Practical Approaches to Early Stage Life Sciences Technology Valuations – Part 1
pharmafile | August 11, 2010 | Feature | Research and Development | Kinapse, life sciences, pharma
Valuations are essential components of effective transactions in the life sciences industry
As the life sciences industry responds to market pressures, declining productivity, increasing regulatory burdens, looming patent expiries and generic competition, industry leaders are increasingly seeking externally-oriented strategies to augment pipelines, secure finance, expand portfolios and drive long-term revenues. As a consequence, accurate valuation of life sciences assets is of fundamental importance for managerial decision-making in areas including licensing, mergers and acquisitions, R&D resourcing, financial investment and stock-floatation.
However, life sciences valuation is often considered a somewhat esoteric concept. Traditional valuation methods are generally considered to have limited applicability in the life sciences industry owing to the inherent uncertainty associated with lengthy product development cycles, high failure-rates and undefined product/market profiles of life sciences assets. Furthermore, virtual ‘new-economy’ firms with minimal infrastructure and which rely largely on external service providers are increasingly common to the industry. Many such firms do not have marketed products, and as a consequence their value is almost exclusively based upon R&D assets (an overview of R&D Assets is provided in Box 1 of the full paper which can be accessed here or here).
Nonetheless, numerous valuation techniques have been specifically developed to account for the inherent uncertainty within the life sciences industry and are finding increased utility, particularly for late stage assets where the key parameters governing anticipated cash flows – such as time to market launch, probability of regulatory approval and product sales forecasts – can be estimated with reasonable accuracy.
Early stage valuations are an important – yet contentious – area of valuation practice
With fierce competition in the market for late stage life sciences assets, pharmaceutical companies seeking to access new and promising compounds and technologies are increasingly looking towards earlier stage opportunities. Early stage partnering has become an important component of life sciences business strategy, as evidenced by the significant proportion of early stage deals across the industry in recent years.
Despite the high proportion of early stage transactions across the industry, valuation of early stage life sciences technology remains a highly contentious topic amongst life sciences professionals. A commonly cited reason for this contention is that the high degree of uncertainty and risk relating to the necessity, commercial applicability and useful lifetime of early stage technology (such as preclinical and early clinical phase R&D projects) invariably leads to differing perceptions – and hence lack of agreement – about early stage valuations. As a consequence, the practice of early stage technology valuation is viewed by many as indeterminably vague, imprecise and often meaningless.
However, many valuation methodologies exist that can account for both uncertainty and risk (a summary of life sciences valuation techniques is provided in Box 2 of the full paper which can be accessed here or here). Furthermore, research into the valuation practices employed amongst life sciences valuation professionals from across the industry suggests that much of the contention surrounding early stage valuations arises from neither uncertainty nor risk per se, but from the commonly held view of the practice of valuation as a narrow, highly quantitative set of defined techniques and methodologies which rely on numerous, well-defined assumptions in order to generate precise value outputs. Such a narrow perspective of valuation as a tool invariably places significant emphasis on the precision of the valuation output, which is exquisitely dependent upon the assumptions that are used in the valuation process. In many cases it is the inability to reconcile differing perceptions surrounding the assumptions used in early stage valuations that leads to contention over the resulting disparate valuation outputs. In order to avoid this contention and conduct more meaningful early stage valuations, new approaches towards valuation are required.
Meaningful early stage valuations require encompassing approaches to valuation
Much of the contention surrounding early stage valuations can be minimised – and even avoided – by adopting more holistic perspectives in which valuation is considered not just as a narrow, highly quantitative process, but as a broader more encompassing framework. Whilst the selection of the appropriate valuation methodologies is undoubtedly an integral component of a rigorous valuation approach, overreliance on narrow quantitative techniques that yield discrete and seemingly impossibly precise outputs invariably results in valuations being met with scepticism. Repositioning the view of valuation as a broad and encompassing framework is an effective approach to deriving meaningful valuations of early stage life sciences technology.
Such an approach expands the perspective of valuation by utilising a framework that incorporates a range of qualitative and quantitative evaluation practices to generate balanced and more widely accepted early stage valuations.
Encompassing valuation approaches integrate complementary evaluation practices to build robust valuation outputs
A central tenet of an encompassing approach to valuation is the principle that an integrated suite of complementary qualitative and quantitative evaluation practices provides more widely accepted, balanced and transparent valuation outputs that facilitate productive and mutually beneficial transactions.
Value can be defined as a measure of the utility derived from consumption of a ‘good’ and is by definition subjective and multi-faceted. Since value reflects the utility derived from consumption, it follows that a good will be valued highest by those able to derive the greatest utility from its consumption and vice versa. It is important here to recognise the context within which utility can be realised. For instance in the case of early stage life sciences technology, utility may be derived directly from the technology (termed independent value) as in the case of a novel therapeutic compound, or may exist in the capacity of a technology to lever the value of other assets (termed dependent value), as in the case of a novel discovery platform that speeds the identification of potential therapeutic candidates. Consequently, any valuation approach needs to consider not simply an early stage technology in isolation, but also the context of its use in the prevailing environment.
It is also important to recognise that the utility derived from a good is ultimately realised upon its consumption, therefore a good also represents a store of utility until such point that consumption takes place. The capacity to store utility provides a basis upon which goods can be traded, thereby allowing value to be quantified in monetary terms. Consequently, value is commonly defined based upon the net cash flows attributable to a good (which can be thought of as economic value). However, goods may also represent as yet unrealised opportunities to provide utility (which can be thought of as potential value). Whilst economic value reflects the value of a good as it currently stands, potential value reflects the value that could be realised in the event of further investment, and therefore it is important to recognise that the overall value of a good is comprised of both economic and potential components. Measuring value, or valuation, is the process of determining worth, and any comprehensive approach to valuation should consider both economic and potential components of value as well the context within which value is to be realised.
Therefore the overall value of a good is most fully defined in terms of its constituent independent and dependent economic and potential values;
i) independent economic value reflects the ability of a technology to generate cash flows in isolation without further investment, such as in the case of a marketed therapeutic product;
ii) independent potential value reflects the ability of a technology to generate cash flows in isolation following subsequent investment, as in the case of a therapeutic compound in clinical development for an as yet unapproved indication;
iii) dependent economic value represents a technology’s ability to generate immediate cash flows in concert with other assets, such as a therapeutic compound approved for use in combination with another compound(s);
iv) dependent potential value represents a technology’s ability to generate cash flows in association with other assets following further investment, as in the case of a compound which is part of an unapproved combination therapy for a new indication.
It should be emphasised that a given technology may simultaneously possess none, one, two, three or all four of the different characteristic components of value. In the case of life sciences technology, economic value reflects the net cash flows attributable to the technology (e.g. licensing income, product revenues, divestment proceeds etc.) in its current state with no further investment other that that which has already been committed. Of the many valuation techniques with applicability to life sciences technology, discounted cash flow (DCF) techniques that measure the net present value (NPV) of a technology – based upon forecasted future cash flows and projected risk in view of the current status of the technology – are widely used to determine economic value.
In contrast, the potential value of a life sciences technology reflects the range of investment opportunities that exist to generate utility from the technology, such as the potential to develop new product lines or expand into new markets. Options-based valuation methods are purportedly finding increased use on the basis of their ability to quantify the potential value of unrealised opportunities (a ‘real’ option is the right to invest in a potentially valuable technology by paying the investment cost before the opportunity to invest disappears). However, research undertaken into the valuation practices employed amongst valuation professionals from across the life sciences industry suggests that options-based methods are used only to a limited extent within the industry, and that the majority of valuations tend to disregard the potential components of value. Whilst arguably a valid approach for late stage assets where future cash flows can be forecast with reasonable certainty and accuracy, this can be problematic for early stage life sciences technology where the ultimate commercial necessity, applicability and useful lifetime is frequently difficult to determine, and where value is often largely comprised of the unrealised potential to generate cash flows.
To realise the full value of early stage technology invariably requires further investment (eg. in future clinical development, development of new product lines, expansion into new indications etc.), therefore in order to derive meaningful early stage valuations it is essential that the valuation approach encompasses both economic and potential components of value.
This article – part 1 of a 2-part series – has discussed how meaningful early stage valuations require new approaches that integrate complementary evaluation practices to build more widely accepted, balanced and transparent valuation outputs. The second article in the series will go on to described a series of practical steps that encourage the use of encompassing approaches that blend complementary qualitative and quantitative techniques to build realistic and widely accepted early stage valuations.
The original Journal of Commercial Biotechnology article is available here. The 2-part series is also available as a complete White Paper or can be accessed via our website at www.kinapse.com.
ACKNOWLEDGEMENT
The author would like to thank Stuart Pavelin for his contribution to this work.
ABOUT THE AUTHOR
Stephen Mayhew is a Manager in the Consulting Practice at Kinapse Ltd. He consults to the life sciences industry in valuation, deal-making and asset and portfolio management.
e-mail: stephen.mayhew@kinapse.com
ABOUT KINAPSE
Kinapse provides consulting and outsourcing services to the life sciences industries, globally.
Our mission statement is: ‘Collaborating with our clients to innovate for exceptional results’. Kinapse clients include many of the world’s leading pharmaceutical, biotechnology, medical device and specialty pharmaceutical companies, government organisations and life sciences service providers.
For more information please visit http://www.kinapse.com
Other Kinapse thought articles can be found at http://www.kinapse.co.uk/insights/
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