Spring 2013 issue of Horizons

LIFE SCIENCES

Decision Tree: Valuing A Life Sciences Company

Probability Weighted Valuation

Valuations of Future Cash Flow

Clinical Trials

FDA Approval

Market Adoption

Joint Probability

14% Probability of completion of clinical trials, immediate FDA approval, and HIGH market adoption 54% Probability of completion of clinical trials, immediate FDA approval, and LOW market adoption 2% Probability of completion of clinical trials, delayed FDA approval, and HIGH market adoption 20% Probability of completion of clinical trials, delayed FDA approval, and LOW market adoption

20% Probability of HIGH market adoption after immediate launch 80% Probability of LOW market adoption after immediate launch 10% Probability of HIGH market adoption after delayed launch 90% Probability of LOW market adoption after delayed launch

DCF Model #1

$500,000,000

$70,000,000

75% Probability of immediate FDA approval

DCF Model #2

$250,000,000

$135,000,000

90% Probability that clinical trials are successfully completed

DCF Model #3

$100,000,000

$2,000,000

25% Probability of delayed FDA approval

DCF Model #4

$50,000,000

$10,000,000

10% Probability that clinical trials are not competed (no FDA approval, no market adoption)

10% Probability that clinical trials are not completed

$0

$0

$217,000,000

Cost of Capital Another tricky aspect of valuing early stage companies is determining an appropriate cost of capital, which is the rate of return that the market requires in order to attract funds to a particular investment. A company’s weighted average cost of capital (“WACC”) is calculated by determining the company’s cost of equity, after-tax cost of debt, and optimal capital structure. Specifically, WACC = re x we + rd x wd x (1-T), where re is the cost of equity, we is the percentage of equity in the capital structure, rd is the cost of debt, wd is the percentage of debt in the capital structure, and T is the corporate tax rate. The WACC captures systematic risk, industry risk, and company specific risk.

Pepperdine University publishes the Pepperdine Private Cost of Capital Survey biannually, which surveys market participants for required rates of return in various investment categories throughout the United States. The table at the top of the following page includes data from 68 respondents to the bank debt survey, 74 respondents to the mezzanine debt survey, 152 respondents to the angel investor survey, 213 respondents to the venture capital survey, and 327 respondents to the private equity survey. In addition, the latter portion of the table includes public equity data from 1926 through 2011 published by Morningstar.

page 24 | horizons Spring 2013