OneStart 2015 London Bootcamp: Matt Foy, SR One - Value: What is it, how do we measure it and why is it so important?

Fundamental Value:
What is it, how do we measure it and what can we learn from it?
Matthew Foy

Table of Contents
Executive Summary
What is Value?
Introduction to Fundamental Valuation
Applying it to Biotech
Implications for Biotech

Executive Summary
Creating “Value” is the primary goal of all business
enterprise
Being able to measure fundamental value enables rational
decision making
This is embodied by a “Discounted Cashflow” analysis
– For which the “Time Value of Money” is the underlying principle
– However, biotech is a special case
Understanding these concepts provides insight into many
critical aspects of biotech entrepreneurship beyond
valuation

What is Value?
The goal of all business enterprise is to create monetary
value for its shareholders
Linking back to this fundamental principle is / should be
what drives ALL decision making
– Build a new factory
– Roll out employee training programme
– Expand into the emerging markets
– Shut down an unproductive R&D site
– Sell a division
– Buy a competitor
– Raise capital - equity or debt
– Distribute cash to shareholders: dividends or share buybacks
Being able to measure the value impact of each of
these allows us to decide whether to do it

£30
£300£36
£60
£50
£40
£84
£0
£50
£100
£150
£200
£250
£300
£350
Costs Revenue Profit / Value
Materials Labour
Rent Sale Price
Net Profit
Tax VAT
Basic example
An amateur carpenter makes a table
– The cost of materials is £30
– It takes him 5 hours, when he could otherwise be earning £10/hr driving
for UBER…lost income / labour cost of £50
– He had to rent a workshop in a local university for £40
– He sells it on MADE.COM for £300, less 20% VAT = £240…A profit of £120
– He pays 20% in tax...leaving a Net Profit / Value of £84
Based on this making tables is a more value creative endeavor
than UBER and he should change career
Note: Return = revenue / total costs… £200// £110

Table of Contents
Executive Summary
What is Value?
Introduction to Fundamental
Valuation
Applying it to Biotech
Implications for Biotech

Carpenter Profit & Loss Statement (P&L)
Revenue £300
VAT (£60)
Net Revenue £240
Cost of Goods:
Materials (£30)
Labour (£50)
Gross Profit £160
Central Costs:
Rent (£40)
Operatig Profit £120
Tax (£36)
Tax Rate 20%
Net Profit £84
Introduction to Financial Statements
Financial statements are numerical representations of what
is happening in a business
Further Reading
The other main financial statements are:
- Balance Sheet
- Cashflow Statement
- Statement of Shareholders Equity
We won’t go into these here other than to mention that the
difference between the P&L and Cashflow Statement is
timing and depreciation:
- Cashflow logs when cash is paid / received
- P&L logs when it is “accrued”: items are bought, services
received…but it often invoices aren’t paid until later, or
sometimes cash is paid upfront for services to be received
later
- And if there is an asset that is purchased in year 1, but
you have the use of for many years e.g. a hammer, the
P&L spreads the cost of this over time “depreciation”
- For this seminar you should assume they are the same

Carpentry Business
So let’s assume he does set up a full time carpentry
business and in 2015 he builds and sells 100 tables
And beyond that he intends to continue to grow rapidly
A large design company is looking to acquire young start-
ups and takes notice…how do they decide whether to try to
buy it?
They assess the Carpentry Business’ “Fundamental Value”
by building a financial model that makes predictions about
the Company’s performance
If they can negotiate a sale price with the carpenter
that is less than this, they will have created value and
therefore should do the transaction

Casflow Forecasts
Assumptions about growth and keeping the costs %-of-
revenues constant, drives the cashflow / net profit up to
£29,300 in 10yrs time
The “bottom line” is all that counts…a stream of cashflows
flowing to the owner of the business…so what is this worth?
Fiscal Year Ending December
Historical Estimated
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
(all figures in £'000 unless otherwise stated)
No. Tables 100 120 144 173 199 229 263 289 318 350 367
Growth 20.0% 20.0% 20.0% 15.0% 15.0% 15.0% 10.0% 10.0% 10.0% 5.0%
Price (less VAT) 240 240 240 240 240 240 240 240 240 240 240
Net Revenue 24.0 28.8 34.6 41.5 47.7 54.8 63.1 69.4 76.3 84.0 88.1
Cost of goods (8.0) (9.6) (11.5) (13.8) (15.9) (18.3) (21.0) (23.1) (25.4) (28.0) (29.4)
Rent (4.0) (4.8) (5.8) (6.9) (7.9) (9.1) (10.5) (11.6) (12.7) (14.0) (14.7)
Marketing (1.5) (1.8) (2.2) (2.6) (3.0) (3.4) (3.9) (4.3) (4.8) (5.2) (5.5)
Capital expenditure (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0)
Tax (1.7) (2.1) (2.6) (3.2) (3.8) (4.4) (5.1) (5.7) (6.3) (6.9) (7.3)
Cash Flow 6.8 8.5 10.5 12.9 15.1 17.6 20.5 22.7 25.1 27.8 29.3
Accounted for annual capital expenditure. This is the
purchase of long term goods e.g. tools...in the P&L,
this would be represented as Depreciation

The Time Value of Money
We could just add up the cashflows: £190,000…but this has
two problems:
– We have only modelled out to 2025…what about after that? Any growth at all
would make the value infinite
– We haven’t accounted for the “Time Value of Money”
Money in hand today is worth more that the same amount of
money promised in 10 years time
There is risk that the money never turns up…but what if the
UK government is your payer…effectively zero risk
You could be doing something else with the money in the
meantime, had you not tied it up in the Carpentry
business…“Opportunity Cost”

The Time Value of Money
If you had £100 today and you put it in a bank account, you
could earn 2% in interest
Therefore by 2025, your bank balance would be £121.90
having taken no risk
The other way round £121.90 in 2025 is worth £100 today on a
risk free basis by applying a Discount Rate of 2%
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
(all figures in £ unless otherwise stated)
Cash Flow 100.0 102.0 104.0 106.1 108.2 110.4 112.6 114.9 117.2 119.5 121.9
Interest Rate 2% 2% 2% 2% 2% 2% 2% 2% 2% 2%
Discount time period: - 1 2 3 4 5 6 7 8 9 10
Discount rate 2%
Discount factor 100% 98% 96% 94% 92% 91% 89% 87% 85% 84% 82%
Net Present Value 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Discounted Cashflow (DCF)
We apply the same logic to the carpentry business and
consider each year of cashflow as an individual promise in
the future
However, a business is not risk free and because of this
returns are expected to be higher and therefore the Discount
Rate is higher…for a start-up maybe 15%
We also need to account for the fact that all-going-well, the
company will survive beyond 2025
We make an assumption about growth into the
future…usually set at a very low number near inflation and
assume that continues to infinity
– However, because we also discount this back to today the value becomes a
rational number

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
No. Tables 100 120 144 173 199 229 263 289 318 350 367
Growth 20.0% 20.0% 20.0% 15.0% 15.0% 15.0% 10.0% 10.0% 10.0% 5.0%
Price (less VAT) 240 240 240 240 240 240 240 240 240 240 240
Net Revenue 24.0 28.8 34.6 41.5 47.7 54.8 63.1 69.4 76.3 84.0 88.1
Cost of goods (8.0) (9.6) (11.5) (13.8) (15.9) (18.3) (21.0) (23.1) (25.4) (28.0) (29.4)
Rent (4.0) (4.8) (5.8) (6.9) (7.9) (9.1) (10.5) (11.6) (12.7) (14.0) (14.7)
Marketing (1.5) (1.8) (2.2) (2.6) (3.0) (3.4) (3.9) (4.3) (4.8) (5.2) (5.5)
Tax (1.7) (2.1) (2.6) (3.2) (3.8) (4.4) (5.1) (5.7) (6.3) (6.9) (7.3)
Cash Flow 6.8 8.5 10.5 12.9 15.1 17.6 20.5 22.7 25.1 27.8 29.3
Discount rate 15%
Discount factor 100% 87% 76% 66% 57% 50% 43% 38% 33% 28% 25%
Net Present Value / DCF 6.8 7.4 7.9 8.5 8.6 8.7 8.9 8.5 8.2 7.9 7.2
Terminal value
Valuation Final year cashflow £29,252
Sum of NPV Cash Flows £81,897 Perpetuity growth 2.0%
NPV Terminal Value £56,733 Terminal value (as at 2022) £229,516
2024 discount factor 25%
Total NPV £138,630 Net present value of terminal value £56,733

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
No. Tables 100 120 144 173 199 229 263 289 318 350 367
Growth 20.0% 20.0% 20.0% 15.0% 15.0% 15.0% 10.0% 10.0% 10.0% 5.0%
Price (less VAT) 240 240 240 240 240 240 240 240 240 240 240
Net Revenue 24.0 28.8 34.6 41.5 47.7 54.8 63.1 69.4 76.3 84.0 88.1
Cost of goods (8.0) (9.6) (11.5) (13.8) (15.9) (18.3) (21.0) (23.1) (25.4) (28.0) (29.4)
Rent (4.0) (4.8) (5.8) (6.9) (7.9) (9.1) (10.5) (11.6) (12.7) (14.0) (14.7)
Marketing (1.5) (1.8) (2.2) (2.6) (3.0) (3.4) (3.9) (4.3) (4.8) (5.2) (5.5)
Tax (1.7) (2.1) (2.6) (3.2) (3.8) (4.4) (5.1) (5.7) (6.3) (6.9) (7.3)
Cash Flow 6.8 8.5 10.5 12.9 15.1 17.6 20.5 22.7 25.1 27.8 29.3
Discount rate 15%
Discount factor 100% 87% 76% 66% 57% 50% 43% 38% 33% 28% 25%
Terminal value
We apply a 15% Discount to each year’s
cashflow to translate it into its equivalent
value today…Its Net Present Value
Cash Flow 6.8 8.5 10.5 12.9 15.1 17.6 20.5 22.7 25.1 27.8 29.3
Discount rate 15%
Discount factor 100% 87% 76% 66% 57% 50% 43% 38% 33% 28% 25%

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
No. Tables 100 120 144 173 199 229 263 289 318 350 367
Growth 20.0% 20.0% 20.0% 15.0% 15.0% 15.0% 10.0% 10.0% 10.0% 5.0%
Price (less VAT) 240 240 240 240 240 240 240 240 240 240 240
Net Revenue 24.0 28.8 34.6 41.5 47.7 54.8 63.1 69.4 76.3 84.0 88.1
Cost of goods (8.0) (9.6) (11.5) (13.8) (15.9) (18.3) (21.0) (23.1) (25.4) (28.0) (29.4)
Rent (4.0) (4.8) (5.8) (6.9) (7.9) (9.1) (10.5) (11.6) (12.7) (14.0) (14.7)
Marketing (1.5) (1.8) (2.2) (2.6) (3.0) (3.4) (3.9) (4.3) (4.8) (5.2) (5.5)
Tax (1.7) (2.1) (2.6) (3.2) (3.8) (4.4) (5.1) (5.7) (6.3) (6.9) (7.3)
Cash Flow 6.8 8.5 10.5 12.9 15.1 17.6 20.5 22.7 25.1 27.8 29.3
Discount rate 15%
Discount factor 100% 87% 76% 66% 57% 50% 43% 38% 33% 28% 25%
Terminal value
We then add up all of the Net
Present Cashflows
And calculate the Termal value
out to infinity assuming a 2%
growth rate

Decisions, Decisions & Negotiation
The DCF tells us that the Fundamental Value of the Business
is £138,630, so should the acquirer pay that?
NO! They would exchange one asset worth £138,630 (Cash)
for another of equivalent value (Business)…no value created!
Therefore they need to offer less and thus make it a value
creating decision
How much less comes down to what other value creating
opportunities the Company has; and
What the entrepreneur is willing to accept…which will be
based on his own financial aspirations and if he can get other
buyers interested and create an auction

Biotech Valuation
Unfortunately the financing of drug development is more
complicated
Before a drug gets to market a significant amount of
preclinical and clinical development must be done
All of this work can take 8 – 12 years and costs a large
amount of money
To so for all this time the company is losing money;
It only starts making positive cashflow once approved by
the regulators
But as we know money promised in 10yrs is worth
significantly less then money today

Biotech Valuation
Additionally, for many different reasons most drugs never
make it to market and so they never make any money
BUT, they have incurred all of the development costs up to
the point where the drug fails
For this reason the probability that you incur the near term
expenditures is significantly higher than the revenues you
hope to make
And then after all that, having taken 12yrs to get to market,
the patent life is 20yrs and so expires after 8yrs of revenue
Soooooo, our DCF needs adjusting:
– Risk-adjust the cashflows
– No Terminal Value: generic competition reduces revenue close to 0

Key milestones Duration
Year of
completion
Probability to
reach revenue
Probability of
passing stage
Probability to
reach stage
Costs
Cumulative
Costs
Implied cost /
approved drug
Start / patent approval 01-Jan-15 5% 100.0% 100.0% £1m £1m £20m
Preclinical 3yrs 31-Dec-17 5% 20.0% 100.0% £15m £16m £300m
Phase 1 1yrs 31-Dec-18 25% 71.4% 20.0% £10m £26m £40m
Phase 2 2yrs 31-Dec-20 35% 48.6% 14.3% £20m £46m £57m
Phase 3 3yrs 31-Dec-23 72% 88.9% 6.9% £150m £196m £208m
Approval 2yrs 31-Dec-25 81% 81.0% 6.2% £5m £201m £6m
Ramp up years 2yrs 31-Dec-27 100% 100.0% 5.0%
Revenues 8yrs 31-Dec-35 100% 100.0% 5.0% £632m
Biotech Valuation
Looking at historical data shows us that only c.5% of drugs
make it to market
The example below shows that it costs c.£200m to get a drug
to market
However, accounting for all the failures this becomes >£600m
These numbers will vary widely based on: indication, patient
availability, statistical powering, manufacturing complexity etc

Revenues Patent Expires
2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037
(all figures in £m unless otherwise stated)
Cash Flow 333 667 1000 1000 1000 1000 1000 1000 1000 1000 -
Operating Costs (167) (333) (500) (500) (500) (500) (500) (500) (500) (500)
Margin 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Operating Profit 167 333 500 500 500 500 500 500 500 500 -
Margin 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Probability to reach stage 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 100%
Risk-adjusted cashflow 8 17 25 25 25 25 25 25 25 25 -
Discount time period: 13 14 15 16 17 18 19 20 21 22 23
Discount rate
Discount factor 16% 14% 12% 11% 9% 8% 7% 6% 5% 5% 4%
rNPV 1 2 3 3 2 2 2 2 1 1 -
Sum of rNPVs 4
Ramp-up
Fiscal Year Endin
Patent Phase 1
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Cash Flow (1) (5) (5) (5) (10) (10) (10) (50) (50) (50) (3) (3)
Operating Costs - - - - - - - - - - - -
Margin
Operating Profit (1) (5) (5) (5) (10) (10) (10) (50) (50) (50) (3) (3)
Margin
Probability to reach stage 100% 100% 100% 100% 20% 14% 14% 7% 7% 7% 6% 6%
Risk-adjusted cashflow (1) (5) (5) (5) (2) (1) (1) (3) (3) (3) (0) (0)
Discount time period: 1 2 3 4 5 6 7 8 9 10 11 12
Discount rate 15%
Discount factor 87% 76% 66% 57% 50% 43% 38% 33% 28% 25% 21% 19%
rNPV (1) (4) (3) (3) (1) (1) (1) (1) (1) (1) (0) (0)
Preclinical Phase 2 Phase 3 Approval
Biotech DCF - Risk-Adjusted - rDCF

Fiscal Year Endin
Patent Phase 1
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Cash Flow (1) (5) (5) (5) (10) (10) (10) (50) (50) (50) (3) (3)
Operating Costs - - - - - - - - - - - -
Margin
Operating Profit (1) (5) (5) (5) (10) (10) (10) (50) (50) (50) (3) (3)
Margin
Discount time period: 1 2 3 4 5 6 7 8 9 10 11 12
Discount rate 15%
Discount factor 87% 76% 66% 57% 50% 43% 38% 33% 28% 25% 21% 19%
rNPV (1) (4) (3) (3) (1) (1) (1) (1) (1) (1) (0) (0)
Revenues Patent Expires
2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037
Cash Flow 333 667 1000 1000 1000 1000 1000 1000 1000 1000 -
Operating Costs (167) (333) (500) (500) (500) (500) (500) (500) (500) (500)
Margin 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Operating Profit 167 333 500 500 500 500 500 500 500 500 -
Margin 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Discount time period: 13 14 15 16 17 18 19 20 21 22 23
Discount rate
Discount factor 16% 14% 12% 11% 9% 8% 7% 6% 5% 5% 4%
rNPV 1 2 3 3 2 2 2 2 1 1 -
Sum of rNPVs 4
Ramp-up
Biotech DCF - Risk-Adjusted - rDCF
We add another step: before we
discount the cashflows for time,
we also discount them by there
likelihood to occur
So rDCF is the sum of the
adjusted cashflows only
Final year cashflow is Zero due to
patent expiry and therefore no
Terminal Value…
Sum of rNPVs 4

The net result of this is a drug that promises to make £1bn in annual
revenue is only worth £4m at the start
This is often counter-intuitive to founding scientists, but it is the reality
During negotiations with investors bear in mind the following:
– It is far better to own a small % of £1bn, than a large % of nothing
– If you are good at your job investors will maintain your ownership at an appropriate
level via options…the founding equity will be worth far less in Phase 2
What can we learn from this

As attrition rates fall and revenues becomes nearer, the value of
biotechs increases significantly as they go through development
But what you will also notice is that while the company is
preclinical its value is rarely worth more than the cash
invested…and in many cases…less!
Therefore raise enough in one go / have a pre-formed investor
syndicate to fund you all the way through to exit…ideally you
don’t want to go back to market
Fiscal Year Endin
Patent Phase 1
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Cash Flow (1) (5) (5) (5) (10) (10) (10) (50) (50) (50) (3) (3)
Probability to reach revenue 5% 5% 5% 5% 25% 35% 35% 72% 72% 72% 81% 81%
Risk-added Cash Flow (20) (100) (100) (100) (40) (29) (29) (69) (69) (69) (3) (3)
Rolling rNPV 4 5 11 88 176 216 532 633 778 1,063 1,278 1,818
Flat Valuation 9 10 16 98 186 226 582 683 828 1,065 1,281

However, small assumption changes significantly impact the value
Many of the scenarios end up with negative valuations
Therefore rDCFs are not often used to value early stage biotechs
Instead, investors use Comparable Companies valuation and adjust
based on a number of variables: single product vs. platform; Time/cost
likely needed; Management track record
If you exit in phase 2 however, rDCF will be how you are valued
and therefore it is worth always keeping in mind
Peak Sales
4 £500m £750m £1,000m £1,250m £1,500m
2.0% (12.1) (10.1) (8.2) (6.2) (4.2)
3.0% (10.1) (7.2) (4.2) (1.3) 1.6
4.0% (8.2) (4.2) (0.3) 3.6 7.5
5.0% (6.2) (1.3) 3.6 8.5 13.4
6.0% (4.2) 1.6 7.5 13.4 19.2
7.0% (2.3) 4.6 11.4 18.2 25.1
%tomarket

As we have discussed the FAILURE RATE and the TIME taken have a
huge impact on the value of a product
Therefore if there are directions you can go in that can improve either
of these (without sacrificing the commercial opportunity of the
product), you should take them
– Many governments have special incentives on both of these for certain diseases
e.g. Orphan / rare diseases, antibiotics (GAIN act) etc
– In some diseases approval is granted using biomarkers vs. clinical outcome. These
trials are often smaller and shorter due to the lower variability of the endpoint
Always have contingency plans e.g. if your supplier goes bankrupt, it
could cause a year’s cash burn and delay to your trial…if you already
have alternative lined up this can be mitigated

When you look at the cumulative economics of getting a single drug to
market you will notice that the negative Value impact of a drug failing in
Discovery is tiny compared to it failing in Phase 3
Therefore killing a programme or a company early is a net value
creative decision…be honest with yourself
– Run the most challenging preclinical models, not the ones which will give you the
answer you are seeking
– Always measure its efficacy against competitive products (where same or different
modality), if it is no better then might be not worth progressing
It will also free you up to start your next…hopefully successful
company!!

Platforms are exciting technologies which can produce multiple
products so should be worth much more than a single product, right?
Wrong!!! Companies ultimately want products they can sell; the
platform is just a means to produce products…
Any new ones they start after the sale will be discovery stage
programmes…and we know how little these are therefore worth!
In our model a Ph2 product is worth £532m vs a product ready to go
into the humans for the first time is worth £88m
If you exit now, your pipeline adds little value and may even hinder a
sale if they are not also directly aligned with the buyers strategy
Therefore: make sure your lead product is a great economic
opportunity in its own right…and not just a proof of principle that adds
validity to the platform technology

Most importantly, if you want an investor to make “Value Creating
Decision” to fund your company…
You need a product that will ultimately generate huge amounts of
annual revenue!!!!!!
Therefore in every decision you make in your company I want you to
remember the principles underlying this DCF model
AND THEREFORE BE LASER-FOCUSED ON DELIVERING A PRODUCT
WHICH SOLVES A BIG UNMET NEED
…And how can you generate enough evidence / data to convince an
investor that you can get there and when you do it will have been worth
it
– e.g. it is not enough to show that your product works in a lab…you need to show
that is better than EVERYTHING else on market AND in development

Our DCF shows for investment in drug discovery, the peak
market sales needs to be high…i.e. drug price is high
The actual price is determined by supply/demand i.e.
performance of drug and unmet need
How / who pays is a complicated political / ethical issue
But unless the time / cost of drug discovery comes down
significantly, drugs will stay expensive
…alternatively no new ones will be produced
Melanoma
Number of new patients / yr 75,000
Number of deaths/yr 10,000
c. number of 3rd line patients 25,000
Market share 25%
Number of drug courses sold / yr 6,250
Required Peak Market Sales £1,000m
Required Cost / Course £160,000
One More Thing…

OneStart 2015 London Bootcamp: Matt Foy, SR One - Value: What is it, how do we measure it and why is it so important?

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