Even companies with no revenue or little revenue can be worth billions. Take the largest biotech M&A transaction of 2017, when Gilead acquired Kite Pharma for nearly $12 billion. Kite Pharma had an accumulated deficit of over $600,000,000 at the time of the acquisition but also possessed a pipeline of CAR T cell therapies that treat cancer. This article explains how to value channels. The report also focuses on portfolios of drug candidates and the risk-adjusted NPV method.
The following is a brief introduction to the topic
It should not surprise you if you are interested in biotech or have some experience with the industry that companies with very little revenue can be worth billions. Consider the largest biotech M&A in 2017, when Gilead acquired Kite Pharma for nearly $12 billion. Kite had a deficit of over $600,000,000 at the time of the acquisition. However, the company also had a pipeline for CAR-T cells that treat cancer. Kite was not an anomaly. Over 150 companies with a market cap of over $250 billion are part of the Nasdaq Biotech Index. The average VC investment has doubled in the last decade from $4.6 Billion in 2005 to $12.9 Billion in 2015. We institutional equity investors know that the exuberance among investors cannot explain this. It’s intended to show that a pipeline can often justify the value of a business.
This article examines the valuation of such pipelines for biopharmaceutical companies. It focuses on pharmaceutical companies (not companies that are not focused on drug development, but rather on healthcare devices). Let’s start by examining how the value of biotech companies differs from other assets. We’ll then focus on the risk-adjusted NPV method and conclude with a discussion about two relevant topics: how to think of portfolios of drug candidates and how the characteristics of an investor or acquirer can impact value.
Why do we need to understand biotech pipeline valuation?
Drug development can be expensive. A prominent study estimates that the cost of developing a drug successfully (which usually involves many failed attempts) is more than $2.5 billion. Some studies (see table below) indicate that costs totaled around $1.4 billion. This figure is less than the $2.5bn estimate because it includes the estimated opportunity cost of capital invested.
Drug development, therefore, requires large amounts of capital right from the start. It’s almost impossible to bootstrap an entire drug company. Accordingly, investors are needed from the start as well as during various stages of the development cycle. Investors can be venture capitalists, strategic investors, or public market investors. The article on biotech fundraising is easy to write. Still, investors and founders/biotech executives will also need to understand valuation, even if a product that can be sold in the near future may not have been approved.
This is a timely reminder: If you’re reading this in Asia, you probably know that the Hong Kong Stock Exchange has recently allowed Biotech companies to be listed on the stock exchange without revenue or profit. The valuation of these firms will require the discussion we will have in this article.
Why Biotech Pipeline Value is Different
You may not have learned how to value biotech companies in your MBA or CFA classes. Continue reading to learn about the unique characteristics of this industry.
What are the Revenues?
We’ve noted that many biotech companies do not have revenue, let alone cash flow or profitability measures. Cash flows before a drug’s approval will be negative. This means that “standard” multiples of valuation like EBITDA and P/E will be less relevant. Alternative multiples include EV/invested R&D, which is essentially cost-based. Comparative value is a popular method that uses comparable M&A or public market transactions. Comparative analysis is not always applicable, as biotech companies tend to be idiosyncratic. Below, we will examine an alternative method of valuation.
Even more established biotech firms have historically varying revenues, so estimates must be built from scratch. They cannot rely on previous intra-company data or other comparable companies to guide projections. The traditional approach of extrapolating trends from the past is out. See below the current pipeline for the Swiss pharmaceutical research company Idorsia. Note the variety and range of mechanism-of-action (the method by which a drug produces a therapeutic effect) and indications of use.
Structured Development Process
The biotech industry also faces a lengthy development period. As shown in the following graphic, the typical timeframe from the submission of an Investigational New Drug in the US (IND) to the market entry after regulatory approval is eight years. The process is divided into phases, which include research, testing, and FDA approval.
Drug Roulette: Black or Red?
Said the effectiveness of a drug in treating a disease is determined by its outcome. It may be approved or not by regulatory agencies, even if the drug is effective. Before approval, medicines undergo a structured procedure (pre-clinical trials and clinical trials), during which any medication can fail. Once they die, this process is usually irreversible. This is a very different risk profile than most other businesses, where the outcomes are less binary. Silicon Valley lingo says that it’s very difficult to “pivot” or change direction, a drug that isn’t working. In early-stage, non-biotech startups, failure is also likely, but there is a wide range of outcomes. That new mobile application may receive thousands or tens of millions of downloads with consequential impacts on revenue, cash flow, and value. When non-biotech companies face difficulties, they often adjust their business model to ensure survival. You can recall when Netflix used to be a DVD mailing company before it became a streaming service when Instagram used to be a Check-in App that had gaming and photo features before it evolved into the dominant photo app of today.
We must reflect this risk profile when we create a discounted Cash Flow and choose the appropriate discount rate. There are two general ways to do this:
The first thing we can do is assume that the drug will work, get approved, and generate revenues. We then reflect the risk by using a higher discount rate. (The earlier in the process, the higher the discount rate because of the increased risk). This is the ” Venture Capital Method,” which is used for non-biotech startup companies.
Alternatively, we could reflect the unpredictability of outcomes explicitly by building a number of outcome scenarios and probability-weighting them. The plans might include “failure during phase I,” “failure during phase II,” and so on. This method is more accurate than the VC method because drug development has a well-defined process and scenarios. The VC method subsumes risk in its high discount rate. The rest of the article will be devoted to this method, which is the risk-adjusted NPV.
