Practical Approaches to Early Stage Life Sciences Technology Valuations – Part 2

pharmafile | August 26, 2010 | Feature | Research and Development |  Kinapse, White paper, life sciences, pharma 

With fierce competition in the market for late stage life sciences assets, pharmaceutical companies seeking partnering strategies to bolster pipelines and drive long-term revenues are increasingly looking towards earlier stage compounds and technologies.
Valuations are essential components of effective transactions in the life sciences industry, however owing to the perceived uncertainty and risk associated with early stage life sciences technology, early stage valuations are a contentious area of valuation practice.
This article is part 2 of a 2-part series. Part 1 described how meaningful early stage valuations require new approaches that integrate complementary evaluation practices to build more widely accepted, balanced and transparent valuation outputs. This second article in the series describes 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 methodology promotes rigorous interrogation of early stage life sciences technology to identify and characterise key value drivers, and advocates the development and simulation of robust practical scenarios to generate meaningful valuation outputs with practical relevance.
The full article was first published entitled Practical approaches to early stage life sciences technology valuations in The Journal of Commercial Biotechnology, Volume 16, Q2 2010, doi:10.1057/jcb.2009.31. Palgrave Macmillan, a division of Macmillan Publishers Limited.

Practicalities of encompassing approaches for valuation of early stage life sciences technology

Whilst conventional DCF valuation approaches can be readily used to quantify economic value, it is generally more challenging to apply these conventional approaches to determine potential value. This is largely because the increased uncertainty associated with realisation of potential value requires numerous assumptions to be made about key valuation parameters for which actual information is as yet unknown, which can result in unwieldy and controversial valuations. And although options-based approaches have strong theoretical applicability for quantification of potential value, they tend to be conceptually demanding and are often difficult to model in practice.
To address the challenges associated with valuation of early stage life sciences technology, a series of six practical steps have been developed to encourage the use of encompassing approaches that blend complementary qualitative and quantitative evaluation practices to build realistic and widely accepted early stage valuations. The methodology promotes rigorous interrogation of a technology to identify and characterise key value drivers, and advocates the use of conventional valuation approaches alongside the application of more expansive valuation perspectives to integrate the dependent and independent economic and potential components of value into meaningful valuation outputs with practical relevance.

1. Identify the economic and potential value drivers

The term value driver refers to any characteristic of a life sciences technology that confers utility and as such represents a source of value. The economic value of an early stage life sciences technology reflects the net cash flows attributable to the technology as it currently stands. Cash flows are typically relatively straightforward to identify – cash inflows generally arise from subscription/licence income or sale revenues, whereas cash outflows are the costs associated with developing and maintaining the technology.
In contrast, the potential value of an early stage life sciences technology is that which could conceivably be realised from a range of different investment opportunities (e.g. investment aimed at reducing development risk, expanding existing markets, creating new applications etc.), therefore in order to determine potential value, each of the potential value drivers – i.e. the available investment opportunities – must be identified.
However, because of the subjective and multi-faceted nature of value it can be difficult to identify all of the independent and dependent economic and potential value drivers for an early stage technology, and therefore it is also helpful to adopt an approach that systematically considers different perspectives of value. Based upon ‘balanced scorecard’ principles, an expansive perspective approach to valuation retains the conventional financial perspective that recognises economic value, but also systematically incorporates other perspectives of value to build more widely accepted, balanced and ultimately more meaningful valuation outputs.
Adopting an expansive perspective provides a means of interrogating a technology to gain insights into where the greatest value is located, as well as highlighting areas where value can be created or strengthened. Because of the subjective nature of value, there is no universal prescription for the perspectives to be incorporated for any given valuation, save that each of the perspectives adopted should be clearly relevant to the valuation being undertaken. Notwithstanding this, there are certain key organisational perspectives reflecting the interests of key stakeholders that are generally relevant in the case of early stage life sciences valuations and which recognise the independent and dependent economic and potential components of value on the basis of their contributions to innovation, human resources, reputation, marketing and finance;
i)    the innovation perspective recognises value based upon a contribution to the application of new ideas;
ii)    the HR perspective recognises value based upon the impact on employees;
iii)    the reputation perspective considers value based upon the perceptions of external stakeholders such as customers, suppliers and society;
iv)    the marketing perspective views value in terms of commercial activity in markets;
v)    the financial perspective recognises value based upon the ability to generate shareholder wealth. In this respect the financial perspective represents any direct economic benefit to the overall value of the business, and importantly, also integrates the components of value from each of the other different perspectives into an overall valuation output.
An illustration of how the expansive perspective can be integrated into an encompassing framework to identify the value drivers of early stage life sciences technology is provided in Box 3 of the full paper which can be accessed here or here).

2. Evaluate the economic and potential value drivers

Once a technology’s value drivers have been identified the next step is to quantify the value attributable to each driver, and in practice value is generally expressed in financial terms.
The economic components of life sciences technology value can readily be quantified using conventional financial valuation techniques, and research indicates that market-based comparables/ benchmarking methods and income-based DCF methods are widely-used for these purposes. Income-based approaches that take a view of the future cash flows attributable to a technology are generally considered to be the most ‘conceptually-correct’ valuation methods, however such approaches often depend on numerous assumptions which can sometimes be difficult to model in practice. Therefore, where possible (i.e. where financial information is available for sufficiently comparable technology) it is invariably good practice to augment income-based valuations using market-based comparables/ benchmarking approaches.
In contrast, potential value is often measured in non-financial terms and therefore in most cases must be monetised. Put simply, monetisation is the process whereby perceived value measured in non-financial terms is translated into a corresponding financial value, and typically involves determining the payment cash flows necessary to obtain equivalent utility to that which could be derived from the technology (as determined using market-based comparables/ benchmarking approaches), and subtracting from these payment cash flows the investment cash flows required to realise the potential value.
Since value is subjective, the degree of monetisation of potential value will depend upon individual perceptions of willingness to pay to obtain equivalent utility to that derived from the technology. This has clear consequences for the magnitude of the valuation output, which will be highest from the perspective of those that recognise the greatest degree of utility in the technology and vice versa. This is known as value discrimination and can have practical commercial implications for early stage valuations.
Life sciences technology valuations are rarely undertaken in isolation, and are usually performed for reporting purposes or to inform some form of decision-making in relation to potential transactions. For instance a common purpose of life sciences technology valuation is to help sellers (licensors) and prospective buyers (licensees) to establish financial terms for transactions such as technology acquisitions or licences. As a consequence of value discrimination, prospective buyers might be expected to have different perceptions of the value of a given technology based upon the degree of utility they are able to derive from it. And by recognising and exploiting value discrimination, sellers have an opportunity to realise the greatest value by focusing their marketing activities towards identifying those prospective buyers who are able to derive greatest utility from the technology.

3. Assess relationships between value drivers

The practice of systematic and inclusive identification and evaluation of a technology’s value drivers allows the contribution of each driver to the overall value of the technology to be established. In most cases the overall value of a life sciences technology is not simply the sum of all the independent and dependent economic and potential components of value, because certain value drivers are likely to be interdependent (and perhaps even mutually exclusive). Furthermore, when evaluating potential value it is important to recognise that in practice many available investment opportunities will never be pursued (and hence the potential value of such opportunities will never be realised).
To illustrate this, consider the case of an early stage technology that has the ability to modify a particular therapeutic compound to enhance half-life. One value driver for the technology may be its capacity as an exclusive product improvement that expands the commercial scope of the therapeutic compound in question, whereas another value driver could be its potential as a platform with applicability to a range of different products. Choosing to develop the technology as a unique product improvement would necessitate restricting its widespread availability (for obvious commercial and competitive reasons), whilst pursing a platform approach with wide applicability would preclude the opportunity to benefit from the competitive advantages of exclusivity.
Therefore in addition to individual quantification of each value driver, it is important to assess the nature of any relationships between value drivers. Doing so will not only highlight the key value drivers for the technology, but will also allow the contribution of each key driver to the overall value of the technology to be determined under different scenarios.

4. Develop robust practical scenarios under which value is realised

Valuations of early stage life sciences technology based upon forecasts of future income are frequently viewed with scepticism. Whilst this is a commonly perceived consequence of the inherent uncertainty and risk associated with early stage technology, in many cases this scepticism arises specifically because of an inability to reconcile differing perceptions surrounding the parameters used in early stage valuation approaches. An effective means of mitigating this scepticism is to focus on selecting a number of specific practical scenarios under which the value of the technology could be realised and developing these scenarios in a ‘bottom up’ fashion using the most relevant and accepted valuation parameters.
Income-based valuation approaches typically utilise numerous different valuation parameters to generate forecasts of the future income attributable to a technology. For example, consider the case of an early stage compound where a key value driver is the compound’s therapeutic potential. In order to forecast the timing of future cash flows, relevant parameters to consider include clinical development timeframes, regulatory submission and review timeframes, commercial timeframes, patent lifetime, etc.; and in order to forecast the magnitude of future cash flows, relevant parameters include market size/share, pricing strategies, manufacturing and sales costs, etc. Moreover, the likelihood of realising the future cash flows under any given practical scenario will depend upon the technical risks associated with development of the compound, therefore the valuation approach also needs to account for the technical risks of R&D by adjusting the future income forecasts based upon the probability that they will be realised. In the case of a therapeutic compound, technical risk is mitigated by progression through the stages of clinical development, therefore in order to forecast the likelihood of future cash flows the relevant valuation parameters are the probabilities of success (POS) for each development phase.
For many cases involving early stage technology, much of the information relating to the relevant valuation parameters is unlikely to exist, and therefore assumptions have to be made as to the most appropriate parameter values to use. A common practical pitfall of early stage valuations is the use of unsubstantiated approximations for key valuation parameters. The main drawback with this practice is not that it creates uncertainty around the valuation output – uncertainty is practically unavoidable with early stage valuations – but that it compromises the perceived robustness of the valuation approach, which in many cases is the major source of contention regarding early stage valuations.
In order to generate robust and meaningful valuations it is critical that the valuation parameters used are both realistic and justifiable, which means that any assumptions should be based upon the most appropriate and highest quality available data. Such assumptions may be based on data that relates directly to the technology in question – if such data is available – or may be derived by benchmarking available data against relevant comparable technology, markets, companies or industries. Where assumptions are based on external data, the use of recognised data sources such as renowned experts in the field or reputable market intelligence providers is strongly encouraged to provide credibility and encourage acceptance of the valuation parameters used.
Selecting the most relevant and accepted valuation parameters not only facilitates development of robust practical scenarios to help generate more meaningful and widely accepted valuation outputs, but also allows more informative sensitivity analyses to be performed in order to assess the extent to which changes to individual valuation parameters impact the ultimate valuation output.

5. Use simulation tools to model chosen scenarios

Because of the uncertainty associated with early stage life sciences technology, an important feature of any valuation approach is the ability to assess the extent to which changes to any one or more of the valuation parameters and assumptions used to develop the practical scenarios impact the ultimate valuation output.
Simple scenario analysis can be used to determine the effects of variations in key valuation parameters on the final valuation output. For example the impact of a 10% underestimation of market share on the valuation of a given R&D project can be explored by simply increasing the relevant market share parameter variable by 10% and recalculating the value. However, although such approaches recognise that different outcomes are possible, they employ single point estimates and are unable to predict the likelihood of any given occurrence. Calculation of more realistic outcomes requires numerous versions of a single model, each incorporating different parameter variables.
Nowadays highly sophisticated sensitivity analyses can be performed using simulation techniques such as Monte Carlo, which allow the effects of simultaneous variations in multiple valuation parameters to be explored. Monte Carlo applications can be easily incorporated into common spreadsheet software packages allowing thousands of iterations of a valuation model to be performed. This allows a potentially unlimited number of scenarios to be developed from many different parameter variables, each of which is accounted for according to the probability of its perceived value. The final valuation output is then delivered as a probability distribution curve encompassing the range of outcome valuations.

6. Use value ranges to represent valuation outputs

Conventional valuation outputs are typically represented as discrete numerical entities. Outputs of this nature tend to infer a high degree of accuracy and precision, and as a result are often interpreted as definitive valuations. This can have practical consequences. For example, valuation outputs are often used to set target valuations for transactions, which parties use as a key basis upon which to build deal structuring, pricing and negotiation strategies. At the outset of a transaction, it is not uncommon for parties to have disparate perceptions of the technology’s value (with target valuations of sellers and licensors invariably being somewhat higher that those of prospective buyers and licensees). Parties tend to place a very high priority on achieving their target valuations and therefore disparate perceptions of value based upon narrow, misguidedly definitive valuations can prove very difficult to reconcile. This frequently leads to deadlocked negotiations and can potentially compromise what may otherwise be successful and mutually beneficial transactions.  
In certain cases – usually involving later stage technology assets where utility is well characterised and widely accepted – it is possible to generate discrete valuation outputs that are considered by both the seller and the buyer to be reasonably accurate and reasonably precise, and in such cases there usually exists broad agreement between the parties as to the technology’s ultimate value. However for earlier stage technology where there is typically much greater uncertainty surrounding ultimate commercial utility, it is rare that all parties will be aligned in this regard. Therefore for early stage valuations, it is usually more helpful to represent valuation outputs as probability-adjusted value ranges – or value profiles – that encompass and reflect a range of valuations under different practical scenarios.  Expansive value profiles tend to be easier for parties to reconcile than narrow discrete outputs, and encourage more realistic expectations of what can be achieved when using early stage valuations to plan transaction and negotiation strategies. As such, value profiles are often more useful in practical terms than conventional discrete numerical valuation outputs.

Encompassing approaches towards valuation have implications for life sciences transactions

Encompassing approaches towards valuation are necessarily more complex than the conventional valuation methods that focus purely on financial components of value. In addition to the quantitative data and assumptions used in conventional valuation models, encompassing approaches also involve broad and often qualitative practices that require consideration of different components of value from a range of different perspectives. This requires factoring information from all available sources into the valuation approach. Due diligence activities should therefore seek to identify all available information relating to the technology and to its potential uses, which can then be used to generate a comprehensive and inclusive valuation output.
Parties seeking to realise value from transactions involving early stage technology are encouraged to focus their attention on identifying and engaging potential transaction partners with the capacity to exploit the technology to its greatest commercial potential. Encompassing approaches therefore extend the perspective of valuation to more than simply a process for establishing financial terms for transactions, and seek to include and reflect the full scope of shared commitments pertaining to ensuing relationships. This encourages parties to adopt risk-sharing approaches to agreed valuations and long-term success, as opposed to the sole pursuit of near-term target valuations that may compromise longer-term outcomes. Diligence activities should therefore include both the typical ‘internal’ diligence activities relating to the technology and to potential transaction partners, as well as ‘external’ diligence activities involving a thorough market assessment. The latter are surprisingly uncommon, yet rigorous external diligence activities to identify potential partners who are best positioned to exploit the technology and for whom the technology represents strategic, technological and cultural compatibility is key to ultimately realising the full value from transactions involving early stage life sciences technology.
The emphasis on valuation as a means of facilitating productive and mutually beneficial transactions is particularly important in scenarios where repeat business is sought, or where transactions between buyers (licensees) and sellers (licensors) typically represent the start of longer-term relationships in which parties are expected to work together for mutual gain – as in the case of early stage life sciences technology partnerships.

Conclusion

Developments in healthcare technology and economics are continuing to change the business environment in which the life sciences industry operates. Early stage partnering represents an important component of life sciences business strategy and therefore there is a high need for new approaches to valuation that account for the uncertainty and risk associated with early stage life sciences technology. By incorporating an integrated suite of qualitative and quantitative evaluation practices, encompassing valuation approaches reposition and expand valuation perspectives to provide more widely accepted, balanced and transparent valuation outputs. The use of encompassing valuation approaches can minimise much of the contention that often surrounds early stage valuations, thereby facilitating productive and mutually beneficial transactions that form the basis for successful long-term partnerships.

This article – part 2 of a 2-part series – has 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 methodology promotes rigorous interrogation of early stage life sciences technology to identify and characterise key value drivers, and advocates the development and simulation of robust practical scenarios to generate meaningful valuation outputs with practical relevance.
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 www.kinapse.com.
Other Kinapse thought articles can be found at http://www.kinapse.co.uk/insights/.