FORENSIC ACCOUNTING SPECIAL INTEREST GROUP VALUING A BIOTECHNOLOGY COMPANY

DAVID RANDERSON ACUITY TECHNOLOGY MANAGEMENT PTY LTD Melbourne, May 2001

1.

Valuation Methodologies

Techniques used for valuing intangible assets, of which intellectual property (IP) is one form, may be put into three main categories1: 1. Cost Based; 2. Market Based; and 3. Revenue Based. Biotechnology companies, because their main assets are generally IP, have values that are invariably determined by their intangible assets. The valuation of a mature company tends to follow a methodology that draws heavily on its historical income, either by performing a discounted cash flow of future earnings the confidence in which derives from past activity, or capitalisation of maintainable earnings. Another technique considers the orderly realisation of assets. As most biotechnology companies have no historical revenues and the tangible assets are not representative of a companys real value, these methods are seldom applicable. Conceptually, the value of a company is the sum of its assets value. However, accounting practices allow companies to reflect only the tangible part of their assets. Obviously, high valuations of companies that are in negative cash flow and with minimal tangible assets is causing concern to the taxation office (as demonstrated by their stance on core technology valuations in R&D syndicates) and the Australian Securities and Investment Commission (ASIC).

Reilly RF, Schweihs RP, Valuing Intangible Assets, 1998.

Determining the worth of a research project or R&D based company by discounting free cash flow is more often than not of questionable worth since such methods often result in negative value. Biotechnology companies, as well as other high technology companies, trade on stock exchanges with considerable value. In addition, these companies raise capital, sell or acquire licences to IP, and are acquired at values in excess of their book value or the R&Ds written down value. The guidelines2 issued by the various regulators are not particularly didactic on the issue of valuation of intangible assets, possibly because the need for such assessments has only emerged in the past decade (other than perhaps for brand names and good will) due to the growth in knowledge-based industries and an appreciation that employee training, know-how, licence agreements, trademarks, copyright and patents are of tangible value to an enterprise. The standard definition of fair market value is the amount for which an asset would be exchanged between a knowledgeable, willing, but not anxious buyer and a knowledgeable, willing, but not anxious seller acting at arms length in an open and unrestricted market3. Such definitions dont always apply where there is a limited market for an item of technology. For example, how many xenotransplantation companies are there worldwide, or signal transduction or cell therapy companies, etc. Particularly ones that are able to afford acquisitions or to license a particular item of IP? For more than a decade, Acuity Technology Management has been evaluating technology for companies, institutes and investors. Initially, the issue was whether to proceed with a project but, increasingly it has become: What dollar value can we place on the IP such that decisions concerning the issuance of equity, selling or licensing of the that project/business can be quantified? We are also of the view that project management decisions can best be guided by a knowledge of the absolute or relative worth of a project. The following discussion presents some of our views on technology valuations with a particular emphasis on addressing methodologies used by assessors who are less familiar with the biotechnology/pharmaceutical industry and, in our opinion, use methodologies that are inappropriate.

2 3

ASIC Practice Note 43, Valuation Reports & Profit Forecasts. NCSC Draft Policy Statement 34,555, Identifiable Intangible Assets Valuations.

1.1 Cost Based Methods It should be borne in mind that for someone to reproduce or replicate an invention or scientific discovery, unless they start with the knowledge of the inventor including his trials and failures, will cost a similar amount as the original discovery. As a scientist or engineer who has not trodden the exact route is prone to make the same mistakes, the replication cost cannot be assumed to be lower for the follower. Fortunately, the first to invent may take out patents to protect the discovery and preclude others undermining his market simply because they have the benefit of hindsight. Thus the patents, because they provide market monopoly for a period of time, confer a higher value on the IP than was actually spent. The competitor must circumvent this patent and hence, replacement cost may well exceed the expenditure on the original invention. A recent article in Nature Biotechnology4 reports that in interviews with 44 CEOs of biotechnology companies and company representatives, 21% used cost-plus approaches (adding an arbitrarily chosen margin to their expected cost). In consideration of the methods used for R&D syndication, a research report prepared by the Bureau of Industry Economics (BIE) noted5: The [Bureau of Industry Economics] survey asked firms how they valued their core technology. Notionally, all firms either valued technology by aggregating the historical costs of producing the core technology and/or estimating the present value of an after-tax royalty stream. The second has a more credible economic basis for the valuation of intellectual property but in fact produces extremely wide bounds on values. A seminal work on the valuation of intangible assets by Reilly and Schweihs states that the: Cost approach is one fundamental way of estimating the value of intangible assets and intellectual properties. There are several cost approach valuation methods, the most common being the reproduction cost method and the replacement cost method. According to Reilly and Schweihs: Reproduction [and replacement] cost is the estimated cost to construct, at current prices as of the date of the analysis, an exact duplicate or replica of the subject intangible asset, using the same materials, production standards, design, layout, and quality of workmanship as the subject intangible asset. The reproduction intangible asset will include the same inadequacies, superadequacies, and obsolescence as the subject intangible asset.

Moscho A, Hodits RA, Janus F, Leiter JME, Deals that make Sense, Nature Biotechnology, 18:719, 2000. 5 Research Report 60: Syndicated R&D, An evaluation of the Syndication Program, Bureau of Industry Economics (1994).

Regardless of the type of cost being estimated (eg. reproduction, replacement or other) five components of cost are generally included in the analysis. The five components of cost are: Material; Labor; Overhead; Developers profit; and Entrepreneurial Incentive. In respect of the Developers profit, Reilly and Schweihs note that: It is a cost component that is frequently overlooked. From the perspective of the developer of any intangible asset, first, the developer expects a return of all of the material, labor and overhead costs related to the development process; and second, the developer expects a return on all of the material, labor and overhead costs related to the development process. A building contractor expects to earn a reasonable profit on the construction of any residential or commercial building. Likewise, an intangible asset developer expects to earn a reasonable profit on the development of the intangible. We are firmly of the view that past expenditures is a valid way of valuing research output. As long as every indication is that the R&D is commercially oriented and there is neither technical nor commercial reason to suspect that a product will not eventuate with continued R&D, the IP has value over-and-above the direct investment to that point in time. Guidelines for multipliers on salary of academic organisation have been issued by the Australian Vice Chancellors Committee and 2.5 to 3 times is generally accepted. CSIRO apply a multiplier of three times when charging out their services, which includes a profit margin. John Watson (then Head of Research at BHP Limited) in 1991, reported that he would expect overheads could be at least 2.5 times the salary expenditure6 and that a profit of 40% on top of this would not be inappropriate. In one instance, we advised a medical research institute that a charge-out rate of less than five times salary would leave it out-of-pocket for the services that they provided to external organisations due to the considerable expense of high technology equipment. The Entrepreneurs margin is effectively what one can negotiate and the level of demand for the IP, but there is little doubt that the creativity of scientists and breakthrough discoveries are worth more than a simple profit margin.

Watson JD & Smith DM. Search 22(8), 1991. This report discusses multipliers used by Australian corporations, and also presents data from the Australian Vice Chancellors Committee and CSIRO.

1.2 Market Based Valuations Market based assessments include such methods as Price to Earnings ratios (P/E) and comparative transactions. P/Es of biotechnology companies in particular, are generally meaningless as many firms have little or no revenues. Techniques based on analysis of transactions between companies, equity valuations or capitalisations of comparable companies have significant merit in the biotechnology sector. There are thousands of transactions taking place in the industry every year where one company licenses IP from another or enters into a joint venture. And there are many fund raisings, both private placements and IPOs, which may be used as analogies (excluding the obvious fact that most occur in North America and to a lesser extent, Europe, while there are few in Australia). The comparison is possible only where a transaction relates to an identifiable unit of IP or platform technology that is reasonably comparable or, in the case of the value placed on a company, where that company is virtually single purpose and analogous to the company/IP to be valued. Our experience as consultants to many of the significant Australian biotechnology companies and research institutes is that they draw heavily on comparison with licensing deals overseas. They use comparisons of licensing and milestone payments and royalty rates as the basis for their own negotiations, or at least to support their expectations. Values for companies at specific stages in their development can be gleaned from sources such as Recombinant Capital7, various biotechnology business journals and analysts reports, and US Securities and Exchange Commission filings, eg. EDGAR Online. The leading journal in the biotechnology industry, Nature Biotechnology, each month publishes summaries of important transactions. Australian biotechnology analysts have found that comparison with overseas companies provides one of the most viable methods of valuation. For example, a recent article by David Blake, an independent biotechnology investment analyst, questions the market capitalisation of Melbourne based genomics company, Autogen Limited, currently capitalised at A$40m, when comparable US based companies DeCode Genetics, Inc and Gemini Genomics, Inc, are valued at US$433m and US$210m respectively8. At the least, such analogies can provide an indication that the values derived using other methodologies are in the ball park.

7 8

http://www.recap.com/ Blake D, Genomically Speaking. Share, March 2001, p 34.

1.3 Revenue Based Models Revenue based models attempt to estimate future cash flow and discount this to a present day value. The most common method of adjusting for time profiles of returns on capital investment projects is the present value technique. The discount rate used in such analyses is often determined from a Capital Assets Pricing Model (CAPM) or Weighted Average Cost of Capital (WACC) whereby a premium is added to the risk free interest rate attaching to financial instruments with very low, or non existent financial risk, for example the 10 year government bond rate. The premium aims to reflect the risk associated with the volatility of a particular market portfolio9. Typically, discount rate premiums are derived from observing the level of operating risk of listed entities with assets comparable to the valuation subject. However, these comparisons are best suited to the valuation of mature assets since discount rates for start-ups are not readily observable. There is little doubt that such methods are useful for analysing an investment in a project or assessing the worth of a business where cash flows are close at hand, investment is over a short period and the industry profile is well understood. Over the years, this method of risk adjusting has become distorted as the NPV technique has become a tool of adjusting for both risk and time with the consequence that high-risk and long-term R&D projects have become unfairly disadvantaged. More often, financial analysts incapable of assessing technical risk, with little understanding of the scientific process, or even assessing markets and competition appear more and more to choose high discount rates to compensate for these methodological and personal inadequacies. The addition of a risk premium to compensate for market volatility is a rational process, within bounds, due to the fact that this factor remains with the stock in perpetuity. However, scientific risk is finite - once the discovery process is complete or technical hurdle is overcome, there is no further risk. Many analysts are of the view that use of discount rate premiums to adjust for risk is both logical and essential, but Benzion, et al10 have shown that in real practice, the decision makers discounted cash flow is not always consistent with the classical present value approach. These authors analysed responses to investment decisions made by individuals in relation to a number of financial scenarios, size of cash flow and time. They concluded, consistent with studies by other investigators, that mean discount rates decrease monotonically both in time and with size of cash flow. When considering investments with long term implications, individuals compensate by use of lower discount rates and the same is true where larger amounts are involved.

The capital structure of pharmaceuticals is predominantly equity and the CAPM may be the most appropriate. In addition, the use of long-term rates, eg. 30 year US Treasury Bonds, would seem appropriate in determining the CAPM due to the protracted R&D and long product life. 10 Benzion U, Rapaport A, Yagil J, Discount Rates Inferred from Decisions: An Experimental Study. Management Sci 35(3), 1989.

The venture capital industry, supposedly, has come to rely on the use of risk-adjusted premiums in evaluating potential investments. The underlying risk faced by venture capitalists is that the companies in which investments are made have at best only a short trading history and if capital is invested at a very early stage they will often have no revenues or marketing history. A number of studies into the required annual rates of return or hurdle rates for venture capitalists have been performed during the last decade. The Harvard Business School published a study which presented the following average discount rates applied by venture capitalists11: Investment stage Start Up (still in product development or prototype stage) First stage (market studies have produced positive results but companies are unprofitable) Second & third stage (realising revenue and requires more working capital than can be generated from internal cash flow) Fourth stage (operating risk sufficiently reduced to enable the use of debt funding) IPO Annual IRR 33-46 26-39 23-33 20-26 16-23

The London Business School quotes the following internal rates of return (IRR) required by venture capitalists in the United Kingdom12: Investment stage Seed (finance for research to bring an idea to the point where it appears viable) Start up/early stage (finance to develop a product and undertake initial marketing of one not yet in the market place) Expansion/later Stage (for the growth and expansion of an established company) Buy-out (to enable current management and investors to acquire an established business) Annual IRR 33-67 27-40 20-34 17-23

The September 1995 Securities Institutes member circular, Jassa, published the results of a survey which reviewed the required rates of return of 197 investments made by 66 venture capitalists in the UK. The study concluded that the required rate of return from early stage investment ranged from 31% to 55% and that later stage investments ranged from 26% to 35%. The British Venture Capital Association produced data in their 1998 venture capital survey (published May 1999). The survey calculated the average return reported by 189 venture capital funds during 1998. The average annual return reported by these funds was 30%.

11 12

Insights from the American Venture Capital Organisation, Harvard Business School, 1991. Venture Capital in the United Kingdom, The London Business School, April 1994.

In drug development, the reality is that if companies applied a DCF, even with minimal risk adjustment above the CAPM or WACC, to determine the attractiveness of a project, no R&D would be undertaken. Seven to 13 years of negative cash flow invariably renders a research program of negative value. Reilly and Schweihs are silent on the subject of risk adjusting discount rates - in the examples that they provide, discount rates below 18% are employed. Is this because they can find no valid rationale for employing such a methodology or they simply do not support the concept of risk adjustment? Our searches of the literature have failed to find a sound basis for determining a suitable discount rate. In all the above venture capitalist citations it was assumed that the risk profile is constant from one year to the next and the analyst/investor increases the discount rate used in the NPV model according to the perceived level of risk (which is also assumed to be dependent upon the stage of development of the particular entity). As Benzion et al concluded: The classical hypothesis asserting that the discount rate is uniform across scenarios, time delays, and sums of cash flows, was flatly rejected. The decision maker, in deciding the worth or merit of an R&D project, must adjust for both risk and time and it is too simplistic to believe that one parameter, viz. the discount rate, is capable of both. Graves and Ringuest13 have demonstrated that simultaneous adjustment for time and risk penalises long term projects relative to short term ones. A telecommunications or IT project with a short R&D timeframe, high returns and short life may be amenable to elevation in discount rates, or at least may not be adversely penalised. Long term cash flow for such enterprises being of less significance. Venture capitalists may have cut their teeth in such technology disciplines, but if they were to apply similar rules to biotechnology, they would make few investments. A better treatment, as pointed out by Graves and Ringuest, is to explicitly recognise the time profile of the risk. One approach is to apply the risk adjusted discount rate only in the year in which the risky event actually occurs. Thus, if there is a high risk in year one where one has to undertake a particular experiment, a higher discount rate applies, relative to the subsequent marketing stage where the only risk is from competition. Such methods, however, are seldom seen in practice. One reason for this is that risky events are not always discrete and do not impact over the fixed time units employed in DCF analyses. Non-technically trained individuals have difficulty in defining the risk and when it occurs. In any event there appears to be no logical method for correlating the level of risk and an appropriate discount rate. In many circumstances, it may be fair to assume that riskiness declines with time and that sequentially decreasing discount rates are the order of the day, ie. commence with a high discount rate and reduce it as the product approaches market, say 30% in year 1, 25% year 2, 20% year 3, etc.

13

Graves SB, Ringuest JL, Evaluating Competing R&D Investments. Research-Technology Management, Jul-Aug 1991.

It is true that cumulative risk decreases as the R&D progresses, but it is not necessarily true that transitional risk declines. This is most evident to those familiar with the pharmaceutical industry. For example, a biopharmaceutical has an 88% chance of succeeding in a Phase I trial, and a slightly lower success rate at Phase II where efficacy must be demonstrated. The converse is true for new chemical entities (NCE), ie. the earlier stage of development is more risky. Therefore, the discount rate over the second stage of development for biopharmaceuticals should be higher and vice versa for NCEs. If one is expecting a $1m milestone payment on completion of Phase I, one should be concerned if this is discounted at 30% when the risk of failure is low. Grabowski and Vernon14, in a pivotal analysis, determined that the average investment returns on NCE introductions during the 1970s was around 9%: In line with the industrys cost of capital 15. Applying this figure to the analysis of 100 new drug introductions between 1970 and 1979 they determined that the NPV becomes positive on average 23 years from the discovery of the NCE. For those introduced in the first half of the decade the NPV never became positive. The only factor that kept the industry viable was the 20% of new drugs for which the after tax present value exceeded average R&D cost. Ten percent recovered their expenditure while 70% fell well below R&D costs. Where does that leave the discount rates as applied by venture capitalists? Hambrecht & Quist in 1994 proposed the use of the following discount rates:16 Product Development Stage Discovery Preclinical Phase I Phase II Phase III New Drug Application Launch Rapid Build Maturity After Tax Discount Rate % 80 60 50 40 25 22.5 17.5 - 15 12.5 - 10 7.5

These discount rates are applied to the cash flow over the years in which the specified development/marketing stages are involved.

Grabowski HG, Vernon JM, A New Look at the Returns and Risks to Pharmaceutical R&D. Management Sci 36:804, 1990. 15 It is noted that the industry CAPM was derived from long-term government bonds which, at the time, were 1.3% to 1.6% and the pharmaceutical industry beta was unity. The current 30 year rate is 5.4% and a beta for biotechnology should exceed unity. 16 Smith DL, Valuation of Life Sciences Companies - An Empirical Approach. Hanbrecht & Quist Monograph, 4 January 1994.

14

A similar approach was presented by Lehman Brothers (New York, USA) some years earlier17. Product Development Stage Pre-Investigational New drug IND Phase I Phase II Phase III New Drug Application After Tax Discount Rate % >60 >50 45 40 35 18 - 20

Both models often result in negative values which are meaningless, if for no other reason than that they suggest that no drug company would ever be involved with drug development. Furthermore, neither firm can provide a rational basis for deciding the particular discount rates. The deficiency of these models has been highlighted by Ashley Stevens from the Office of Technology Transfer at Boston University. He further proposes a cost of money discount rate be used rather than accounting for risk by high discount rates. In the model presented in his manuscript, Stevens develops the cash flow based on potential market size and share for the product in question, and industry average costs. Probabilities for the various stages of drug development are obtained from literature and the cash flows are adjusted by multiplying by the probability of reaching that point in the cash flow.

17

Tanner M, Financing Biotechnology Companies. Association of Biotechnology Companies, NYC Annual Meeting, September 1991.

The following is an example of the calculation (as taken from Stevens):

Year Stage Transitional Probability Cumulative Probability Cash Flow $m Prob. Adj. cash flow PANPV $m

0 1 2 3 4 5 6 7 8 9 10 11 16 19 28

Origin Preclinical Phase I Phase II Phase III NDA Launch Maturity Patent Expiry

100 100 50 75 48 75 85

100 100 100 100 50 38 38 18 18 14 14 11 11 11 11

-1 -1 -2 -2 -3 -7 -10 -20 -20 -15 -7 6 168 200 1

-1 -1 -2 -2 -1.5 -2.7 -3.8 -3.6 -3.6 -2.1 -1 0.66 18 22 0.11

34 37 40 43 93 135 147 336 373 552 606 774 640 371 1

Stevens used an after tax discount rate of 7.5% in this example (based on the figure used by Hambrecht & Quist) but comments that 12% may be more appropriate. It is important to appreciate that a fixed, yet low discount rate is employed. Harvard University academics, Rivette and Kline, discuss methods for assessing financial value of intellectual property and describe a knowledge capital discount rate as the expected rate of return for knowledge assets18. For software, biotech and pharmaceutical industries this is :At least 10.5%, after tax.

18

Rivette KG & Kline D, Discovering New Value in Intellectual Property. Harvard Business Review, Jan-Feb 2000.

For a decade or more we have been using a probability adjusted net present value model (developed by KPMG with Randersons involvement) in which probability adjustments are made to the cash flow as a consequence of each individual risk. In pharmaceutical development the risks are well defined, starting from the candidate molecule and progressing through preclinical development, Phase I, Phase II and Phase III trials. A number of sources provide statistics on transitional probabilities19. These factors relate to vaccines, new chemical entities and biopharmaceuticals: Biopharm Validation Pre-clinical Phase I Phase II Phase III Registration 0.57 0.88 0.86 0.93 1.00 NCE 0.70 0.50 0.35 0.65 0.50 0.90 Vaccine 0.57 0.72 0.79 0.71 0.96

Additional probability factors are determined through a technically competent risk assessment and variations to the published factors may be applied through insight into the differences between the average project and the specific one in question. Each probability factor is applied at the time at which the risk hurdle is encountered and it applies a linear discount to all future cash flows beyond that time point. Subsequent risk factors apply further linear discounts. Revenues received prior to a risk occurring, such as a milestone payment is unaffected by a future risk. Such models enable values to be determined at a future point once a risk has been overcome simply by setting the past risks at unity. Thus the models are ideal for project management - to assess whether a project is heading in the right direction and gaining in value, and for comparing projects of differing risk and for examining investment profiles. The models can be employed to explore different licensing scenarios comprising milestone payments and royalties. Similar method have now been made available on-line by Recombinant Capital. A recent publication by European-based McKinsey consultants reports a variance on the methodology. Mosho et al place a value on a project at the time of launch by discounting at a constant rate the sales revenue of the drugs (determined by top-down analysis and supported by bottom-up analysis)20. Mosho et al talk about a pharma R&D-specific WACC of 9%, citing Grabowski and Vernon. Thus a drug with sales of US$550m and ten years residual patent life, will have a value at launch US$2.8 bil based solely on revenues. From this they deduct 25% being marketing and sales costs and 25% for marketing and sales knowhow contribution by the drug company partner to the revenues. A further 10% is
19

DiMasi J, Clin Pharmacol Ther 58(1), 1995; Struck MM, Bio/Technology, 12:674, 1994; Struck MM, Nature Biotechnology 14:591, 1996. 20 Moscho A, Hodits RA, Janus F, Leiter JME, Deals that make Sense, Nature Biotechnology, 18:719, 2000.

deducted for manufacturing costs plus know-how margin and 2% for clinical development know-how. The final launch value is, in their example, US$1.06 bil. (It should be pointed out that, to this point, there is no difference to the determination of NPV based on free cash flow, except perhaps for capital cost considerations). In apportioning this value between the R&D partner and the licensing drug company, Mosho et al apply the following formula to estimate clinical development contribution:

RI =

1 (Y Y ) (1 + WACC ) l t pt

Where RI is the risk adjusted interest factor, pt is the success probability of the respective development stage, ie. from where the project is currently to the time of launch (for which they use published cumulative success factors), Yl is the projected year of launch and Yt is the year of the respective development stage.

This is simply a probability adjustment to the future income stream, or NPV at launch, with discounting back to present day. Again the WACC is the pharma R&D-specific WACC. It is not risk adjusted and is no-where near what a venture capitalist would expect. The authors did not go so far as to break-down the value over the various stages of development as this was not their purpose, although the formula allows this. On the basis of this approach, Mosho et al split the value at launch between the R&D partner and the drug company as US$743m and $315m respectively. The former they term the Margin for drug intellectual property and the latter, the Return on clinical development costs. In an alternative, and possibly equally applicable approach, McKinsey Consulting presented a method for the valuation of internet companies. A DCF is applied to a number of financial models based on what the subject company might look like once it has attained a sustainable, moderate growth state. Probabilities are applied to each scenario to give a weighted valuation across all scenarios21. There may, however, be some argument to a modest increase in discount rate above the CAPM due to growing competition and other unknown factors as a direct consequence of the fact that we are dealing with long time frames. Risks of competition and the unknown do increase with time and hence the cumulative effect of the discount factor is useful.
2. Summary

We would, therefore, propose that: The use of cost based methodologies is useful and valid. They may be used to determine a minimum value (depending on what one applies as the Entrepreneurs margin) as long as all evidence is that the R&D is both commercially oriented and technically viable to point at which the valuation is being undertaken; The use of Price to Earnings ratios is meaningless in the context of biotechnology. However, others have proposed a multiplier based on net tangible assets and this appears to have some merit; Analyses based on comparable values derived from market capitalisation of companies developing similar technology, private placement values, acquisitions and licensing deals are valid as long as one can be assured that the technology is truly comparable in science, application and status of development; The use of risk adjusted discount rates is inappropriate for R&D projects with long time frames. There is no valid basis for determining what a suitable risk

21

Desmet D, Francis T, Hu A, Koller T and Riedel G, Valuing Dot-coms. The McKinsey Quarterly, 2000(1).

premium, above the CAPM or WACC, and in any event such premiums should not be constant with time. A probability adjusted net present value is useful for valuations because the probability adjustments recognise the fact that once a risk is resolved there should be no further penalty imposed on subsequent cash flows. The tool is highly useful for updating valuations as time and risk varying independently.