For biotech companies, the valuation
process can sometimes be a long and
difficult one. In fact, according to Carl Saba, Senior Manager, Consulting, for Burr
Pilger Mayer in San Francisco, valuation is
one of the biggest issues biotech companies
are currently facing.
“The Financial Accounting Standards
Board (FASB) increasingly requires fair value
measurements in accounting, so valuations
are needed in order to comply with financial
reporting requirements,” says Saba.
Saba notes that, in general, valuations are
done for financial reporting, tax purposes,
mergers or acquisitions, or in litigation. He
says that while most of the time biotechs will
fall under the first two categories, the exposure risk makes it imperative to get one —
regardless of what stage of development the
company is in.
Smart Business spoke with Saba about valuations, and how biotech companies can use
them to their advantage.
What are some of the tax and accounting
requirements that drive valuations for
biotech companies?
Many biotech companies issue stock
options to employees in order to conserve
cash resources, because the biotech business
model generally takes a long time to mature.
When a biotech does this, there are both tax
and accounting implications.
On the accounting side, Financial
Accounting Standard 123 (FAS 123) was
recently revised, becoming FAS 123 (R),
which, in part, says that companies have to
expense the fair value of their stock option
awards on their income statements. Under
the old rules, stock options didn’t have to be
expensed on financial statements; they were
generally shown as a footnote disclosure. In
order to expense options under FAS 123 (R),
biotechs need to know what grants are worth
on the grant date and, in order to value that
option, they must know what the underlying
stock is worth. Biotechs primarily use valuations as a basis for valuing options, and subsequently expensing them. If they don’t, they
may have issues clearing an audit or possible
restatement risk if the company becomes
public, and thus, subject to SEC review.
On the tax side, IRS Section 409A deals
with deferred compensation, and part of that
covers stock options. IRS Section 409A prevents companies offering stock options to
employees from setting the exercise price on
the option below the fair value of the underlying stock. If they do, the grant becomes
subject to IRS Section 409A, and both the
issuing company and the employee can face
adverse tax implications.
What risk factors do biotechs face in valuations?
There is significant tax exposure to a company’s employees in the issuance of options,
so if the company doesn’t complete regular
valuations, it could be in trouble. Also, unlike
in the past, a company’s board of directors
cannot ‘decide’ what the stock is worth without a proper valuation analysis to support
that conclusion. The Silicon Valley rule of
thumb establishing a 10 to 1 or 8 to 1 ratio
between common stock and preferred stock
will likely not hold up to an IRS audit under
409A. On the financial reporting side, the
risks are either not clearing an audit or
restatement if the company becomes public
and there is a large gap between a recently
determined stock value and the IPO price.
What are some of the challenges that come
up in valuations of biotech companies?
The biggest challenge is that the business
model for most biotechs takes time to
mature. Typically, a biotech will spend 10 to
15 years incurring heavy research and development expenditures, while trying to generate compounds that might have marketability, and then try to get them through all the
stages of preclinical and clinical trials. Thus,
a lot of conventional valuation approaches
don’t work. Most valuations use income, cost
or market approaches. The cost approach
doesn’t generally apply to a going concern
company, and the income approach is reliant
on the ability to forecast future cash flows,
which is difficult to do as far as 10 to 15 years
out. The market approach uses metrics that
are typically related to positive cash flow,
which is non-existent for most early-stage
biotechs. A biotech has to try to determine
possible future outcomes for the company
and the relationship between current expenditures and future results.
What makes biotech valuations unique?
As biotechs have to keep raising capital for
an extended period of time, they often end up
with complicated capital structures. There
isn’t just one type of ownership, such as common stock. Other types of ownership include
a layered capital structure, with common
stock, preferred stock and, possibly, convertible debt, options and warrants. One has to
value the biotech’s total equity, then determine how to allocate it among the layers of
ownership. There are three ways to do this: a
probability-weighted approach based on
future outcomes, a forward-looking option
model, or by considering the company’s
worth on the valuation date — which is only
acceptable in very limited circumstances.
The body of knowledge, models and expectations within the valuation profession have
increased dramatically. I expect that we will
continue to refine our ability to address the
unique challenges in valuations of biotechs.
CARL S. SABA is Senior Manager, Consulting, for Burr Pilger
Mayer in San Francisco, California. Reach him at (415) 288-6261
or [email protected].