results in lower than expected revenue growth in the future.
Questions: How are the performances of similar products in the same stage, earlier stage, and later stage? Understanding these can serve as a check on the big market the product could capture.
- Market Share: Say the market share of two products, X and Y, will be 25% and 36% respectively after 5 years.
Questions: What’s the market share of the biggest competitor in the market? If it’s 25% (in case of X), can the management explain how they plan to overtake the biggest competitor so fast and so easily? Is the technology/product revolutionary or with added benefits such as higher safety/efficacy? If the answers to these questions are negative, the forecasting is inconsistent and inflated.
- Reinvestment: Growth is never free. To grow, the company needs to reinvest back in the form of capital expenditure (CapEx) and working capital. The company ABC claimed to be less risky and had low CapEx.
Questions: Low risk, low reinvestment, and low growth do not raise any eyebrows but low risk, low reinvestment, and high growth do not pass the consistency check.
- The Return On Invested Capital (ROIC): Say the forecast for two products is 40% and 156% respectively in the fourth and fifth years.
Questions: The industry ROIC is 28%. Can the management explain why their products’ ROICs are so high? Can it be sustainable and for how long? What are the parameters that justify such a high ROIC? Does the product deserve price premium? Will the technology/product provide cost competitiveness? Does the product generate capital efficiency i.e. selling more products per euro of invested capital?
- Higher gross margins: The management claims to have superior technology that reduces the cost of goods sold and hence increases gross margins.
Questions: Will the cost of materials decrease faster than the price?
- Revenue growth: The revenues from the two products grow at a 5-year CAGR of 170% and 210%.
Questions: The revenue growth of comparable companies/industry grows at the CAGR of 14%. For how long can you maintain such a high growth?
Challenging the Assumptions of the Funds
The first question is how do funds price the assets? A professional VC fund would seek to find out the amount of money the company is raising, the VC’s target ownership (typically 30-40%), and if there’s any competition. Then, the VC may price the company by rule of thumb, e.g. if the company is less than two years old, the value cannot exceed €1M or €2M; reverse engineering, calculating value from desired stake and return; or a more classical approach. This would be based on the projection of revenues/earnings assuming a 5-year exit; multiplication of earnings/sales with multiples like the price-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 highly innovative, entrepreneurs may not have good chances of persuading them, especially when they desperately need money.
Entrepreneurs usually have to address the following points:
- Science/Technology: This is the first point of negotiation. An entrepreneur will argue the merits of his or her technology as a product.
- Revenue forecast: A consistency check is fundamental to understand if a projection or market share is an outlier. The growth can be very high in the beginning given zero or little revenues, but it must stabilize or converge to industry standard as the company reaches a steady mature state.
- Return On Invested Capital (ROIC): To be consistent in the forecasting, the entrepreneurs should calculate the ROIC till their company reaches steady state. That ROIC should remain under current levels to reflect the competitive advantages and the trend towards an industry median or towards its cost of capital. The ROIC should exceed the cost of capital (COC) to create value but it cannot exceed the lifetime. Excess returns (ROIC – COC) implies that the company has competitive advantages and to claim that the company will have sustainable competitive advantages at the early stage is a red flag. Excess returns invite competition and the higher the barriers in the industry, the higher the chances of a longer duration of excess returns.
- Comparable Companies: As I pointed out in my last article, your comparable companies should be those publicly listed companies that are similar in cash flow, growth and risk and not just in the same industry/sector. As an example, Novartis cannot be included in the comparable samples of a mid-cap publicly listed companies that are working on developing an oncology drug. The risks, growth and cash flows of Novartis are very different from those of a mid-cap biotech company.
- Multiples: Let’s say the fund uses the enterprise value (EV)-to-sales ratio to find the value in year 5. Taking a median of EV/Sales is fine but doing so implies that parameters like risk and growth of comparable companies are assumed to be similar, which may not be correct. To control those differences, a multiple regression can help.
- Discount rates: Some of the funds might use rates as high as 30 or 40% to discount the value. The companies need to check the reasons for using such high discount rates because frequently, the funds consider the assets to be very risky to justify the discount rates. But if you are developing a new drug, the risk of failure is already encapsulated in the probabilities of success at each phase, so using such discount rates is double-counting risks. Discount rates only capture continuous risk, not discrete risk on assets. If the fund does not agree on this, the company can request to use their estimated higher discount rates without using the probability of failures to avoid double counting of risks.
Some companies may not reach such deep level of discussion for your valuation/price unless VCs are chasing you. After reading these pointers in negotiation, an entrepreneur must be wondering who would pay the highest price or the price based on the fundamentals of the assets? It’s usually going to be the strategic partner, a publicly listed pharmaceutical/biotech company — that’s who you should look for as a partner.
As the founder and partner at Farmantra, Saurabh’s principal expertise is the valuation of technology/product/company besides the development of new market entry and growth strategies of life science companies in Asia, Europe and the US, as well as corporate finance, financial analysis, valuation and go to-market strategy. He is also an independent expert at European Commission to evaluate projects for Horizon 2020.
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