Valuation is a topic near and dear to every Medtech and Life Science founder’s heart. It determines how much of their company they get to keep if they can manage a successful development program and exit. Given that most early stage medtech and Life Science companies have very little in the form of physical assets or revenue, what exactly is being valued? Traditional sales, EBITDA and earnings multiples go out the window. For most companies it’s intangible assets consisting of no more than protected know how and ideas or some combination of patent filings and or granted claims. So what do those actually represent? Well, if the ideas or design or method contained within the patent filings can be proven to have clinical and commercial utility, the value of the company at any point in time is really the sum of all the potential future cash flows that can be generated from those intangible assets over their lifetime discounted back to present day using some weighted risk adjusting metric. This analysis is called a discounted cash flow model and the discount rate is called the weighted average cost of capital or WACC for short. The WACC is comprised of layers representing the risk free borrowing costs and added risk layers in the form of an increased discount rate depending on where the company is at in its development cycle. Over time the WACC should go down as the company makes progress and its development programs become de-risked. This along with the time value of money are two of the major drivers for increased valuations over the life of a company. From a practical standpoint, we think about prototyping and design freeze, CMC and animal data followed by clinical data as what really drives increased value. These are the activities, but in reality, each of these activities is simply a de-risking milestone allowing for less discounting of future cash flows.The DCF allows for a reframing of how we think about value adding activities.
For example if there was no risk adjusted discounting, we could just say that the value of a company or technology is simply adding together the total cash flows that a technology can produce over its lifetime regardless of when they occur and or how likely they are to occur. We can just model out say 10 years and add all of the early negative cash flows against some hopefully very large positive cash flows in the later years. This would give a number of course, but does that number really represent the reality of the uncertainty that Life Science companies face?The discounted cash flow model is really the gold standard for valuing an early stage medtech and Life Science company because it allows for direct combination of different periods of negative and positive cash flows occurring at different points in time adjusted for relevant risk factors. Most early stage Life Science or medtech companies have prolonged early periods of negative cash flow, occasional cash infusions at various fundraising points followed (hopefully) by long periods of largely positive cash flows occurring in later years. So it’s important to understand the significance of de-risking events and milestones and their impact on valuation. Assuming the Total Available Market and expected market share stays the same, risk and time to market are two of the biggest drivers negatively impacting your valuation. Lower your risk through clinical validation and/ or shorten your regulatory timeline to market, and your valuation should go up.
As a Fractional CFO, I often do large and sometimes complex discounted cash flow models in support of my client’s valuation targets. However, in practice this is just one tool to be considered. The Net Present Value of a discounted cash flow model is only as good as the variable assumptions inputted into the model and disagreement can occur over the specific variables, timing and magnitude of their impact. However, this exercise can also create alignment within the leadership team by highlighting which activities are really producing the biggest effects. When done early in the life of a startup, these models can be quite effective in helping to map out the business plan, cash flow assumptions and assumptions around timing and amounts of cash raises to fully execute a development program through a planned exit stage. This can help keep expectations in check and align the leadership team around the major assumptions as the business progresses. For later stage companies, DCF models can still be valuable tools for negotiations, however, there also becomes industry expectations for value ranges within specific stages of development. For instance A round companies in aggregate for the last year or two will have raised within a certain valuation range. This range then often establishes the boundaries for negotiations with sophisticated investors. It creates expectations independent of your company. As such it is important to recheck models and assumptions to see how they align with average changes in industry across funding rounds.For companies that don’t use sophisticated financial modeling, these de facto industry ranges can make expectations easier, however, the challenge with this scenario is that if for instance you are raising an A round, your pre-money valuation range may already be set based on what sophisticated investors expect it to be, but what is also set is what those companies have accomplished prior to the A round. For example many A round companies are now presenting with clinical data generated from seed round financing. This means that if you don’t yet have this data, you’re A round might be more challenging because of industry expectations rather then simply being able to adjust pre-money valuations accordingly.
Regardless of how you model your data, understand the drivers that have impacted your valuation changes as your company has progressed. No CEO wants a down round, but pay attention to how you are deploying your funds. A company that raises $10 million has a post money valuation $10 million higher then its pre-money at funding. That does not mean that you will automatically be worth more than that for your next round as you deplete cash. You need to focus on how investors are being de-risked as a means of creating or realizing increased value. Reduced time to market, increased certainty around positive clinical endpoints, creative clinical trial strategies reducing total cost. These are easy variables to model that lead to higher valuations. Building out your team and adding new equipment and facilities does not always lead to higher valuations, but always leads to added fixed costs and burn rates that need to be maintained even during idle periods where no clinical activity is happening. Consider mapping out expenses a few funding rounds ahead. The later years become budget placeholders, but you can model those against valuation assumptions and cap table impacts to help create alignment and visibility within the leadership team and board around risk reduction milestones, cash needs and valuation expectations.