Finding Common Ground: A Q&A on Valuing Biotech Assets and Investments

Clarifying which methods have been used to value biotech assets may help firms bridge valuation gaps between them.

Life-saving innovations in health care require considerable investments in biotech assets, including drugs in development. Startups often require funding from external investors such as venture capital (VC) firms that take equity stakes in companies in exchange for capital. Before VCs and startups can agree on the size and value of an equity stake in a biotech company, they must first agree on the value of that company’s assets. However, there may be large valuation gaps between parties due to their use of different methods to account for regulatory or clinical development risks and future financial prospects.

Analysis Group Vice President and financial economist Sumon Mazumdar sat down with academic affiliate Amitabh Chandra, an economist who focuses on the health care sector, to discuss this issue. Professor Chandra has served as an expert witness, published case studies, and performed extensive research on how biotech assets are valued. He also teaches a class on investing in the life sciences at Harvard Business School and chairs the group that selects early-stage companies for an incubator program at Harvard. Professor Chandra has advised the US government and testified before Congress and in federal court on topics in health care policy. 

Why is the valuation of biotech assets different from the valuation of assets in other industries?

Some of the hardest valuation issues arise in valuing biotech assets because, unlike most other corporate investments, a biotech asset – such as a drug candidate – must complete a series of clinical trials and receive the FDA’s [Food and Drug Administration’s] approval before it can go to market. This process takes millions of dollars and several years to complete, and the odds of success are very slim, with some estimates lower than 12%. Additionally, as a drug is developed, the competitive landscape and policies related to drug pricing could change considerably. 

Therefore, to value a drug candidate in the early stages of its development, it is necessary to properly incorporate such unique risks and value into a reasonable valuation method. Given the often enormous size of these investments, failing to properly do so could have significant repercussions.

Could you expand on those risks and value drivers?

A biotech asset’s value depends critically on a drug’s epidemiology; how far along the drug candidate is in its clinical development; the likelihood of success at each of the remaining clinical trials; those trials’ expected costs and completion times; and the drug’s projected annual market size, revenues, and costs if it is ultimately launched. Among other things, a drug’s future revenue depends on its expected price, which can be impacted by changes in government policy. For example, legislation such as the IRA [Inflation Reduction Act], the Orphan Drug Act, or the various approval pathways for generics and biosimilars can affect a drug’s pricing. Therefore, the possible impact of policy changes should also be considered in valuing a drug candidate’s present value. Additionally, the value of a drug depends on its expected future competition. So, biotech companies must know the state of the science of a drug in development, the threat of products that could compete against it, and what return their investors expect.

Are there differences in how practitioners could value biotech assets? If so, what could result from those differences?

Biotech investors and entrepreneurs may rely on different information and methods to value drugs in development. In fact, even if parties use the same valuation method, they may disagree about key assumptions, and hence, a drug candidate’s value. For instance, a drug developer may be better informed than external investors about some value drivers such as a drug candidate’s likelihood of clinical success and R&D costs. Conversely, investors may have better knowledge of other factors such as market size and competition. As a result, the negotiating parties may have different estimates about these key value drivers and therefore disagree about the drug candidate’s value. If the parties cannot close this valuation gap, then a potentially life-saving drug’s development may stop due to a lack of capital.

 

What are the most frequently used valuation methods for biotech assets?

Commonly used methods to value biotech assets include the hurdle rate–based formula, risk-adjusted net present value (rNPV) method, and real options method.

Could you briefly explain each method, beginning with the hurdle rate–based valuation formula?

In the hurdle rate–based valuation, an investor determines the at-issue asset’s (such as a drug candidate’s) exit date and estimates its value at that date. Then, it calculates the asset’s present value by discounting its projected exit date value using a hurdle (or target rate of return) as a discount rate. For example, suppose an investor’s projected exit date is 10 years from now, and it estimates that, if the drug candidate is successful by then, it would be worth $5 billion (five times its projected peak sales of $1 billion), based on its peers’ valuations. If the investor’s hurdle rate is 30% per year, then the business’s present value is equal to its future value ($5 billion) discounted for 10 years at 30% per year, or $362.7 million. So, in exchange for $100 million into the unleveraged company today, the investor would demand a 27.6% (100/362.7) equity stake in the company.

A key feature of this method is that it incorporates the valuation impact of all the risks associated with bringing a drug to market by using a single parameter: a high hurdle rate. This method typically ignores the fact that drug development risk (the risk that the drug candidate may fail its clinical trial) generally declines as the drug’s development progresses. By glossing over the stage-specific differences in clinical development risk, this method can result in a valuation that is quite different from the conclusion one may reach by explicitly modeling the drug candidate’s probability of success at each clinical trial phase.

Switching gears for a moment, could you describe how value is assessed using the rNPV method?

Instead of incorporating the valuation impact of all risks associated with bringing a drug to market by using a high hurdle rate, as in the hurdle rate–based valuation formula, the rNPV method explicitly incorporates the probabilities of success associated with each clinical trial phase and therefore accounts for any change in an asset’s value at the start of each phase. But those probabilities are difficult to estimate. Analysts using this method must carefully assess the drug candidate’s clinical success probability at each remaining stage of development and the rate to use to discount the asset’s expected cash flows after accounting for its likelihood of success at each stage. 

To assess a drug candidate’s likelihood of success at each stage of clinical development, analysts may use stage-specific probabilities of success of drugs that have undergone clinical development. In doing so, analysts should use success probability data of drugs that are closely related to the at-issue drug candidate, which published studies or industry experts with custom databases may be able to provide. Analysts should also consider running sensitivity analyses to assess the impact of alternative assumptions about key value drivers, including the success probabilities at each clinical trial stage, the R&D costs at each stage, and the time to complete each stage of clinical trials, among other factors.

In addition, the rNPV method can also allow analysts to incorporate the expected impact of other key value drivers that may affect a drug candidate’s present value, such as expected future changes in public policy or the competitive landscape, which could affect the drug’s future revenue.

Does the real options method yield additional valuation insights?

The real options method accounts for the uncertainty associated with a drug candidate’s future cash flows and the flexibility of a firm to discontinue drug development at or ahead of clinical trial phases. The value of those “real options” are estimated by considering, among other things, the “exercise price” (that is, the cost of continuing development) at each remaining clinical trial phase and the uncertainty associated with its future cash flows if the drug ever goes to market.

According to the real options method, if the cost of continuing that drug’s development at a particular stage is greater than its expected value at that stage (its continuation value), then a firm would optimally discontinue its development. The option to abandon the project midstream, which other valuation methods ignore, increases a drug candidate’s present value.

How can negotiating parties use these methods to close a valuation gap between them?

Parties may disagree about a drug candidate’s value because they use different information or methods to value that candidate. To close this valuation gap, the parties should share their respective valuation methods and the assumptions they made in valuing the drug candidate. Clearly understanding how the other side has incorporated the impacts of key value drivers in valuing a drug candidate can help parties resolve their differences. Experts can play an important role in this connection.

For example, a biotech valuation expert can evaluate the methods and assumptions that the parties have considered and ultimately conduct an independent valuation based on their own reasonable assumptions. Such a transparent and independent valuation analysis that clearly explains the method used to value the drug candidate and highlights the method’s key assumptions can allow both negotiating parties to better understand the impact of specific value drivers on a drug candidate’s present value. Ultimately, if the parties agree that the expert’s valuation method and assumptions about the key value drivers are reasonable, then the valuation gap between them can be closed.

If parties can resolve their differences regarding a drug candidate’s value, what are some of the broader implications for drug development and innovation?

Closing valuation gaps may permit a life-saving drug candidate’s clinical development to continue, which could ultimately bring that drug to market. On the other hand, if parties cannot resolve the valuation gaps between them, then such a drug may never be developed, which could have a tremendous impact on society. ■