**Many bioentrepreneurs incorrectly estimate the value of their technology by failing to account adequately for the cost, risk, and time inherent in product development.**

Venture capitalists are often wary of investing in biotechnology because bioentrepreneurs seldom provide realistic estimates of the value of their technologies.

To evaluate accurately **cost** and **time** needed to get the product to market, and the various **risks** faced along the way.

Entrepreneurs can approach the venture community with a **more rational basis** for investment by expressing ** rNPV**; see “Glossary”), as discussed here. Investments, milestone payments, clinical trial costs, and royalties on sales can then be compared directly using the common currency of

*rNPV*.

A researcher has made a scientific breakthrough that could be worth millions of dollars. To attract the investment needed to commercialize the biotechnology, the researcher must now convince venture capitalists and pharmaceutical companies of its potential. However, investors want to know what the biotechnology is worth today and will require evidence to substantiate this estimate.

#### The numbers game

Unfortunately, estimates of the value of **too often clearly unrealistic**. “Valuations” are typically made in the following (unrealistic) manner: “The market for our product is $2 billion per year, so if we capture only 10% of that market for 10 years, then the company is worth $2 billion today,

How, then, can we put a price tag on biotechnology? The best solution is to evaluate *rNPV*. Using *rNPV*, researchers and potential investors can price the biotechnologies that they are considering selling, investing in, or acquiring. However, it should be noted that the management, science, and intellectual property surrounding

#### Start at the end

The first place to start when valuing biotechnology is at the end—the projected revenue stream. The end product for most biotechnologies is a medicine, and the payoff is frequently the **royalty** ^{1}, the take-home percentage (typically divided between milestone payments and royalties on gross sales) due pre-market biotechnology developers is about 40% of gross product revenue (see “Parameters for biotechnology”).

To illustrate the *rNPV* method, we have created a hypothetical scenario: A company has developed Acmed, a potential treatment for asthma. The preclinical science and intellectual property are sound, and Acmed has passed initial testing in animals and is now ready to enter phase 1 trials. The company is seeking venture funding and partnering opportunities with multinational pharmaceutical companies, so what should they charge for Acmed today?

The annual market for asthma treatments is around $5.8 billion. To estimate

Consultation with a patent attorney suggests that

Although we have identified the theoretical payoff, the true value of Acmed is far less. Several factors consume the present value of the biotechnology in nibbles, bites, and chomps. Indeed, these factors can eat up the entire value of the biotechnology—leaving nothing for the biotechnology company or its investors. These three factors are the cost, risk, and time associated with drug development.

#### Factor 1—Cost

The cost of drug development can be estimated using industry standards^{2, }^{3}, and any deviations from these standards must be justified.

Overhead costs vary considerably between companies, and the value of the technology will vary in parallel. The same situation arises in other walks of life: For example, if you can repair your own house, total repair costs are lower, and the house is effectively worth more to you than it would have been to an unskilled owner. However, in this

#### Factor 2—Risk

It would be grossly inappropriate simply to subtract the costs from the payoff to estimate Acmed’s intrinsic value. Such a calculation would imply that each clinical trial was a guaranteed success. Instead, clinical drug development should be regarded as a series of high-risk wagers where success in the first wager (e.g., a phase 1 trial) allows a company to make additional wagers (e.g., phase 2 and 3 trials) before reaching the ultimate payoff (e.g., a marketed drug). A company may never see the payoff, but then the company may not have to pay for a phase 3 trial. Each wager is associated with an ante (the stake or sum wagered), such as the cost of each clinical trial. The key to determining the value of the wager series is to risk-adjust both the payoff and the ante (see “Risk adjustment”).

#### Factor 3—Time

A company would rather have a dollar today than a dollar tomorrow because today’s dollar can be invested and earn a return, increasing its worth tomorrow. By the same argument, a dollar received tomorrow is worth less than a dollar received today. The net present value (*NPV*; see “Glossary”)—a standard finance equation—is what tomorrow’s cash flow would be worth today.

The amount that future money loses in value each year is termed the “discount rate”. Discount rates normally include many factors including risk. However, in the ^{1}. Research and development (R&D) risk

The effect of discounting can be dramatic. For example, if clinical trials began today, Acmed would not begin earning revenue for another nine years. Furthermore, the $1 billion in total revenue generated is spread out over 10 years (Acmed’s has only 18 years of blocking patent life remaining). Assuming a 20% discount rate, the *NPV* of Acmed’s payoff cash flow is only $117 million total (calculation not shown), and this is before any adjustment has been made for development risks. Because the payoff will not come for some time, the *NPV* of the money is much lower than one might have expected. Clearly, time is a significant factor when valuing biotechnology, especially when the brunt of clinical trial costs comes before revenue is generated. On the upside, the most expensive clinical trials take place later in development and so have significantly discounted *NPV*. In the case of

#### rNPV

To calculate the true present value of biotechnologies, revenue, cost, risk, and time must be combined into a single calculation of *rNPV*. In the *rNPV* equation, Equation (2), the present value of each risk-adjusted cost is subtracted from the present value of the risk-adjusted payoff to arrive at the *rNPV* of the biotechnology.

By adding together all of Acmed’s costs and risks and then discounting for time, the true *rNPV* is finally revealed. Today, *rNPV*“).

#### Investment

Estimates of *rNPV* can be useful in deal-making scenarios: For example, if a company wants to raise money from investors, how much of its equity is it fair to give away in return? If a pharmaceutical company wants to pay milestones and a royalty on sales, what should this royalty be? Both investments and milestone payments can be calculated simply by reducing each to the common currency of the *rNPV*.

For example, a venture capital company is willing to invest $9 million in *rNPV* of $9 million, which is added to Acmed’s *rNPV* ($18 million) to yield a new *rNPV* of $27 million. The venture capital contribution represents a third of the assets of the now-capitalized project, so a fair value for the venture capital investment would be about 33% of Acmed. (Although we will not develop this method here, the equity must be increased to account for company overheads and anticipated equity dilutions.)

In a second scenario, a pharmaceutical company is willing to in-license Acmed for milestone payments of $5 million today, $10 million on entering phase 2, $15 million on entering phase 3, and a royalty on gross sales. Also, the pharmaceutical company will split Acmed’s remaining development costs. What would be a fair royalty?

By calculating the *rNPV* of each milestone and the clinical trial costs borne by the pharmaceutical company, the pharmaceutical company has made an investment with an *rNPV* of $15.9 million. In return, it would be fair to give the pharmaceutical company 68% of the $23.4 million *rNPV* of Acmed’s payoff.

#### Selling price versus fair value

Using the *rNPV*, the inventor and investor can arrive at a realistic value of a biotechnology (see Fig. 1). By adopting an auditable valuation approach, biotechnology companies may be able to seek debt financing even at early R&D stages. However, as Steven Burrill, chief executive officer of Burrill & Company (San Francisco, CA) cautions*rNPV*.

### Figure 1: The value of biotechnology.

Simplistic cash flows (in red), which include revenue and costs, present unrealistically high valuations for biotechnologies. A better representation is the net present value (*NPV*; in green), which discounts the revenue cash flow over time, but even the *NPV* overestimates the value of biotechnologies during all R&D stages. Risk is mitigated as biotechnologies progress through development. When this increasingly mitigated risk is taken into account, the risk-adjusted cash flow can be discounted to arrive at the risk-adjusted *NPV* (*rNPV*; in blue). The *rNPV* is an estimate of the fair price of *rNPV* coincides with *NPV* only once risk is mitigated.

© Amy Center

*Note: A Microsoft Excel spreadsheet for calculating the rNPV is available as supplementary information.*

*The spreadsheet version accounts costs by calculating the risk-added costs rather than risk-adjusted costs. Risk-added costs are C _{i}/R_{i}; R_{0} is multiplied later to arrive at the risk-adjusted costs. This rearrangement of the equation yields the same rNPV.*

Acknowledgements

We thank D. Constable of Hollister–Stier Laboratories (Spokane, WA), S. Litwin of the Fox Chase Cancer Center (Philadelphia, PA), M. Sanders of ProPharma Partners (Hayward, CA), S. Burrill of Burrill & Company (San Francisco, CA), and S. Trimbath and P. Wong of the Milken Institute (Santa Monica, CA), whose input was invaluable; we also thank J. Wadsack of the New Jersey Virtual Campus (Chatham, NJ) and J. Johnson (Moscow, ID), without whose support this publication would not have been possible.

Jeffrey J. Stewart^{1}, Peter N. Allison^{1} & Ronald S. Johnson^{1}

Jeffrey J. Stewart (e-mail: jjs@alumni.princeton.edu), Peter N. Allison, and Ronald S. Johnson

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- Moscho, A.
*et al*. Deals that make sense. Nat. Biotechnol. 18, 719–722 (2000). | Article | PubMed | ISI | ChemPort | - US Congress, Office of Technology Assessment. Pharmaceutical R&D: costs, risks and rewards, OTA-H-522. (US Government Printing Office, Washington, DC; February 1993).
- PhRMA. The pharmaceutical industry profile 2000. Pharmaceutical Research and Manufacturers of America. http://www.phrma.org/publications/publications/profile00/
- US Food and Drug Information Office of Planning. FY 2000 Performance Report to Congress for the Prescription Drug User Fee Act of 1992 as reauthorized and amended by the Food and Drug Administration Modernization Act of 1997 (2001). http://www.fda.gov/ope/pdufa/report2000/default.htm

Source

http://www.nature.com/bioent/2003/030101/full/nbt0901-813.html