Spring 2013 issue of Horizons

The income approach determines the value of a business based on its expected earnings, or cash flow. With the market approach, the value of a business is determined by comparing the subject company to publicly traded shares of similar companies, or to like businesses which have recently been sold. The market approach can be difficult to apply to life sciences companies, as many of these companies provide innovative solutions for which there are no suitable comparable companies or transactions in the market. In using the asset approach, the value of a business is determined by considering the value of its assets and liabilities. This method is also called the cost approach, as it values a company based on the individual or component costs of its assets, rather than the future cash flow the company is expected to generate. The discounted cash flow method is used when a company’s future income stream is expected to differ from recent or current operating results, which is usually the case with early stage companies. Under the discounted cash flow method, the value of a business is determined by discounting future expected cash flow to present value using a cost of capital. The two inputs driving a discounted cash flow model are the projected cash flow and the discount rate, which is based on the timing and risk of receiving future cash flow. Projected Cash Flow Projected cash flow takes into account the company’s projected revenues, profitability, and required reinvestment. The required reinvestment is the capital that the company must invest to be able to earn the future The two methods used to determine value under the income approach are: 1. Direct capitalization method 2. Discounted cash flow method

cash flow; for example, purchasing new equipment or a building.

Life sciences companies are typically early stage, and are often pre-revenue or pre- profitability. It can be difficult to project future cash flow with any certainty without a track record of historical cash flow on which to base the projections. One solution is to create a decision tree, which uses a probability weighted scenario analysis to value a company. The decision tree on the following page provides an example of a probability weighted valuation. The joint probability is calculated by multiplying prior probabilities. For example, the first joint probability is calculated as 90% x 75% x 20% = 14%. The sum of all joint probabilities is 100%. The “valuations of future cash flow” are calculated in four separate discounted cash flow models (not shown) and then multiplied by their respective joint probabilities to determine the probability weighted value of the company of $217 million.

The three main determinants of the hypothetical company’s cash flow are:

1. Whether or not they successfully complete clinical trials

2. Whether the product receives immediate or delayed FDA approval

3. Whether the product receives high or low market adoption.

The decision tree allows us to consider these various scenarios, which is especially helpful when valuing early stage companies that have not yet started generating positive cash flow. Another benefit of the decision tree is that the valuation can be updated over time as the company reaches certain milestones or as market conditions change.

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