The Valuation Dilemma: VCs vs Pharmaceutical Companies
I had an interesting discussion with one of the biotech entrepreneurs last week. He was curious to see that when he discusses the value of his product with the VCs, he gets a very different value. On the other hand side, the pharmaceutical companies provide a different value based on the fundamentals – future cash flows, risks and the growth of the product. Let us understand this case by case.
The Venture capital typically uses their target rate of return to discount the estimated value at the end of the forecast period. These target rates are set very high. For example for a start up, the typical target rates of return varies from 50% to 70%, for first stage it could range from 40% – 60% and so on. However, these rates are not the actual discount rates of the project. These target rate of returns are very high because they have survival risks built into them. This is evident from the fact that first of all, these rates tend to decrease as the project moves through the life cycle and the chances of failure drops off and second, the actual returns earned by VCs are nowhere near their target rates of return. For example – The early stage investors earned an annual return of 21.4% over the last 20 years as opposed to their target return of 50%-70%.
Instead of making it explicit that their rates of return have survival risks embedded into it, VCs use these high rates as their negotiating tool to push the value down. So, the value of an early stage product will be perceived very low by a VC due to very high target rate of return.
The value of a product will be different if it is out licensed to a public pharmaceutical companies than to a private pharmaceutical company. The reason is that the marginal investors in the public companies are diversified and the only risks they care about is the market risk. In case of private companies, the investors/owners are exposed to not only the market risks but also all of the risks. This pushes up the discount rates. Hence the value of the product if out licensed to a public company will be higher than that to a private company.
You might argue whether the public pharmaceutical companies would pay the higher value or the lower value? This would depend on how many buyers you have. If you have only one public company interested in your product, you do not have a choice. However, if there are 2-3 public companies competing for your product, you might like to push the value to the point which is win-win for both parties.
– Saurabh Mishra