Valuing early-stage healthcare and life sciences startups presents unique challenges due to their lack of revenue, high-risk profiles, and massive capital needs. Conventional methods often fail to capture the potential upside and downside risks in these companies. The venture capital valuation (also referred to as the venture capital method or VC method) provides a valuation framework designed specifically for pre-revenue startups based on investor return targets and ownership requirements.
Why Use the Venture Capital Valuation Method for Startups
There are a number of advantages to using the VC method to value your healthcare or life sciences startup:
- It is a market-based valuation method that uses real multiples that investors pay for companies at certain stages and metrics.
- It is tailored to the unique needs of healthcare and life sciences startups, such as their high-risk and binary risk profile.
- It provides a flexible framework that can be adapted to the specific circumstances of each company.
- It is commonly used by angel and VC investors, which makes it easier to attract investors and raise capital.
How to Use the Venture Capital Method for Healthcare and Life Sciences Valuations
The VC method aims to derive a startup’s current fair value based on investor return expectations at an assumed future liquidity event, typically an IPO or acquisition. It incorporates the following key elements:
- Future Exit Valuation: Based on projecting financial metrics like revenue or earnings and applying a relevant industry multiple at exit, typically 3-5 years out for healthcare and life sciences.
- Investor Return Target: A typical 10-20x return for early-stage healthcare and life sciences investors based on the amount invested and timeline.
- Equity Percentage Needed: The equity stake required to achieve the target return given the future exit valuation.
- Current Valuation: The pre-money valuation today satisfies the needed equity percentage based on the upcoming investment round amount.
Rather than rely solely on speculative projections, the VC method grounds the valuation in justifiable assumptions around exit timing, real-world multiples, and investor return benchmarks. When applied appropriately, it can provide a reasonable valuation range for seed and Series A companies in healthcare and life sciences.
Key Inputs and Assumptions in the VC Method
In order to derive a sensible valuation through the VC approach for healthcare and life sciences startups, several key inputs must be determined upfront:
- Industry Multiple: A relevant ratio like price/earnings (P/E), enterprise value/revenue (EV/Revenue), or enterprise value/EBITDA (EV/EBITDA) multiples from comparable public companies. This reflects standard valuation practices for each subsector like biotech or medical devices.
- Financial Projections: Projected revenue, earnings, or other applicable financial metric at the expected future exit date. This factors in required funding and milestones to reach projection.
- Time to Exit: The expected years until a liquidity event like an IPO or acquisition, typically 3-5 years for early-stage healthcare and life sciences companies.
- Capital Needed: The amount being raised in the current fundraising round.
- Investor Return Target: The desired return multiple on invested capital over the defined timeline, normally 10-20x.
- Percentage Ownership: The equity percentage owned by the investor after the new capital is raised, used to calculate their return.
Realistic assumptions must be made for each input using comparable deals, expected timelines and benchmarks, and typical investor expectations. Founders should validate assumptions with advisors and investors.
Conducting Valuations Using Venture Capital Method
Once inputs have been determined, the VC method involves several steps in estimating value. The process for performing valuation using the venture capital method is illustrated in the table below:
| Steps | Description | Example |
|---|---|---|
| Identify an appropriate industry multiple | Choose a relevant ratio (e.g., P/E, EV/Revenue, EV/EBITDA) based on comparable public companies in the same subsector (e.g., biotech, medical devices). | For a biotech startup, assume a 5x price/sales multiple based on comparable commercial-stage biotech companies. |
| Develop projected financials at exit date | Project future financial metrics (e.g., revenue) at the expected exit date, considering required funding and milestones to reach the projections. | Let’s project $100M in revenue in 5 years based on estimated market share and target pricing. |
| Calculate exit valuation | Multiply the projected financials by the selected industry multiple to determine the estimated exit value. | 5x (assumed multiple) x $100M (projected revenue) = $500M exit value. |
| Define the target investor return multiple | Set a desired return multiple (e.g., 20x) on the investment amount (e.g., seed investment), aligning with typical investor return expectations. | Let’s say we target a 20x return on a $5M seed investment, which is a typical target. |
| Derive percentage ownership needed | Calculate the equity stake needed to achieve the target return based on the calculated exit value and return multiple. | $100M (target return) / $500M (exit value) = 20% ownership. |
| Calculate the current pre-money valuation | Determine the pre-money valuation that provides the investor with the required ownership percentage after the new capital is raised. | $5M investment / 20% ownership = $25M pre-money valuation. |
Advantages of the Venture Capital Valuation Method
When applied properly, the VC approach provides several advantages for valuing healthcare and life science startups:
- Market-based: Leverages real multiples investors pay at certain stages and metrics.
- Sector-specific: Flexible application across subsectors like biotech, devices, and diagnostics.
- Accounts for exit and dilution: Factors in future liquidity events and new investor capital ownership.
- Frames investor expectations: Provides a structure aligned with typical investor return targets and ownership.
- Facilitates discussion: Creates a baseline valuation for founder and investor conversations.
Particularly for pre-revenue companies with limited current financials, the VC method gives founders a sensible framework for estimating current value based on future potential under standard funding terms.
Limitations of the Venture Capital Method for Valuation
However, there are also several limitations to consider when applying the VC approach:
- Forecasting uncertainty: Exit projections may prove inaccurate given clinical, regulatory risks and market dynamics risks.
- Applicable multiples: Some subsectors lack enough VC comparable companies.
- Static exit timing: Liquidity events often take longer than the assumed timeline.
- Complex break-even modeling: Required ownership math can be complex for founders.
- Value disconnects: The method may indicate a valuation disconnect from comparable deals.
- Pre-money anchoring: VCs may still anchor on low pre-money valuations.
Founders should view VC method valuations as a starting point rather than a definitive fair value. It provides a logical framework to engage investors in valuing highly uncertain healthcare and life sciences startups.
Best Practices for the Venture Capital Method
Given the limitations, here are some best practices for founders when leveraging the VC methodology:
- Seek advisor input on key assumptions like multiples, timelines, and projections.
- Develop reasonable upside and downside cases for projections.
- Start with a sensible pre-money range based on comparable deals.
- Use methods to frame a valuation discussion rather than dictate terms.
- Supplement with other applicable methods like discounted cash flow.
- Anchor on milestones achieved rather than arbitrary projections.
- Assess the resulting share of equity versus alternatives like milestone-based vesting.
The founders should be prepared to explain key assumptions and projections in detail, and consequently, the VC method promotes open dialogue on valuation and its inputs. However, it is critical for founders to be aware of the key drivers of valuation.
In summary, the venture capital valuation method is a useful tool for founders and investors to value healthcare and life sciences startups. It is a market-based approach that accounts for future exit and dilution, and it frames investor expectations. It is important to be aware of the limitations of the method and to use it in conjunction with other valuation methods to get a well-rounded view of the company.
BiopharmaVantage is a specialist consulting firm that specializes in providing valuation services specifically for healthcare and life sciences companies and investors. If you would like to explore how we can assist you, then please get in touch with us.