On Valuation

There’s been a lot of recent discussion on valuations for life science companies. Most of the focus has been on biopharma companies, but the broader sector has been feeling the heat. This has been particularly true for earlier stage companies, meaning anything from pure day 1 startups to companies that have been around awhile but are still in the pre-clinical stage.

What’s prompted all of this discussion? The biggest factor by far has been the impact of the COVID19 pandemic, in a variety of ways. Two years ago, at the outbreak, there was a lot of general fear for the economic impacts, concern that many biotech companies would be shut down, that employees would get sick, and sales people would not be able to travel, and even if they could, they wouldn’t be permitted access to customers in medical centers.

As things turned out, 2020 and 2021 we incredible boom years for life science companies. Society turned to the sector for everything from PPE to test kits to surveillance services to new vaccines and anti-viral drugs. An enormous amount of money was invested in early stage companies, and an IPO boom followed with companies going public earlier and earlier, and at higher and higher valuations. SPACs became fashionable, along with direct listings, further accelerating access to the public markets. Broad consumer interest was fueled by constant discussion of the pandemic, and many individuals working from home turned to speculating in stocks, further driving up valuations.

Over the last six months, however, the bubble has clearly burst. Many of the companies that went public at sky high valuations over the past two years are now trading down 75% or more. Pandemic related inflation, in particular rising fuel prices, and then the Russian invasion of Ukraine, have further conspired to tamp down valuations. Tons of cash have been raised by venture investors, hedge funds, and strategics. All of these groups have incentive to see a reset in valuations of early stage private companies at a time when the public markets are no longer looking attractive, and they are likely to begin a feeding frenzy of M&A activity with all of that cash they have on hand.

If you’re a CEO or Board member of a startup, how do you think about valuation? My approach would be no different in the current environment than at any other time, but my expectations would certainly be altered. Great deals can get done for great companies at any time, especially for those companies that make good strategic fits for investors or acquirers. It’s even been said that the best companies get funded in the most difficult times, partly due to the simple fact that there is more scrutiny being paid to allocation of funds. I would guess that the majority of early stage ventures, however, should expect that investors and acquirers will be seeking valuations that are substantially reduced versus the past two years.

In light of these developments a CEO should be very open minded to alternative structures that they might not have considered when valuations were so frothy and funding so relatively easily attainable. I’d also be thinking about taking more money than I might have otherwise planned should it be offered, and developing budgets for more capital efficient operations so that whatever money is raised will last as long as possible. If a company was fortunate enough to have raised 2-3 years of funding in the past year, then I’d hold off on trying to raise more money right now. If you’re just starting out, however, you have no choice but to proceed. Perhaps your story will be so compelling that the response will be fine. If you find that the reception is less enthusiastic than you had anticipated, then maybe you raise funds in the form of convertible debt or a SAFE (simple agreement for future equity) with a mutually agreed valuation cap on the conversion to provide some extra incentive and protection for early investors.

Whenever I’m looking at early stage valuations I first consider the broad market conditions (real data on valuations that have actually been attributed to similar sized companies, at a similar stage in their growth cycle). Then I look to directly comparable companies and hope to find one or more that I can use in my models. These would be companies of similar size and stage, in the same sector (and ideally the same niche, or as close a possible), with similar business models. For example, if I’m raising for a startup developer of cancer therapeutics, then I want to know what valuations have been like for other early stage oncology drug development companies. Of course I’ll also consider any kind of drug company, but the closer the match the better.

Knowing the baseline of market comparables, other key considerations include some of the specific attributes of the company: how far along is it in development? Is there compelling in vitro data? Or animal model data? Is there a strong IP position? Is there some angle that provides a rapid path to regulatory clearance? Is it clear how the company will be paid for its products and services? If reimbursement is required, how far along is the company towards obtaining a coverage decision? Who are the people involved, and have they done this before? What kind of track records do they have? I’m most interested in who will be leading the company (the CEO), and the experience and reputations of the people who will actually be doing the work.

If there is a strong Board of Directors and/or Advisory Board, then I want to know how committed these individuals are to the success of the venture. Ideally I want to find that they all have “skin in the game” in some respect. In some cases this will be indicated by personal investment commensurate with their net wealth. In other cases it will be some obvious indication that the success of this venture really matters to them personally – that this isn’t just a job, but a passion play, and that I can count on them to be relentless in their efforts to push the company to achieve it’s goals.

All of these factors weigh on investment decisions in general, at any valuation, but they also should be considered by the company itself in developing their internal thoughts around a valuation that feels credible and defensible. Obviously the market opportunity matters, and how well differentiated the company is, and what there are projecting in their financial models. At the end of the day, however, valuations are less about calculating NPVs on some model, and more about what an investor feels something is worth at that point in time, taking into consideration other ways in which they might choose to invest their funds.

In my experience, all of these additional factors beyond the market comparable data serve to nudge the valuation up or down a bit. You just have to come up with a rationale you feel comfortable defending, go out and sell it, and see how it plays in the market. You’ll know you’re in the right ballpark based on having serious interest from experienced investors. Once you’re at that stage of discussion, there are all sorts of structures, perks, carveouts and other creative modifications that can be used to come up with mutually agreeable terms, but I’ll leave the discussion of negotiating term sheets for another time.