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 firstname.lastname@example.org.