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
Entrepreneurs can approach the venture community with a more rational basis for investment by expressing
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
How, then, can we put a price tag on biotechnology? The best solution is to evaluate
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
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.
The cost of drug development can be estimated using industry standards2, 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
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”).
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
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
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,
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
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
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
© Amy Center
Note: A Microsoft Excel spreadsheet for calculating the rNPV is available as supplementary information.
The spreadsheet version accounts
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 (e-mail: email@example.com), Peter N. Allison, and Ronald S. Johnson
- 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