Valuation Metrics and Methods: DNA processing Healthcare Startups
While the exact metrics that are used to value Freenome and Grail, both biotechnology startups in the liquid biopsy space whose objective is the early detection of cancer through DNA analysis, could not be located in the public domain, a few sources reveal how pre-revenue biotech or health tech startups are typically valued. Based on these sources, biotech or health tech startups such as Freenome and Grail are often valued through one of two metrics or methods, the discounted cash flow (DCF) and the risk-adjusted net present value (NPV). The latter, which is the recommended method, takes into account the projected cash flows and the scenario or outcome probabilities.
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.
Strategy #1: We initially looked for articles, press releases, reports, and case studies in credible publications such as Bloomberg, BioSpace, Forbes, Reuters, and Taiwan Tech Arena to find information on how Freenome and Grail are valued. We also looked through Freenome and Grail's website to see if they include any information about how their investors valued their companies. While we came across sources indicating how much these startups are worth, including those published by Bloomberg and Taiwan Tech Arena, which note Freenome and Grail were most recently valued at $28 million-$42 million and $3.2 billion, respectively, we were unable to find any article or report detailing how the valuation was determined. It appears investors do not typically disclose how they value the startups they invest in. Using this strategy, we learned that both startups are biotechnology startups operating in the liquid biopsy space, so from here we employed a different strategy.
Strategy #2: We changed tactics and looked for similar companies. As Freenome and Grail compete directly with Guardant, Datavant, and Apostle, we checked first if the methods used to value these competitors are publicly available. In doing this, we looked through these competitors' websites as well as searching for press releases, articles, or other published information in sources such as Bloomberg, Reuters, and Forbes, and BioSpace. However, the closest information we were able to find was Guardant's Form S-1. Guardant recently undertook an initial public offering (IPO) and the only valuation methods mentioned in Guardant's registration statement were the valuation methods used in common stock valuation. Additionally, we came across DeciBio's report listing the questions investors should ask before investing in a startup in the space. While this information does provide some insight on the valuation process, it does not explain how investors value startups. Our next step in this strategy was to expand the scope of our search to include biotechnology startups in general. We found registration statements detailing common stock valuation methods, such as those of biotechnology startups Moderna and Allogene Therapeutics. However, searching for any information on how investors value biotechnology startups in general also did not return any specific data.
Strategy #3: Since searching for specific companies did not produce useful results, our final strategy was to look at how pre-revenue health tech or biotech startups are valued in general. We looked for articles, press releases, reports, and case studies that include information on this process in the same publications as listed in the above strategies. This third strategy proved more effective because it led us to a biotech valuation case study involving Syros Pharmaceuticals, Toptal's article on "biotech valuation idiosyncrasies and best practices," and Seeking Alpha's article on "how to value biotech firms." While we were not able to determine specific information on how investors value Freenome and Grail or biotechnology start-ups in general, these sources provide a number of helpful findings.