Valuation for start-up enterprises can be a tricky proposition. Regardless of industry, start-ups generally share a common set of operational characteristics and valuation needs that are distinct from mature firms. Because both the subject enterprise and valuation purpose are misfits within the context of typical valuation work, typical valuation practices are generally not applicable for start-up companies. Combined with the unique market dynamics and regulatory environment associated with the medical device industry, medical device start-ups present a unique set of valuation considerations.
Defining the “Value” of a Business Ownership Interest
Through casual observation, the value of an enterprise seems like an easy concept with a single definition. In reality, the appropriate definition of value varies depending on the circumstances surrounding each valuation engagement. The actual analytical framework for determining value is only developed once these aspects are defined. There are other types of values for different situations and requirement, but we focus on the “Investment Value” in business acquisition or exit situations.
Investment Value is the value to a specific investor based on their particular investment requirements and opportunities. This value reflects the knowledge, expectations, synergies, and economies of scale of the particular investor. Investment value is generally used when valuation or investment banking professionals are advising their clients as to the merits of executing a specific transaction such as raising additional equity capital, selling the business, or completing an IPO. Investment value answers the questions – what’s it worth to them? Or what’s it worth to me?
Approaches to Value
There are three general approaches to determining business value – asset, income, and market. Under each approach there are specific ways to determine value that are commonly referred to as methods. As a general rule every valuation should consider each of these approaches. Ultimately, the conclusion of value will reflect consideration of one or more of these approaches (and perhaps various underlying methods) as being most indicative of value for the subject ownership interest.
The Asset Approach
The asset approach determines the value of the subject business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. For start-up companies, the asset approach is generally inappropriate to apply unless the start-up is in a very early stage of operational development such that there has been no intellectual property or other intangible value developed internally. The asset approach can provide meaningful valuation benchmarks for start-ups that have recently completed fund-raising rounds.
The Income Approach
The income approach is based on the idea that the value for a given enterprise is created by the expectation of future cash flows and thus focuses on the capacity of a start-up company to generate future economic benefits. The mechanics of an income method require an estimate of future cash flows and an appropriate discount rate with which to determine the present value of future cash flows.
Methods under the income approach are wide ranging but typically fall into one of two categories: 1) single period capitalization of income; or 2) discounted future benefits. By nature, income expectations for medical device start-up companies are often characterized by a period of anticipated operating losses and increasing capital needs, followed by an expected payoff in the form of proceeds from an IPO, strategic acquisition, or other exit event. Accordingly, single-period capitalization of income methods and conventional applications of discounted future benefits methods are rarely appropriate to use.
The Market Approach
The market approach compares the subject to similar businesses, business ownership interests, or other assets that have been recently transacted. Market methods include comparison of the subject interest with valuation metrics implied by investments in publicly traded companies and those implied by transactions involving controlling interests in similar companies. Consideration of prior completed financing rounds or other transactions in interests of a start-up is also a method under the market approach.
Most start-ups are not near IPO or acquisition, however, so there is generally not sufficient information to implement the market approach to determine the enterprise value for start-up enterprises with the exception of the occasional very late stage start-up.
Prior financing rounds can provide meaningful indications of value for a particular equity class in a start-up, but differences in rights and preferences between various classes of equity create difficulties in translating value of one equity class (e.g., preferred stock) to another (e.g., common stock). Generally, medical device start-ups are funded by one or more financing rounds subsequent to the company’s initial formation, and thus are capitalized by several classes of equity—which complicates the determination of enterprise value based on a given share value. However, such per share pricing information from capital rounds provides helpful valuation anchors in the form of upper or lower boundaries for enterprise value and can credibly substantiate the reasonableness of valuation conclusions.
Medical Device Start-Up Valuation Considerations
Ultimately, the value of a start-up company is a function of:
- The range of potential exit values for the company if successfully developed
- The probability of achieving a successful exit
- The expected time period necessary to achieve a successful exit
- Expectations of future capital needs
For medical device start-ups, exit events generally take the form of a strategic acquisition or an IPO. In either case, exit value will be driven by the relevant market characteristics combined with the expected impact the company will have on that market. At any given point in time, the probability of achieving successful exit and the expected time period necessary to achieve a successful exit will be a function of the development stage of the company as well as certain key indicators such as management quality.
Market Characteristics. All companies operate within a given market and this context is perhaps the most significant factor in the exit valuation of a medical device start-up. Even if a start-up has everything else in place, 100% market share of nothing is still nothing.
Market dynamics within the various medical device segments tends to share the same broad contours. The most significant market factor to consider for a medical device start-up is the absolute size and growth prospects for the pertinent market. Relevant measures in evaluating a particular medical device market often include the number of physicians performing procedures, the number of procedures performed in a given year, and the reimbursement rate per procedure.
Most new medical devices tend to be improvements on devices used in existing procedures, and thus have a readily defined market at the start of the device development process. Less frequently, new devices offer revolutionary solutions for which there are no existing markets. Developing expectations of market characteristics in this situation is more difficult, but such products typically command far greater market impact.
Market Impact. Market impact can be defined as the market share that, if development efforts succeed, a medical start-up would likely command. Market impact is driven by the disruptive potential of the new technology and management’s ability to develop the technology, execute the business plan, and fully realize the new technology’s disruptive potential.
Other than the disruptive potential of the new technology itself, strategic acquirers in the medical device space commonly consider a variety of factors in evaluating the potential market impact of a new device:
- Strength of intellectual property
- Stability of design
- Technical performance data
- Support from animal studies
- Support from human clinical studies
- Completion of regulatory approvals
- Reputation of “early-adopter” surgeons using device
- Reliability of supply chain
- Reliability of distribution partners
- Availability of technical expertise (to facilitate transition after acquisition)
Stages of Development. The value of a given start-up is largely related to its level of operational development. Most medical device start-ups tend to follow similar patterns in operational development regardless of industry segment. Loosely speaking, medical device start-ups often follow the following development pattern:
- Conceptual Design
- Market Verification
- Device Design Verification
- Regulatory Approval
- Human Clinical Trials
- Initial Product Launch
Since the development of start-up enterprises is measured by the passing of various milestones, the meeting of milestones (or the lack thereof) contributes significantly to the valuation of a start-up. Passing certain milestones create a bigger impact on value than others; examples of such milestones include the completion of the initial round of financing, proof of concept, regulatory approval, delivery of product to customers, and profitability.
With the passing of each milestone, the level of uncertainty associated with the start-up decreases and thus drives value upwards. Generally, meeting later-stage milestones generates greater increases in value than that of earlier-stage milestones.
Key Indicators. Compared to mature enterprises, financial information for start-up companies is less frequently available and typically of lower quality. Due to this relative lack of information, qualitative factors such as the quality of the management team, clinical advisory team, and venture capital investor group become an important consideration, especially in the valuation of early-stage start-ups.