F-508 REAL OPTIONS FINAL PROJECT

Biolife Solutions: Valuation of the Option to Acquire Savsu

Trevor Allred & Ryan Rothgeb

Introduction

Company and Option Background

Biolife Solutions is a provider of cell preservation solutions for cell and gene therapy. Biolife
makes preservative solutions that allow the cells to maintain function after being out of the
body for a few days. This is vital as cell viability is critical for functional of these medicines. If the
cells die, they cannot perform their task and the therapy won’t be effective.

They are working to acquire more life science tools in the supply chain for these therapies and
have selected a company, Savsu, which they own 44% of, as a potential target for a full
acquisition. By acquiring Savsu, Biolife would be able to immediately enter into the supply chain
market for cell and gene therapies with cryogenic shipping containers.

Savsu has created next-generation cryogenic shipping containers and operates in a new portion
of the supply chain, providing shipping solutions, cryogenic storage and temperature
monitoring for these therapies. This is also a vital part of the supply chain for these therapies.
As an emerging and potentially dangerous set of therapies, it is vital that chain of custody and
chain of identity be maintained throughout the logistic process. It is therefore vital that they
remain within a specified temperature range and that there be a log of where the temperature
of the product has been at all times.

Biolife has an option to acquire the other 56% Savsu that they do not own for the greater of
either $23M in issued equity shares or 1M total issued equity shares with an option length of 18
months. Biolife paid $5M to increase their equity stake in Savsu from 36% to 44% and to
purchase this 18-month option. Was this a good value to Biolife? We need to value the option
and Savsu to find out.

Industry Background

Cell Therapies
Cell therapies are an emerging means of therapy for the treatment of many diseases. Cell
therapies may be allogeneic or autologous – allogeneic cells are cells which are harvested from
a donor and infused to a patient for a therapeutic effect. Autologous cells are derived from a
patient, modified and then re-infused or implanted for desired effect. Many of the new and
emerging therapies revolving around autologous cells are chimeric antigen receptor T-Cells
(CAR-T cells), tumor-infiltrating lymphocyte (TIL) therapy, or mesenchymal stem cell therapy.

CAR-T cells are cells that are modified to include a protein on the surface of the cell that
recognizes a target. These cells are generally used for treating various states of cancer and
therefore recognize an antigen (a protein on the surface of the cancer cell) that is specific to
that cancer cell. It then triggers a response within the T-cell which causes a cytotoxic (cell-
killing) effect in the cancer cell.

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TIL therapy involves selective growth of a type of lymphocyte which has properties that allow it
to destroy tumors. These therapies involve extraction of a tumor, lysis of that tumor to release
specific tumor-infiltrating white blood cells, depletion of all white cells and selective
amplification of a subset of those white blood cells through addition of a selective stimulating
growth factor. These are then reinjected into a patient at very high volumes to achieve a
therapeutic effect.

Mesenchymal stem cells have a wide range of applications. Doctors can remove portions of
organs or bones, apply them to a scaffolding with mesenchymal stem cells and facilitate
regenerative properties for these low-growth areas. These are then re-implanted back into a
patient where the restorative effect will be much faster than it would have been through a
patient’s normal healing process.

More ideas and modification continue to arise from the scientific community. Gene editing has
become a national topic of conversation as the potential to remove diseases from our
population through modification of our genome is now an actual possibility. There are a
number of public companies which have seized this as an opportunity and this may be the next
evolution in cell therapy.

Gene Therapies
There are several approaches to gene therapy. These approaches involve knocking out or
skipping a mutated or dysfunctional gene to achieve an effect, replacing a dysfunctional gene
with a healthy gene, or introducing a new gene into the genetic sequence which was previously
absent.

Gene therapies have the potential to treat diseases for which there has never been an effective
treatment for. Some of the most recent developments include Sarepta’s production of a gene
therapy which can treat Duchenne Muscular Dystrophy, Spark’s therapy for mutation-
associated retinal diseases, bluebird bio’s therapy for β-thalassemia with many more products
on the horizon.

These therapies involve identification of an erroneous genetic sequence associated with a

disease state. Researchers then develop the correct genetic code, identify a virus to implant the
genetic material, then develop a delivery vehicle which allows the virus to infect patient cells
and implant the new genetic information which will be integrated into the patient’s genome,
causing a therapeutic effect – theoretically in perpetuity.

Real Option Analysis

The real option that Biolife has is the option to acquire the remaining 56% of Savsu that is does
not currently own, and enter the supply chain market for cell and gene therapies with cryogenic
shipping containers.

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In this case, the underlying asset is the company, Savsu. There is a great deal of uncertainty
involved with Savsu, they have one major competitor which entered the space much earlier.
They are expected to have a superior product and service, but it remains to be seen if they are
technologically superior enough to warrant companies switching their processes to Savsu. It is
uncertain how much market share they may be able to get. It is also uncertain what their
growth rates might be and what kind of growth the industry will see going forward - many
companies may fail their cell and gene therapy trials.

Biolife’s option to purchase Savsu is similar to a company that would invest in research and
development and then have the option to enter the market with a new product. Instead of
spending in R&D on their own, they made an investment in another company and have the
option to fully acquire the company at the end of the period, much like a company would need
to scale production to enter a market.

This option is not just a straight forward call option though, as the strike price that Biolife pays
is tied to their own stock. There is effectively a floor price of $23 million that Biolife would have
to pay. It is slightly more complicated though, as the option is to buy Savsu for the greater of 1
million shares in equity or $23 million of equity. If Biolife’s share price goes above $23 per
share, then Biolife will effectively pay more in overall value to attain Savsu. The payoff for this
option will look like a call option to Savsu.

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They are going to get $23 million if Biolife exercises the option regardless, but if Biolife’s share
price goes above $23, then Savsu’s owners will receive linear growth in value for each dollar of
appreciation. This is effectively a changing strike price for Biolife and it is based on their own
share price. Essentially, the strike price is the greater of $23 million or 1 million times Biolife’s
share price at exercise. In valuing the option, Biolife’s share price is a second underlying asset
that needs to be factored into the option value.

Real Option Valuation

When valuing the option, one needs to know the starting value of the underlying, the volatility,
the risk-free rate, the strike price and the time to maturity. Many of the standard option inputs
for Biolife’s option are available information to us – we know the risk-free rate (assume 10 -
year US treasury rate), the time to maturity is explicitly stated, and we know the strike price.
We can also derive the staring value of the underlying from an NPV analysis.

Risk-Free Rate: 2.85%

Time to Maturity: 18 months
Strike Price: Max[$23 million, (1 million x Biolife stock price)]
Starting Value of Underlying: Derived from NPV analysis

To estimate the starting value of Savsu, we would use an NPV analysis and start DCF approach
to come up with a value at the expiration. We would forecast out the free cash flows of Savsu
and value the company using discounted cash flows. We would then adjust the values to
reflect the option is to buy the 56% of Savsu they do not own. To do this we would use an
approach like what was used in the Boeing Case, where we would have different cases for
different scenarios, and then assign probabilities to them. Based on these cases we would
adjust the inputs to the NPV model, like revenue growth, expenses, and synergies that could be
recognized by the acquisition.

Based on the industry demand for the new product and the potential competition from existing
and new entrants, we would develop a matrix that had different expected values of Savsu. For
simplicity sake, we would have nine possible outcomes in our valuation:

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After getting the possible values for Savsu in 18 months’ time, we would then probability
weight the values and calculate an expected value. If you assume P is probability (P1+P2+P3=1
and P4+P5+P6=1) and EV is expected value, you would get the formula:

E{18 Month PV }= (P1*P4*EV1)+(P1*P5*EV4)+(P1*P6*EV7)+(P2*P4*EV2)+(P2*P5*EV5)+

(P2*P6*EV8)+(P3*P4*EV3)+(P3*P5*EV6)+(P3*P6*EV9)

That would be the value in 18 months, so we would have to discount that back for 18 months at
the cost of capital. To get the appropriate required return, we would estimate the required
return using the CAPM model. That rate would be r, and would give us the following:

Today’s E{18 Month PV} = E{18 Month PV }/e(r*1.5)

This would be the expected value of Savsu at the beginning of the option. To get the static NPV
of the Savsu acquisition, we would have to discount the value of the strike price back 18
months also, and then subtract the value of Savsu at the beginning of the option that we
calculated. This would obviously not take into account the value of the option. Assuming
payment of $23M for 56% of the company, management would value Savsu at a minimum of
$41M upon exercise of the option.

The last item we need to value the option is volatility. In estimating the volatility, we need to
estimate volatility of each of these companies since both have influences on what the option
value would be. Given that Savsu is an even earlier stage company that Biolife, and a lot of
their value depends on the contracts that they will be able to get as they launch their suite of
products, we believe that Savsu will have significantly higher volatility to its share price
compared to Biolife.

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We would estimate the volatility of Savsu starting with the expected log return over the 18
months. Once we calculated the 18-month log return, we would calculate the 6-month log
return by dividing it by 3 (as we are using 6-month periods). We would then use the mean log
returns to calculate the variance in log returns, first calculating the 18-month standard
deviation and then dividing that by 3 to get the 6-month standard deviation. We would take
the square root of that number to then get the six-month variance we would need.

To estimate the volatility on Biolife stock, we could use historical information to derive what
the historical volatility has been. Being a publicly traded company, there is lots of stock price
data available that would be easily useable to estimate the volatility. We would estimate a 6-
month variance.

After establishing the assumptions, the next step is to calculate the risk neutral probabilities,
including the value of an up step, the value of a down step, and the discount rate between each
step. We would need to do this for both the value of Savsu and the share price of Biolife. If we
were actually valuing the option, we would use 18 one-month periods, but due to the dual-
underlying asset nature of the option, 18 periods make it very complicated and long to
illustrate. For simplification purposes, we are going to use 3 six-month periods, but the concept
would be the same and you could expand it out to 18 periods.

Value of the up step:

Savsu: U = e(σ*√(6/12))
Biolife: U = e(σ*√(6/12))

Value of down step:

Savsu: D = 1/U
Biolife: D = 1/U

Discount rate between each step:

Savsu: e(0.285*(6/12))
Biolife: e(0.285*(6/12))

After determining these, we would calculate the binomial trees for both underlying assets:

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The Rainbow Model

A rainbow option is an option that has two or more sources of uncertainty. As mentioned
earlier, the option for Biolife is a rainbow option because the value will depend on both the
value of Savsu and the value of its own stock. After determining the value of both underlying
assets with respective binomial trees, we would need to link the trees to get the value of the
option. With two sources of uncertainty, the value of Savsu and the effective strike price set by
Biolife’s stock price, at each step in the binomial trees there are four potential stares of nature:
(1) the value of Savsu increases and the share price of Biolife increases, (2) the value of Savsu
decreases and the share price of Biolife increases, (3) the value of Savsu increases and the share
price of Biolife decreases, and (4) the value of Savsu decreases and the share price of Biolife
decreases. An illustration representing the end of the first period is:

After the first period, there are four additional possible moves for each state, going from four
possible outcomes after period 1 to nine possible outcomes after period 2. This continues and
the number of possible outcomes for n number of periods is (1+n)2. It helps to visualize it like a
pyramid where the last period is the base, and each prior period is a higher progressive layer
until you reach the top where there is only one outcome. The value of an outcome at time t is a
block that is built upon its four possible outcomes at t+1 multiplied by the probability weighted
average of each block. Below is a visualization to show where the values would come from in
period 2 to derive the value for period 1 (the four red blocks from period 2 would be used to
derive the value of the one red block in period 1).

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With four possible steps instead of two, the value of a rainbow option is derived slightly
differently than a binomial option. A binomial option’s value at time t is equal to
[(q*Ut+1)+((1-q)*Dt+1)]/R where q is the risk neutral probability of an up move, U is the value of
the option in the up state, D is the value of the option in the down state, and R is the discount
rate for a period. With a rainbow option, there are more than just two moves and there is
possible correlation between the assets that needs to be considered, so q will be different. The
value of a rainbow option at time t is equal to
[(qUA,UB*U(A)t+1,U(B)t+1)+(qUA,DB*U(A)t+1,D(B)t+1)+(qDA,UB*D(A)t+1,U(B)t+1)+(qDA,DB*D(A)t+1,D(B)t+1)]/R
where qx is the probability weighted average of a specified move in the risk neutral world.

With Biolife and Savsu, there would be correlation between the underlying asset values. Biolife
already owns a stake in Savsu and investors know that Biolife has the option to acquire Savsu,
so the underlying value of Savsu should have an impact on Biolife’s stock price. For example, if
Savsu is doing very well and has a high value, that should have a positive impact on Biolife’s
stock price as investors would know that the option should be profitable for Biolife. This
correlation is something we would have to calculate, and it would be considered in the
calculation of q.

In the case of Biolife and Savsu, the q values would be calculated as the following where A is the
value of Savsu and B is Biolife’s share price:

qU(A),U(B) = (1/4)*[1+ρA,B+√t*[(r-0.5σ2A/σA)+(r-0.5σ2B/σB)]]
qU(A),D(B) = (1/4)*[1+ρA,B+√t*[(r-0.5σ2A/σA)-(r-0.5σ2B/σB)]]
qD(A),U(B) = (1/4)*[1+ρA,B+√t*[-(r-0.5σ2A/σA)+(r-0.5σ2B/σB)]]
qD(A),D(B) = (1/4)*[1+ρA,B+√t*[-(r-0.5σ2A/σA)-(r-0.5σ2B/σB)]]

After calculating q, we would start at the end of the final period and build backwards to value
the option. With the option being for Biolife to acquire Savsu, they would be purchasing the
remaining 56% of Savsu not already owned. If 56% of the value of Savsu is greater than the
strike price (the value Biolife would have to pay), then Biolife would exercise the option and the
option is worth the difference. If 56% of the value is less than the strike, they would let the
option expire and it would be worthless. The formula to calculate the value would be Option

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Value = Max[(0.56*Value of Savsu)-Max($23 million, 1 million*Biolife share price), 0] where the
value of Savsu and the Biolife share price are derived from the underlying binomial trees.

We would calculate this value of the option at the end of period 3 (18 months from now) for
each of the possible outcomes, and then work backwards, multiplying those values by the
respective q values we calculated to get expected values in period 2 for possible outcomes
using the formula:

Value=(qUA,UB*U(A)3,U(B)3)+(qUA,DB*U(A)3,D(B)3)+(qDA,UB*D(A)3,U(B)3)+(qDA,DB*D(A)3,D(B)3)]/R

This would be assuming that A is the value of Savsu and B is the share price of Biolife. We
would then repeat the process to get the values for outcomes in period 1, and finally the value
of the option at t=0.

To help describe the valuation process visually, the graphic below has a block for each possible
outcome of the two underlying assets, Asset A being Savsu and Asset B being Biolife. A U next
to the asset signifies an up move, while a D signifies a down move (AUUU, BUDD would be the
state where Savsu had 3 up moves and the Biolife share price had 1 up move and 2 down
moves). We would calculate the value for each of the blocks below, starting in period 3 and
then working backwards to the one block for t=0. Assuming A is Savsu and B is Biolife, the value
at the end of period 3 is Value = Max[(0.56*A)-Max($23 million, B*1 million), 0] for each
possible outcome. You would then multiply the value calculated in those blocks by the
respective q to get the values in period 2 (12 months from now), period 1 (6 months from now),
and the at time 0.

The value calculated from working backwards to today is the value of the option, and in theory
is the maximum amount that Biolife should pay for the option. That is the value that takes into
account the value of learning that the static NPV does not capture.

It should be noted that we are assuming Biolife will not exercise the option early and that there
is no convenience yield in holding Savsu. In reality, this may not be the case, but it is a
simplifying assumption we are making to be able to value the option. With Savsu being a

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private company, it is not known to us if the company is cash flow positive or if there are other
factors that could lead to them having a convenience yield.

Management’s takeaway

Management needs to evaluate the opportunity that lies within the business that it wants to
acquire, specifically what the opportunity is and how much penetration and acceptance the
new shipping system and smart containers will have. Negotiating an option to acquire the
company will allow them to purchase at a time when Savsu will be cash flow positive while
keeping the company off of its financial statements until that time. It also allows Biolife to
evaluate how much acceptance Savsu is getting amongst the cell and gene therapy companies
with which it is trialing its products.

The option also gives Biolife the opportunity to not purchase the company if they do not do
well with their product launches, obviously a very volatile time. Biolife needs to decide what
kind of value it should attribute to the learning that will come over this 18-month period in
which it can purchase Savsu. They also need to evaluate what value they receive from being
able to keep a potential dilutive company off their financial statements.

What will require far more evaluation is whether they exercise early and at what price. While
we assume Biolife would not exercise early in our proposed valuation, they do have the ability
to exercise at any time. We estimate that management would only truly exercise this option
early if Savsu is able to make significant strides in providing services to cell and gene therapy
companies, or, if Biolife has extreme confidence in their share price appreciating above $23 and
staying above that level or dropping precipitously. Management would likely want to bring
Savsu’s value into the company early if it is accretive to their cash flow and they want to bring
public how effective Savsu has been.

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