METRICS USED TO VALUE BIOTECH STARTUPS

• Healthcare investor Dale Hershman explains how he arrived at his valuation of Syros Pharmaceuticals, a biotech startup he invested in. He describes the valuation formula he used as "potential revenue from assets x number of assets x probability of success."
• In using this formula, he excluded pre-clinical assets or "very young molecules that are still being tested in mice, or in cell cultures," as the value of these pre-clinical assets are very hard to assess.
• In determining the revenue potential, he took into account the prevalence of the targeted disease, the potential price, and the probability that the drug or technology will be approved by the U.S. Food and Drug Administration (FDA). This is because not all biotechnologies reach FDA approval. For example, the odds that drugs or technologies in Phase I testing will reach FDA approval are only around 10%, and the odds that drugs or technologies in Phase II testing will reach FDA approval are only around 30%.
• In the biotech space, the pipeline is what justifies a company's value. As most biotech startups do not have any sort of revenue or profitability yet, valuation multiples such as P/E or EV/EBITDA will not apply. Each biotech firm has its own idiosyncrasies as well, so the use of public market comparables will often not be appropriate too.
• Compared to startups in other industries, biotech startups have a different risk profile that needs to be incorporated in the valuation analysis.
• In the biotech space, where Freenome and Grail operate, "the probability of success is very hard to predict; success [is not] binary and the payoff is complex as well."
• Financial analyst Raphael Rottgen says there are two valuation approaches by which this high-risk profile can be taken into account: (a) the discounted cash flow (DCF) method in which a high discount rate is used to reflect the huge risk biotech firms face and (b) the risk-adjusted net present value (NPV) method in which the various outcome scenarios are assigned weights or probabilities. According to Rottgen, of these two methods, the risk-adjusted NPV method is the more reliable one.
• The risk-adjusted NPV method involves two key elements, the projected cash flows plus the scenario probabilities. The valuation process should be performed for each asset in the pipeline.
• As biotech startups have their own peculiarities, projected cash flows should be determined from scratch, not from comparables. Biotech startups have only cash outflows in the development stage. Only when the market is reached will there be cash inflows.
• In forecasting revenues, items such as potential customers, epidemiology, growth rate, market share, access, competition, adoption, partnerships, regulations, and price need to be considered.
• The scenario probabilities, on the other hand, should take into account the probabilities of success and approval at each development stage (e.g., new drug application, Phase I, Phase II, and Phase III).
• Investors look beyond the standalone value, as defined by the DCF or the risk-adjusted NPV, and take into account operational, strategic, and financial synergies as well.

QUESTIONS INVESTORS ASK BEFORE INVESTING IN LIQUID BIOPSY

•  Is the performance of the test superior to what is on the market at present? If it is not, does the company have a foolproof plan to make it superior to existing tests?
•  Can the company clearly explain how the test is better?
•  Is the company pursuing a compelling application?
•  Does the liquid biopsy assay make use of an established platform?
•  Does the business model make sense? Regardless of whether the company plans to distribute kits or offer centralized service, does the company have the ability to carry out its business model effectively?
•  What types of data does the company have access to?
•  What barriers to entry does the company create for its competitors?
•  Have the product specifications been vetted by a technical expert on the company's team?
•  What do initial customers say about the test?
•  Does the leadership team have the necessary market expertise?
• Please note, investors are advised to answer these questions before investing in a liquid biopsy startup such as Freenome and Grail. Though these questions are not explicitly about valuation, they offer insights into what makes a liquid biopsy startup worth more than another.

RESEARCH STRATEGY