Life Sciences

EAC VALUATIONS LLC

The Art and Science of Valuation of an Early-Stage Life Science Company

Background

Early-stage Life Science companies are start-up businesses with potential products, know-how, andintellectual property, with little or no revenue. In a life science company, it can take years to translatepotentially great ideas into approved products that can generate an income stream.

Valuing a company which does not have a steady flow of income but offers great potential for futurerevenues raises the following questions:

What are the best methodologies for valuing a company with a rich pipeline but no approvedproducts?

Can valuation methods utilized for companies generating revenues from a portfolio of productsand a rich pipeline also be used for such early-stage companies?

These are important questions for which there are no definitive answers, as no single valuationmethodology can be applied to all early-stage companies. However, it is important that a value bedetermined for raising capital, possible mergers, and developing strategic alliances, for example. Investorsneed to know the value of a pre-revenue company to understand the potential of the product pipeline andthe ultimate value going forward.

To develop a valuation for an early-stage company with potential assets, it is necessary to look at themarket potential of the products. This can be done for individual products, and a final valuation derived forthe portfolio of products. However, due to potential unique industry factors, valuation is complex, andcertain risk factors must be estimated, requiring judgments to be made in the face of uncertainty.

An important driver of value in any start-up company is the value of the intangible assets such as patents,in-process R&D, and know-how. For most early-stage companies, the value of intangible assets are likelyto be much greater than the value of the tangible assets. Therefore, it is important to understand the uniquefeatures of intangible assets so that the correct valuation methodology is applied.

Because business valuation is as much an art as science, a skilled BV professional with in-depthknowledge of the specific industry is not only able to provide valuation for the total business, but also valuethe contribution of intellectual property to the enterprise value. In effect, the valuation professional providesan independent third party analysis with the insight of an in-house employee.

1450 E Boot Road, Suite 500-BWest Chester, PA 19380

(610) 687.5855 | Fax: (484) 887.8703

Valuation Methodologies

Valuation is both an art and a science. The ability to judge which valuation method is best suited to acompany’s needs and apply it to get an accurate picture of value requires experience and skill.

In general, there are three (3) approaches to valuing a business - market, income and cost approaches.The market approach relies on historic transactions or stock valuations of comparable businesses. Theasset or cost approach looks at all the tangible assets owned by the company, and the historic costsincurred to develop the intellectual property being valued. The income approach uses past performanceand the expected value of future performance to calculate a future income stream, discounted to presentvalue. Each method used appropriately has its benefits. Values generated from each method are judgedby the experienced appraiser as to its reliability, defensibility, and completeness, then weighted to providea final valuation.

The market and cost/asset methodologies may not be easily applied to valuing a start-up company. Onenotable exception to this is the value of intangible assets owned by the company (intellectual property),where, using the substitution principle (What would it cost me to get to the same commercialization stage?),development costs can be used to determine the value.

The income method typically works well for companies with positive cash flows. However, for start-upcompanies with little or no revenue, discounted cash flow (DCF) methods may also be used to estimatethe intrinsic value of products in development. The DCF technique (referred to as risk-adjusted net presentvalue method (NPV)), when applied to a product development project, involves estimating cash flows overthe forecasted life of the product, including costs of development and projected revenues fromcommercialization. The cash flows are discounted to estimate the total present value in today’s currency.There are complex factors and assumptions involved in making these calculations, therefore, the calculatedbusiness value is subject to the uncertainties in the assumptions.

Alternative Valuation Methodologies

As noted above, start-up companies can be difficult to value because they are high-risk in nature and havelimited historical information. Valuation approaches that include using less common alternative methodsmay provide more robust valuations for start-up companies.

Real option pricing methodology may be an appropriate way to value a pre-revenue business because ittreats the development portfolio of the business like a market call option. The presumed advantages of thisapproach is that it captures value in the uncertainty of success or failure of the start-up company betterthan a DCF/NPV income valuation approach. The Black Scholes OPM is commonly used because it isrelatively simple to estimate certain key values. However, the Black Scholes methodology may tend toover-estimate value if the characteristics of the company and its portfolio opportunities (e.g. exclusivity) donot fit closely with the assumptions of the option pricing method.

Another approach for valuation of pre-revenue companies and their underlying assets which may eliminatesome of the limitations of DCF or option pricing methods is PWERM. This method models potential futureexpected outcomes and assigns a probability weighting to each scenario (e.g. outright failure, delay indevelopment of a candidate drug, moderately successful, etc). The resultant values can be used to discountthe potential outcomes and the value of the company associated with each outcome. As an extension ofthese approaches, Monte Carlo simulations can be performed to estimate the probability weighting for eachoutcome.

1450 E Boot Road, Suite 500-BWest Chester, PA 19380

(610) 687.5855 | Fax: (484) 887.8703

Summary

Approaches to valuing a start-up company can be the same as those used for more matureenterprises with positive income with some important exceptions.

The market and cost methods are not easily applied because much of the value lies in the futurepotential of products in development rather than assets and historical prices.

Intellectual property holds value for pre-revenue companies. The income approach is performed by estimating the risk-adjusted NPV across the portfolio of

projects. Other valuation approaches that may be used to value pre-revenue companies include real option

pricing, PWERM, and Monte Carlo simulation.

Conclusion

Due to the complex nature of valuing a start-up company, it is important to fully understand the nature ofthe industry and specific risk factors that might be unique to the company and the industry. Becausebusiness valuation is as much art as science, a skilled BV professional with industry experience can helpbusiness owners arrive at a valuation more accurately than could be done on their own. If the businessowner is planning to sell a business, a professional BV can provide a valuation before it is on the marketthat may help the owner to understand what the business is worth and to determine if it could be mademore attractive. EAC Valuations LLC offers business valuation services to companies throughout the LifeScience, Healthcare, and Chemical process industries.

About the Author: David Abercrombie, Ph.D., Senior Business Analyst

David joined EAC Valuations in November 2013 as a Senior Business Analyst specializing in businessvaluation services for Life Science and Healthcare businesses. David has served in the bio/pharmaceuticalindustry in various technical and management positions since 1989.

David received his Ph.D. degree in Biochemistry from the University of Maryland in College Park, MD. Hesubsequently completed a post-doctoral fellowship in membrane biochemistry and biophysics atMassachusetts Institute of Technology. David is currently completing training as a Business CertifiedAppraiser from International Society of Business Analysts.

About EAC Valuations LLC

EAC Valuations LLC has provided in-depth and trusted appraisals and valuation reports since 1971.Located outside of Philadelphia in the city of West Chester, our assignments have taken us around theworld, and next-door. We have completed more than 10,000 appraisals for clients ranging frommultinational, multi-billion dollar Fortune 100 companies and financial institutions, to privately held localmanufacturing and services companies. Our highly qualified, certified and experienced appraisers canexceed expectations for a wide range of appraisal needs meetings IRS, FASB, IFRS, USPAP, and FIRREArequirements.

EAC Valuations pharmaceutical business experience encompasses working with over 40 companies in 32states and 8 foreign countries. From generic, prescription, and OTC drugs to medical devices andcosmetics, we have learned, appraised, and grown over the entire constantly changing pharmaceuticallandscape. Over the years, we have worked with everything from start-ups to multi-national global firmsand have journeyed with them through mergers, acquisitions, and spin-offs.

1450 E Boot Road, Suite 500-BWest Chester, PA 19380

(610) 687.5855 | Fax: (484) 887.8703

BUSINESS VALUATION BEST PRACTICES

What is a Business Valuation?

The act or process of determining the value of a business enterprise or ownership interest therein.

Why do I need a business valuation?

Corporate Planning Key Person Insurance Sale of Business Financial Reporting Merger and Acquisition

Transfer of Business Buy/Sell Agreements Estate Planning Goodwill Impairment Litigation

Who uses a Business Valuation?

A Business valuation is a valuable tool for any business, large or small, public or private, thatneeds to adequately and professionally address any of the needs listed above.

What information is needed for a Business Valuation?

The information required varies and is dependent upon the purpose and scope of the assignment. Typical information requested will include:

o History & Description of SubjectBusinesso 3 to 5 years Audited Income Statementso Purpose & Intended Users of theValuationo Industry Overview

oOwnership Structureo 3 to 5 years Balance Sheetso 3 to 5 years ProjectionsoDescription of Competition

How is a Business Valuation performed?

Three Approaches to Value:

Asset Approach Market Approach Income Approach

Typical Discounts:

Lack of Marketability Minority Interest (Control Premium)

Will a business valuation tell me the value of the Real Estate and Machinery & Equipment?

No. The contributory value of the real estate and machinery & equipment must be derived in aseparate and distinct tangible asset valuation.

Who should you select to do your Business Valuation?

A Certified Valuation Expert or firm that has multiple appraisal disciplines should an assets valuation(Tangible or Intangible) be needed.