SPECIAL REPORT

Healthcare Valuation:
How to Prepare and Effectively Defend Your Position

By Luis Pareras Published by Greenbranch Publishing, LLC Copyright 2012 by Greenbranch Publishing, LLC. All rights reserved.

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Copyright 2012 by Greenbranch Publishing, LLC. All rights reserved. Published by Greenbranch Publishing, LLC PO Box 208 Phoenix, MD 21131 Phone: (800) 933-3711 Fax: (410) 329-1510 Email: info@greenbranch.com www.greenbranch.com All rights reserved. No part of this publication may be reproduced or transmitted in any form, by any means, without prior written permission of Greenbranch Publishing, LLC. Routine photocopying or electronic distribution to others is a copyright violation.

About the Author

Luis Pareras, MD, PhD, MBA, is a neurosurgeon and Director of Innovation and Entrepreneurship at the Barcelona Medical Association. He serves on the boards of several healthcare start-up companies and he holds a Global Executive MBA from the IESE Business School. Pareras is a physician-entrepreneur, being involved in the launch of Medicine Television, where he served as General Manager for 5 years. He advised venture capital firms in their healthcare investments, providing deal flow and healthcare sector analysis, and he serves on the investing committee of Alta Partners Venture Capital Fund, as a specialist in healthcare investments. Dr. Pareras is also Director of Healthequity, a venture capital firm investing in the life sciences, medical devices and healthcare services.

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Healthcare Valuation:
How to Prepare and Effectively Defend Your Position

How much is my company worth? We are getting to one of the most complex questions that a healthcare entrepreneur is going to have to face at the time of negotiating for capital. The ownership percentage of our company that we should cede to the investor depends on the capital needs of our idea. Any healthcare professional that gets to this stage and looks for financing in exchange for shares of the company, should know the different valuation tools that the investors will use to estimate the value of the start-up. This is important because: It helps the entrepreneur to be prepared to provide the investor with the relevant and appropriate information for the valuation process. It helps the entrepreneur to be able to defend the valuation in the face of those done by the venture capitalist, and therefore helps in trying to get the best agreement possible. What is certain is that even though the process may look like objective (science), the valuation of start-ups, companies that do not have any profits yet, is more an art and it is conditioned by elements of great subjectivity. The valuation of a start-up is highly negotiable. In the absence of objective results (the profits that the entrepreneur defends in the business plan are merely a hypothesis), the valuation is subject to the negotiating skills of the entrepreneur. A trendy start-up, with patents or competitive advantages and with elevated revenue predictions, will get a higher valuation than another without these characteristics. In this report, we will refer to the science and to the art, offering descriptions of the different methods of valuation based on objective data and also on the subjective elements on which venture capital normally relies. But before we do, we need to understand the process that takes place in the mind of the investors, introducing important concepts such as pre-money valuation and post-money valuation. In the process we initiate, investors will not only try to evaluate our idea (pre-money valuation) but also they will decide how much money to invest in it. After this injection of capital, logically, the company will have a higher valuation (post-money valuation). Lets continue looking at the process from this point of view.

OW MUCH IS MY IDEA WORTH?

Investment Process
Ideally, financing on the part of business angels or venture capitalists could be sufficient so that a start-up might be able to take off, generate profit and positive cash flow, and grow from now on with its own generated cash flow. Nevertheless, this usually

never happens, because profits never come sooner than expected (it is usually quite the opposite) and the type of ideas that gain access to venture capital have an ambitious run, and when the moment arrives, if the opportunity is there, they will need more investments to finance growth more quickly. For this reason, start-ups normally are financed with different rounds of financing (round A, B, and so on). As the company grows and demonstrates its profitability, it is a little easier to calculate an objective valuation, but in this initial stage, it can appear that the process is nothing more than a game of roulette. Nevertheless, to visualize the process carried out by investors in order for them to decide their participation in the start-up we need to better understand that the process is nothing like roulette and that a series of steps will lead to a valuation and a specific decision. The investors have an objective. Lets say they want the investment to multiply their capital by 10 in the term of four to seven years. Venture capitalists will ask themselves: does this company have the potential to multiply our investment 10 times? Or similarly, and here we have the crux of the question: what value do I have to give this company today, so that with this investment it can multiply my capital by 10? Lets remember that investors need a minimum return on their investment and this minimum return, together with the projected value of the company five years later (at the moment of disinvestment), determines what percentage of ownership of the new startup they should posses. Therefore, the investors are interested in the future value of our start-up at the moment of their exit, and not so much in its current value. And that future value is conditioned, as clear as it can be, by the strength of the team that is going to execute that idea. This path toward valuation is a counterintuitive path, it is an inverse path to what the entrepreneurs are imagining, but is extremely effective to help the venture capitalists to get a first provisional valuation for the company and to decide if the investment is suitable for them. The math of the capital risk operation is easy to understand, at least in the most general aspects: In the first place, capital is known as something that is going to be invested, the money that the entrepreneur is looking for. Lets suppose that for example, we need and we are looking for $1,000,000. Today the company is valued, before the investment is produced, by means of a method that we will see at the end of this report. Lets suppose that, for example, the pre-money valuation is $1,500,000. Adding up these two amounts, the invested capital and pre-money valuation, we will get the post-money valuation, the value of the company after the capital is invested. In this case, the post-money valuation will be $2,500,000. Pre-money valuation (V_pre) = $1,500,000 Invested capital (C) = $1,000,000 Post-m money valuation (V_post) = V_pre + C = $2,500,000 From this data, we can calculate the percentage of the company that is going to the hands of the investor, in this case 40 percent, that is no more than the relationship between the invested money and the final evaluation of the company:
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

Ownership (%) = C/V_post = 1,000,000/2,500,000 = 0.4 (meaning 40%) At this time, healthcare entrepreneurs as founders of the company would retain 60 percent of their ownership after receiving an investment of $1,000,000. For many of the healthcare entrepreneurs that I have accompanied in the process, this is the most surprising phase. They ask themselves. If my company is still an idea, how is it possible that is worth $2,500,000? The answer is not easy, but without getting into too much detail, we should not forget that these are virtual valuations, obtained for the basic need of quantifying and regulating the relationship with the investor. These evaluations are not real; there is nothing to sell, except the most important part of all, the execution of the idea, leading our product to the market. Lets see for a moment what happens if the valuation that gets our idea is $500,000 instead of $1,500,000: Pre-money valuation (V_pre) = $500,000 Invested capital C = $1,000,000 Post-m money valuation (V_post) = $1,500,000 Ownership (%) = C/V_post = 1,000,000/1,500,000 = 0.66 (meaning 66%) In this scenario, entrepreneurs would only retain 33 percent of the company. It is clear therefore that with the same monetary need, a good part of the final result depends on the pre-money valuation that is estimated during the negotiations. That is the key. Lets look at it in more detail.

Pre-m money Valuation

As we have seen, the investors first consideration, in order to propose the agreement, is to evaluate if the company has sufficient potential so as to offer the minimum return to the investment that they need. If, while applying this rule, the initial valuation does not make sense, the investor will decide not to go on and do a more objective valuation. Common sense plays an important role because the investor s previous experience with similar companies gives him some sort of sixth sense to roughly estimate, indeed as a guess, the value of the idea. In this initial consideration they do not take into account too much the future cash flows, the revenue, or the profits because they know, and we should know it as well, that the real results that the company will get in the first five years might not look anything like the projections in the business plan. Those projections are only a preliminary estimate, but they rarely reach the volume of profits on time. We have also seen that in order to judge if that desired investment return is possible, there are some variables that the investors should investigate. The return to the investors will depend not only on the final value of the company but also on the percentage of ownership that the investors have in the project. We now are going to introduce a third element of complexity: that ownership percentage can (and in fact it probably will) change during the relationship, for example, when our start-up needs to get more fiHealthcare Valuation: How to Prepare and Effectively Defend Your Position

nancing in order to continue growing in the future. Therefore: The amount of money that we will need is very difficult to predict at first. It depends on future needs that we still do not know about and our rate of growth. We also do not know now the value that the future investor will give to our company.

Post-m money Valuation

This second assessment is also crucial for the success of our project. It is important because it determines the foundation for any future assessment. Although, as we have stated, our project is not worth anything in a strict sense, it gains value when we have external capital to help us carry our idea forward. Now, therefore, is our turn. Now we have the opportunity to use that money to make our idea grow. If over the course of time things go well and we need more money (second round) to finance our growth, the same process we analyzed before should be repeated. New investors (at times the same venture capital company, on other occasions it can be new partners) will need to valuate again the idea and decide a new pre-money valuation. But here, the idea is already in motion and the healthcare entrepreneur and his teams success will be especially visible. If the objectives that we have proposed have happened, that indicates the potential for our team to move forward and it reduces the new investors risk. Therefore they will probably accept a higher premoney valuation now. If this valuation is better than the post-money valuation from the first investment, it will be a good indicator that we have created value and the project is moving forward. If on the other hand, we have not managed the project well, we have a setback and we have not achieved our objectives, the risk for investors will be higher, the pre-money valuation for this new investment will be lower, and therefore, if we get them to invest more money, it will be at a cost of ceding a higher percentage of ownership of our company. Lets continue with the earlier example. The post-money valuation for our company was $2,500,000. Two years have passed, and we are already in the U.S. market and things are going reasonably well, but still we do not have many clients and we cannot finance our growth alone. We need another $2,000,000 in order to get into the world market. Although until now all has gone according to plan, the European market, that we do not know as well, adds a certain risk to the idea, but expanding there is the only way to compete appropriately in the market. If the new capital that is coming in determines a pre-money valuation of $3,000,000: V_pre = $3,000,000 C = $2,000,000 V_post = $5,000,000 Ownership (%) = C/V_post = 2,000,000/5,000,000 = 0.40 (meaning 40%) But what if we had many clients and we had signed an important agreement with a European distributor guaranteeing us excellent conditions for the buyers of our product or service? With a better valuation:
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

V_pre = $5,000,000 C = $2,000,000 V_post = $7,000,000 Ownership (%) C/V_ post = 2,000,000/7,000,000 = .285 (meaning 28.5%) We are establishing again the extreme importance of getting a good valuation. We will take advantage of this example to introduce a new concept. This new scenario with for example 28.5 percent of the shares of our company implies what is known as a dilution of our ownership percentage for the company (and of the initial investors as well). If before we had 60 percent, now we will have a smaller percentage of ownership, because a new partner has invested and has diluted our ownership in the company. But losing ownership percentage of a company that grows and generates value on occasion may be a very positive thing. We have already introduced the concepts of pre-money valuation, post-money valuation, ownership percentage, and dilution. In order to have a complete vision of the process, there are three missing elements we should define now, adding a little more of complexity to the subject: The source of the money (equity or debt). The presence of stock options to be executed in the future. Analysis limitations.

Equity or Debt?
Until now we have considered that the capital that the company receives is in equity, that is, translated in shares given to the investors giving them an ownership percentage. In these situations, the math is easy, as we have seen. Nevertheless, in the real world, the investors can at times decide to invest a part of that money in a debt form, some sort of a loan (with or without collateral), that the entrepreneur should end up returning to them. The motives behind this decision will be analyzed later on, but so as not to complicate the topic unnecessarily, we will show you know some of the principle reasons: Investors are assured in this way that the founders and the team interests are aligned with theirs. Entrepreneurs know that they need to grow and create value in order to be able to profit in a substantial way from their project, because if the company is going poorly and there is a liquidation of the start-up (the sale of all that is possessed), investors will recover a part of the debt from it. The debt has preference over equity at the time of liquidation. And, if the start-up succeeds, investors are assured as well that the returns will not come only at the time of selling their shares; they will also get some returns during the companys activity. This debt is usually in a form of convertible debt, meaning it can be converted into equity at some point in the future if some milestones are met. The relationship between the amount of capital contributed in debt and the amount provided in shares is subject to negotiation at all times and, as we have recommended on many occasions in this report, entrepreneurs will need to follow the advice of a specialist that can help them in the process. Logically, the percentage of ownership may vary depending on this ratio of debt/shares.
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

Stock Options
People do respond to incentives. In the health sector, as in the rest of the entrepreneurial world, it is very common that the founders of a start-up decide to offer stock options to their direct collaborators, those they depend on a fair amount for the success of the idea, in order to give them incentives to join the project. The stock options are basically a promise offering them the option to buy companys stocks in the future at a current prefixed price. In this way, if the company grows adequately and the value of those shares grows accordingly, when it comes the time to exercise that right to buy, it can mean an important profit to the owner of those stock options. We are in some way making the most important workers co-owners of the company (with a small percentage). Investors assume that if things go well, all stock options will be executed. Therefore, the normal practice in the sector is that the venture capitalists or business angels calculate their percentage in the company taking into account the percentage reserved for stock options. Before receiving the investment, entrepreneurs and venture capitalists agree on a reduced percentage in a stock options plan (commonly from five to 10 percent), already reserved at the beginning for: Future awards to collaborators that have contributed the most to its success. Attracting key people for the projects future.

Analysis Limitations
As we move forward with the particulars of the process, we have seen that the whole thing is not as easy as we presented at the beginning of the report. It is important for entrepreneurs to seek advice, but it is equally important that the entrepreneurs understand the terminology and the basic concepts in order to be able to contribute important things to the negotiation. It is their start-up, and they should defend it themselves, getting advice from people that have spent time in the same process and that are able to help them. Similarly, we should emphasize again here that the obtained valuations are very volatile and can change in a brusque way for many reasons. We need to understand the method used by venture capitalists, because if we do not understand their instruments, we can commit grave errors that will make an earned return difficult. Lastly, my advice is always that the entrepreneurs should not obsess too much over valuation; it is the agreement as a whole that matters and getting our idea out and profiting from our effort in a fair way is the only goal. Lets remember those shares are not liquid, they are not being transformed into money if there is no real project growth. Instead, entrepreneurs should concentrate on the difficult road to getting profits.

METHODS OF VALUATING START-U UPS

Already we have come to understand the art so lets move to the science. The healthcare entrepreneur can be sure that investors will do all sorts of objective economic valuations. We should be prepared to defend our own valuation. Lets see in detail these methods, from less to more complexity (Figure 1).

(1) Berkus Method

This is the least scientific method of all (and may be even seen as nonsense), but the
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

most straightforward. It serves as an initial guide for the investor, giving a base value of $500,000 to the idea if there is an identified profitable potential, and adding later on: Another $500,000 if the team appears competent and capable of making this company a success. Another $500,000 if the company has completed some agreement or strategic alliance that puts it in an appropriate position for rapid growth. And finally, another $500,000 if the company has completed its prototype and has demonstrated its efficiency before potential clients. The beauty of this method is its great simplicity and it can be used as a guide for those companies that still have not come out in the market and therefore do not have anything to show their viability. Its disadvantage is obviously that it is a very subjective method, not very scientific.

(2) Rule of Thirds

This establishes 33 percent for the founders, 33 percent for the investors, and 33 percent to be distributed to the workers in the start-up. It is also simple, quick, and not very objective but gives the idea of the usual post-financing structures in a start-up.

(3) Use of Multiplier Method, Sales Multiples

With this method, annual revenues, annual profits, or some other key parameter of our business plan is multiplied by a standard figure that usually varies between .5 and 4. This means that if our company is going to make $1,000,000 per year, the value would be established between $500,000 and $4,000,000 depending on the most common multiplier in the sector where our company competes. For example, we can base the valuation of these profits on: The real earnings in the past 12 months (on objective data). Our projection of how much we are going to make at the end of the year (estimated projections from the present year, relying therefore partially on objective data). Our revenue predictions for the next year (completely subjective data). This method is without a doubt a more objective valuation than the two first methods but it does not offer scientific elements of justifying it.

(4) Similar Company Transaction

A very logical way of facing an evaluation is to identify buying operations or similar financing produced in the industry previously and to establish a comparison. If we know the previous financial data from a competitor transaction, we can use that information as a reference. This circumstance (a previous company transaction) is usually common, and it might be easier for investors to find than for entrepreneurs, because the formers have access to all types of data about the activity in the sector. If we believe there is precedent, it is interesting to investigate it. Once we have identified similar operations, we will always be able to adapt that valuation and its logical criteria to the particular differential characteristics of our project.

(5) Book Value

This is practically never used, because companies in the seed phase or in the start-up phase do not have a real balance sheet, but rather they are still in the phase of raising
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

FIGURE 1.

Healthcare Valuation: How to Prepare and Effectively Defend Your Position

Healthcare Valuation: How to Prepare and Effectively Defend Your Position

10

capital and resources to move the idea forward. In any case, it is useful to know that specific companies can set their minimum value by calculating the value of contributed capital to the present date according to what is reflected in the balance sheet.

(6) Venture Capital Method

This is the method analyzed in the first part of this report, consisting of determining an ideal ownership percentage of the company that the investors need to reach their minimum expectation on the investment return, and to evaluate if the valuation makes sense (depending on the investors previous experience and knowledge of the sector).

(7) Pre-v venture Capital Method

This method of evaluation consists of deciding not to valuate the company. It is used in some circumstances by business angels who invest in a start-up without any objective data on which to base their valuation. Instead, it is established that the business angel will be able to enter the company under the same conditions (with an additional discount for the initial investment) as the venture capitalist who invests next. The great advantage of this method is that the evaluation is deferred until there are more objective data to make it a more fair process and simply tries to establish preferential conditions for the entrance of the first investor.

(8) Discounted Cash Flow

It is outside the realm of this report to enter into detailed analysis of this method. What is essential here is that the healthcare professional understands this concept. In the first place, it is necessary to understand that a dollar today is not worth the same as a dollar tomorrow. The basic concepts behind the discounted cash flow are: Our company will have some specific cash flows in the next years, and those cash flows are projected in our business plan. If today I receive a dollar, I can put it in the bank and get some profit out of it. If on the other hand I receive it next year, comparing it with what I would have gotten if I had put it in a bank today, the value is less. Having that dollar within one year instead of now costs us money (we lose something). It is important then to know what this capital costs us (rate of discount) in order to be able to adequately establish that difference between the value today and in one year. Knowing this fact will allow us to predict the value of a dollar today and the value of a dollar within one year. The method of discounted cash flow identifies a potential value in the future (the money in the bank that we will accumulate in the coming years) and the discount rate (that translates the future value to todays value, based on the cost of the money for the company). In the case of the dollar in the bank, it is easy to understand why the dollar of tomorrow is worth less than todays dollar. Transferring this concept to investment, we can also understand that tomorrows value is less that todays because: There is a risk in the investment; we do not know how the new start-up will develop. There is an opportunity cost. If today I invest a dollar in a start-up, I would stop it from being invested in something else. Therefore, I should take into account other opportunities of my surroundings, as an example, depositing it directly in the bank. Given that investors always have better alternatives that putting money in the bank (such as investing in other start-ups), the cost of the money that we mentioned before is high,
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

11

and it should be fixed by investors depending on their expectations (their previous experience from what they normally earn with this dollar). The valuation using this system is more objective, but has some problems as well: It depends on revenue predictions and does not analyze real objective revenues, which does not guarantee that this value is going to be reached. It only determines a specific value that will be real only if the entrepreneur accomplishes the financial projections as promised. It depends on deciding the cost of the money (discount rate), which is different for each investor depending on what that investor can earn with the money invested in other less risky areas. Lets look at a simple example. Lets suppose that a start-up wants to manufacture a new medical device and needs $100,000 today in order to initiate the project. The founders expectations are to get earnings of $50,000 during the first four years and in year five venture capitalists believe that the company can have a value of $300,000. Finally, lets suppose that the discount rate, meaning the cost of the money that the investor plans for this type of operation, is 15 percent annually. The math for tackling this evaluation is: The value of our company today (known as current net value) will be: Current value (in $ thousands) = -100 + 50/(1+.15) + 50/(1+.15)2 = 50/(1+.15)3 +50/(1+.15)4 + 300/(1+.15)5
N

VAFCF = I0 +
t=1

FFt (1 + i)t

Where: VAFCF = the current discounted value of the future cash flows. I0 = the initial investment in order to put the project in motion. FF = the nominal value of the flows in a future period. i = the discount rate, that is the opportunity cost of the invested funds, considering the risk factor. N = the amount of periods that are discounted. VA = 191.90 This means that the investor considers that the start-up is worth $191,900 if the entrepreneurs really accomplish the financial projections that they imagined for the start-up. In some cases, in place of valuating the start-up, investors may calculate the internal rate of return (IRR). The IRR is a capital budgeting metric used by venture capitalists to decide whether they should make investments. It is an indicator of the efficiency or quality of an investment, as opposed to net present value (NPV), which indicates value or magnitude. The IRR is the annualized effective compounded return rate that can be
Healthcare Valuation: How to Prepare and Effectively Defend Your Position

12

earned on the invested capital, that is, the yield on the investment. Put another way, the internal rate of return for an investment is the discount rate that makes the net present value of the investments income stream total to zero. Continuing with the earlier example, the formula would be: 100 = 50/(1+r) + 50/(1+r)2 = 50/(1+r)3 + 50/(1+r)4 +300/(1+r)5 Where: r = the unknown figure we are aiming to calculate we would have a value of 59.56%.

Healthcare Valuation: How to Prepare and Effectively Defend Your Position