If you’re a startup founder, or thinking of founding a startup, you’re most likely looking for capital to grow your business. Especially if you’re a startup in a capital-intensive industry like the life sciences or health care that’s planning on manufacturing a drug. Performing drug discovery and development requires a lot of money right up front.
Fundraising from angel, seed, and VC investors comes with a special vocabulary. You’ll typically hear this type of funding called early-stage funding/financing or equity funding/financing. If the only participants are venture capitalists, you might refer to it as venture capital financing.
Each financing is called a “round,” and equity-based rounds are typically a pivotal moment in a startup’s journey. Equity rounds often involve millions of dollars. Securing funding at this stage, however, requires the founders to provide equity in the company in exchange for capital.
Before any equity financing, it’s typical for startups to go through a pre-seed round, where the founders call on angel investors, friends, and family to invest. This is the initial capital to put the business in motion.
The founding team will then set the pace for a new injection of capital by calculating cash burn rate and cash runway, taking the business to the next stage of development. This new round of funding is referred to as a seed round, and, if subsequent rounds are raised, they are called Series A, B, C, and D rounds.
The Series rounds of investing are ordered by letters; Series A, B, C, D and so on. The A, B, and sometimes C rounds are considered early-stage. By the time a company reaches a Series C or D round, they typically have a fully developed product, a well-established market share, and are generating profit.
Some founders are able to fund their growth entirely through personal wealth and the support of family, generally called bootstrapping. But, those companies are more likely to be software companies and businesses that don’t require significant capital for infrastructure, unlike biotechnology and biopharmaceutical startups that rely on equipment, lab space, and manufacturing.
(Note: Here, we’ll broadly define biotechnology as the use of living organisms and their products for commercial purposes, and biopharmacy as the use of biological sources to develop a pharmaceutical drug.)
In the case of biotechnology startups, this capital secured in early-stage financing rounds is used for research and development that can prove the science behind a drug or therapeutic . The company may also begin to prove the drug or therapeutic being developed has a chance of FDA approval.
Later rounds, like Series C, D, E and beyond can help companies through their next phases of development: optimizing a product, generating even more revenue (or profits), and expanding the company’s market share. For biotechs, the early Series and even the late Series rounds may be used to fund preclinical studies, clinical trials, and FDA approval.
In order to raise seed or venture capital, a startup must undergo a valuation. To assign a valuation, the founders and investors use various methods to determine the company’s total value based on different metrics, depending on the valuation method used.
Valuations are critical to moving forward with an investment; it can’t happen without one. They are an essential part of any VC term sheet and the negotiations that follow. Valuation decides price-per-share, which in turn affects how much equity in a startup an investor will receive.
Despite the number of valuation methods available, it is often quite difficult to accurately value an early-stage startup. Angel investors and VCs will calculate a number of valuation models and scenarios and take a weighted average of them, creating a starting point for negotiations. After negotiations between the founders and investors are settled, a deal may continue at a certain price per share.
Startups calculate a new valuation for each equity-based financing round. The valuation will either be a pre-money or post-money valuation and, depending on which one, the valuation will alter the founder and investor’s ownership percentage. The differences between pre-money and post-money is critical to your capital raising strategy.
Valuation can become an incredibly complex topic. In this article, I’ll provide an overview of startup valuation, the methods that are used to determine a company’s value, and why valuation is important to founders. I’ll include some specific details regarding biotech startups, as they can differ significantly from tech startups. (The majority of startup-related content on the internet applies to SaaS companies and SaaS companies only.)
A valuation, in finance, is considered “the analytical process of determining the current (or projected) worth of an asset or a company.” Valuation is a huge factor in the percentage of company ownership you will exchange for capital. The importance of valuation in your startup’s journey through the early-stage financing rounds cannot be understated. It will significantly affect your business’s growth and your ownership stakes.
Understanding the methods by which you and potential investors can value your company will help you strategize raising capital, hopefully leaving you with a higher ownership percentage and more control in your company.
Valuation is tricky when a company is new and has little data regarding revenue, profits, or costs. Startup companies are often years away from generating a track record that can be used as part of a forecast. This issue is even more significant in life sciences, healthcare, and, specifically, biotechnology.
Where traditional corporate finance valuation methodologies work for established businesses and publicly traded entities, they often do not work for startups. Determining the value of longstanding companies is a matter of valuing the company as a multiple of its earnings before interest, taxes, depreciation, and amortization, or EBITDA. Valuation can also be determined based on other industry-specific multiples.
An investor performing a startup valuation must balance art and science. The value an investor assigns a startup may differ significantly from the value a founder assigns, adding cost and delay to the investment round.
The methods covered in this article cover a wide range of startups. However, many of these methods are specific to Tech companies. But these methods are also applicable to biotech startups, and, in some cases, a certain method is common practice. We’ll start with the approaches most commonly used in the life sciences industry to value new biotechs.
The Scorecard Valuation Method, also referred to as the Bill Payne Method, is a more elaborate valuation approach than some of the other methods used. (Bill Payne is a well-known angel investor with decades of experience investing.)
The Bill Payne Method, like the VC method and Berkus Method, is meant for pre-revenue startups. It is used by angel and VC investors participating in very early rounds of financing to value a brand new company. Pre-revenue, in this case, typically means pre-seed and seed stage companies.
When it comes to biotech startups, pre-revenue can include companies that go public through an initial public offering (IPO) because not all startups are alike. Biotechs and biopharmas deal in a specific type of product and typically have a much longer time horizon with higher regulatory and financial hurdles, making comparison to Tech companies less useful.
Using the Scorecard Method, you can determine a valuation for your startup based on a comparison between your company and other comparable ones that have already received funding. The method works best when you compare the reference company to your own at the same stage of development.
First, the average pre-money valuation of comparable companies is determined. This number is based on geography, competitive environment within a region, and the state of the U.S. economy. Once the average has been determined, the base value is then adjusted for certain factors, which are individually weighted based on their impact on the overall success of your venture.
Done correctly, you can see how your company stacks-up against comparable companies within the same industry, and region, using the following factors:
Each factor is weighted differently. According to Bill Payne, the weighting should be:
Next, assign each factor a “comparison percentage”. You can be on par (100%), below average (<100%), or above average (>100%) for each comparable quality of your “competitors”. For example, if you give one factor a 125% score because it outperforms the reference company, you’d then multiply 30% by 125% to get a factor of 0.375.
Once a comparison percentage and factor for each quality has been determined, you multiply the sum of all factors by the average pre-money valuation initially determined to arrive at your own startup’s pre-money valuation
The Scorecard Method requires a solid understanding of the average pre-money valuation of comparable companies within a region. As long as this data is available, investors have a useful, albeit subjective, technique to adjust the average valuation of similar startups and arrive at a pre-money valuation for your startup. As a founder, you can use this approach to prepare for valuation negotiations with investors.
The Berkus Method, developed by Dave Berkus, a well-known angel investor, attempts to approach valuations and investments from a risk perspective, instead of using an analysis-based approach comprising projections and forecasts. It’s used by investors, rather than founders, to assess whether or not an investment should be made, while also providing a valuation of the startup.
The Berkus Method considers the key elements of a company and gives each element a cash value. For example, if an investor values a company up to $500,000 in each category, the investor can decide how a startup should be valued and whether or not the risk is worth it. As a founder, knowing the Berkus Method can provide insights into an investor’s valuation for your company. The key elements include:
The sum of all the values designated to these elements results in the pre-money valuation for the startup. The Berkus Method, when including all five elements (valued at a maximum of $500K each) reaches a maximum pre-money valuation of $2.5MM. However, the value assigned to each key element and the total pre-money valuation can differ depending on the location of the company.
For instance, if the business is a tech company located in California, where competition is high, each assigned value could be $1MM or more. In contrast, if you’re located in a flyover state, it could be lower, at around $250K. Despite location, the company’s valuation and each element’s worth could potentially vary quite significantly based on its stage of development or the average valuation of comparable startups.
VC funding has increased over the last ten years. According to Wing VC, the median pre-money valuation for Seed companies in 2020 was $10.9MM, while Series A and B were $30.3MM and $100MM, respectively.
Life sciences funding saw a huge spike in 2020, which was outpaced in 2021. The increase in funding led to much larger rounds on average. According to PitchBook, in 2020, the average early-stage biotech’s pre-money valuation came in at $76MM, a sharp increase from 2018. 2021 saw the average as high as $115MM.
Clearly, early-stage startups are mustering larger valuations on average, with biotechs being valued at all-time highs. This drastically alters the $500K assigned to each element in the Berkus Method. However, according to Berkus, the pre-money valuation should not exceed $2MM.
Nonetheless, it remains a relevant method for angel investors and VCs. Its relevance can attributed to a number of factors:
The Risk-Factor Summation Method, also referred to as the RFS Method, provides a rough pre-money valuation for early-stage startups. It’s similar to the Berkus Method in its assessment of risk. However, it typically considers a larger number of factors for assessing a pre-revenue startup’s value.
The first step in the RFS Method is to set an initial pre-money valuation for the company, based on the average pre-money valuation of comparable companies in your region. A comparable company is one in the same industry and at the same stage of development when it received that valuation and subsequent funding.
Once an average pre-money valuation has been established, consider 12 risk factors that correspond with the startup and its industry. These factors are:
Some of these categories, such as management risk, stage of development, and competition risk, will be familiar to you. But others may be less familiar and harder to assess. For instance, litigation risk and exit value risk might be particularly difficult to grade.
Nonetheless, the RFS Method allows founders and investors to analyze the different risk factors for your startup from a range of very low to very high. The method encourages founders to assess any risks their company can face and map out ways to reduce those risks.
With a base value and risk factors determined, you can begin to adjust the value of the startup by assigning ratings to each risk factor. Adjustments are made using ratings, rather than percentage weights or multiples. These means a risk factor can receive a rating from +2 to -2:
RatingRisk Rationale$ Adjustment to Pre-Money Valuation+2Extremely Positive MitigationAdd $500,000+1Positive MitigationAdd $250,0000NeutralAdd/Minus Nothing-1Negative MitigationMinus $250,000-2Extremely Negative MitigationMinus $500,000
Source: Eqvista, “Risk Factor Summation Method: Everything You Need to Know”
If the element is considered low-risk (i.e., has an “Extremely Positive Mitigation” risk rationale), it receives a +2 rating, which means $500K is added to the valuation. On the other hand, if an element is considered high-risk (i.e., has an “Extremely Negative Mitigation” risk rationale), it receives a -2 rating, and $500K is subtracted from the valuation. In some cases, an investor or author may describe this rating system as having a range from double-plus grade (++) to double-minus grade (–). However, despite these rating systems being slightly different, the same effect is achieved.
Once every risk factor has been assigned a rating, add up all of the additions and subtractions to obtain a sum of all adjustments. This sum is then added to (or subtracted from, depending on your results) the average pre-money valuation you determined in the first. The result is an adjusted pre-money valuation for your specific company.
What makes the RFS method difficult is finding an objective point of reference to measure each component, as well as choosing the correct companies for comparison. This opens up the potential for a subjective valuation.. Using other methods, such as the Scorecard Method, as a starting point may help you when assigning a pre-money valuation for your startup.
Understanding risk in valuation will equip you to negotiate with potential investors. Furthermore, the group of startups you select for comparison will ultimately act as your benchmark, so it’s important that you have a strong understanding of which companies match yours.
Lastly, this approach is seen as a type of “glass-half-empty” method, in which only the negatives, and not the positives, are considered in the valuation. So remember to find ways to highlight the things your team is doing well.
The Venture Capital Method, also referred to as the VC method, is one the most common approaches VCs use to value an early-stage startup.
It focuses on the expected return on investment at the time of the company’s exit. Startups that are venture-backed try to exit after two to five years. However, this range applies more to software companies than to biotech and pharma. In the case of early-stage biotechs, the exit range generally increases to five to eight years. Furthermore, while an IPO is a major accomplishment for a startup, the biotech may still be years away from developing a new medicine, which can take 10 to 15 years.
The VC Method was first described by William Salhman in a case study published in 1987 titled “The Venture Capital Method”. The case study provides a formula for determining the pre-money valuation of a startup by calculating the post-money valuation using industry-specific metrics. It has since been revised, but the idea remains the same: a formula in two parts:
When using the VC Method, there are two key terms to know: terminal value and Return on Investment (ROI). Terminal value is the anticipated value of a company upon exit, and is used to establish an estimated selling price of shares. Return on Investment (ROI) is a measurement of the investor’s expected return as a percentage.
To illustrate this method, let’s go over the four fundamental steps:
The first step in the VC method is to estimate the expected earnings and revenues in the future, with a time range typically between two and five years. However, this range may change. The “forecast period” is set to the year when the investor and founders plan on a liquidity event, or sale of the company.
The second step sets an expectation for terminal value by multiplying the future earnings with the price earnings ratio (P/E ratio) of other comparable, publicly traded companies in the same industry. It’s important that the P/E ratio matches the success of the company. This means that your startup and the comparison company should match in economic characteristics. This match includes size, profitability, growth, capital intensity and risk.
Since earnings aren’t always available, revenue multiples can be used. The multiple an investor decides on will be applied to the projected earnings or cash flow in order to determine the company’s terminal value.
The third step calculates the discount rate. Several risks need to be considered. Three major risks include:
The terminal value is discounted at a rate that includes all risks so that the startup’s value can be established. This value is represented as the present value (the current value of a future sum of money or stream of cash flows given a specified rate of return).
In the final step estimates the equity share based on the money raised. The post-money valuation is the valuation calculated during the third step, plus the new capital the investors will inject. Investors are entitled to a portion of the company equity to the investment amount divided by the post money valuation.
While this method has its drawbacks—it’s often said to be too simplistic in its approach, and doesn’t account for the uncertainty of multiples—it is useful when evaluating how much money investors might make when the company exits. It is also helpful when an investor wants to compare different investment opportunities, since most VCs and angel investors have a minimum ROI goal.
Still, founders can use this method to equip themselves for valuation negotiations with potential investors.
The Comparable Transactions Method, also referred to as the Comparables Method, or Comparables Valuation, consists of two parts: the multiples valuation and transactions valuation.
Like the Discounted Cash Flow (DCF) Method, this approach is a type of equity valuation model. The DCF Method is based on the principle that an equity’s value is similar to other equities in a similar class. In other words, your startup’s pre-money valuation will be compared to similar companies and their transactions involving equity.
This method, although quick to build and relatively easy to understand, is not always useful when valuing biotechs. Many companies in the field are distinctly different. Traditional valuation multiples, such as EV/EBITDA (Enterprise Multiple) and P/E ratio (Price-to-Earnings Ratio), aren’t always relevant because many biotechs are not generating revenue.
The Discounted Cash Flow (DCF) method is an approach used to estimate the expected future cash flows of a startup, which determines a startup’s present value.
The DCF Method relies on assumptions backed by historical data, but most startups lack historical data when the founders begin raising capital. However, the method is useful when valuing biotech startups because it considers the market potential for each individual drug in a biotech startup’s drug portfolio.
By determining the forecasted free cash flow of each drug, you can establish individual net present value, or NPV. (NPV is essentially today’s value of a future cash flow.)
When added all together, the method calculates a fair value for the business today. However, you will want to only include drugs in your forecast that are in Phase I, II, or III clinical trials, because any drug that is in discovery or preclinical studies is seen as a highly risky investment.
If the startup does not have any drug candidates in a clinical trial, there may not be enough data to establish an accurate assessment of the company’s overall value. Moreover, very new businesses lack any revenues, profitability, or cash flow measures to build from and compare.
This overall lack of data, and the subjectivity of forecasting future events that may or may not happen, make valuing an early-stage biotech startup in the discovery phase using the DCF Analysis Method rather difficult. It may be prudent to build multiple scenarios and weight them based on probability, which is how the Risk-Adjusted NPV Method works. (It’s basically a modified version of DCF Analysis)
Certain traditional valuation multiples, such as EV/EBITDA (a.k.a. Enterprise Multiple) or P/E (Price-to-Earnings Ratio), tend to be less relevant when valuing pre-revenue biotechs conducting preclinical studies. There are some alternative multiples like EV/invested R&D and EV / Risk Adjusted Number of Clinical Assets, which is essentially a cost-based valuation worth researching. Eric Liu reviews these multiples in-depth, if you want to dig further into biotech-specific valuation.
If your company has a drug that is entering a Phase I clinical (or has already entered it), then the DCF Valuation Method will prove highly valuable. Investopedia does an excellent job of explaining the usefulness of DCF analysis in biotech valuations.
Lastly, an excellent, more technical valuation method used alongside the DCF approach is the Real-Options Valuation Method, comprising multiple analyses. It’s common to see this valuation method used in the biotech sector to provide an improved valuation; one that takes into account the opportunities and uncertainties inherent in biotechnology.
The Risk-Adjusted NPV method, or rNPV, modifies the DCF analysis by calculating the net present value of assets under a range of scenarios. By valuing NPVs according to specific scenarios, and by assigning probability-weighting, investors can estimate the risks in an uncertain venture (i.e., biotech startups).
rNPV attempts to account for the uncertainty in projecting future scenarios for highly unpredictable companiesThe method builds a projection of eventual revenue and adjusts for several factors. In general, the most important adjustments are costs, risks, and time.
Each factor plays an important role:
By accounting for these factors and using them to calculate a single rNPV, investors can establish a more accurate valuation for a startup. This realistic value, while more complex to create, can assist founders in negotiating a fair value with investors.
It’s difficult to say whether a startup, especially a biotech startup, can be valued accurately using any one method or combination of methods. Early-stage companies have very little data available to use. The startup’s successes, or failures, remain uncertain and projections or forecasts aren’t precise.
There’s a saying that startup valuation is more of an art than a science. That saying holds true the more you learn about startup valuation. However, many analysts have done their best to demystify valuation and predictability to investing in early-stage companies. Doing so makes the art of valuation a little more scientific in nature.
When it comes to biotechs and biopharmas, unlike companies with well understood revenue, investors deal in risk. As a founder, it’s important to show how you’ve de-risked investing in your company. Knowing the underlying frameworks of startup valuation can help you get the best deal from your side of the negotiation.
Even though you may hear countless stories of valuations being made on quick and dirty comparisons, having a strong understanding of several valuation methods can help you secure financing without giving up too much equity.
This article is informative and is not meant to be fully comprehensive or represent legal advice. Before valuing your company or raising capital through equity financing, speak with professionals who have experience in startup and venture capital deals.