Optimal evaluation methodology: Values & prices applied in decision making and negotiation in M
In this paper we shall develop a model and a methodology to provide boards with sound strategic documentation and process methodologies to be used in fund raising and/or in BD&L and M&As decision making and negotiation.
The first step is to derive value tables from the evaluations model and the various scenario as developed in articles 1 and 2 of this serial (insert links).
1. Review of previous findings
Early phase decision making is a strategic exercise based on assumptions loaded with
Uncertainty about the future state of the market and
Technical risks.
Decision models based on valuation of opportunities ought to include the uncertainties in the assumptions concerning key value drivers, and the associated risks into the model itself.
“Price is what you pay, value is what you get” W. Buffett
Furthermore, we argued that the essential elements of board-level strategic decision making include the information on the hypotheses made for both uncertain outcomes and for risks.
Single points estimates are misleading or manipulative when not presented in context
Previous articles have led us to develop a scenario planning method to include uncertainty of both development outcomes and estimates of future market conditions into sales projections; and a simple algorithm to estimate risk related discount rates for the pre-commercialization phases of a development project.
2. Accounting for risk and Modeling for flexibility: r NPV model
As we worked with our students or our clients to model flexibility and account for risk, we found the rNPV methodology an easy to understand method that fits closely to the decision making process.
Diagrams and tables below capture the essentials of a development project in terms of durations, costs, risks and related discount rates, as well as strategic options to abandon, accelerate, modify the project, for each of the retained scenarii.
Table 1
Diagram 2: Expected NPV of project pre decision making
1. Developing strategic decision making
From a strategic point of view the proposed methodology and models allow to present management with best assessments concerning the likelihood of competitive profiles –a key information for forward looking resource planning- and with estimates of the associated and expected returns.
It allows to identify the locus and timing of the management pressure to be made for obtaining information on key outcomes.
Finally it allows for the management to document its decision making process for further visitation when development work will have made additional information available (see application below in the licensing discussion)
2. Applying uncertainties and volatility in decision making process
The decision based solely on the negative expected NPV is wrong. Scenarii with negative NPVs (scenarii 1,2,3) are most likely going to be abandoned at this decision point. Therefore their value should be 0, to account for the option of abandoning before investing any money in them.
By recognizing the option to abandon scenario with negative NPVs at the time of decision, we obtain a different picture of the project, and it becomes a-priori acceptable on financial grounds since the expected NPV now positive at € 0.5 million (Table 2). This is almost right.
Still, the single point estimate does not allow for the management to develop its risk taking / risk adverse decision making. It can be misleading for following reasons:
Management needs to be made aware that at this stage the project relies exclusively on one scenario which has a probability of occurrence of 0.1
Management needs to recognize that the most likely scenario becomes attractive at the next decision making stage, and that at the end of Phase I the likelihood to be positive NPV-wise is 0.85
Management might want to incorporate other strategic decision making parameters in its thinking, such as
The money invested in the early development stages is then
However, based on the low probability of occurrence of scenario 4 most managers would hesitate to start the project, and they would argument their risk adverse position with the negative expected project NPV of €-11 million.
However scenario 4 has quite an interesting risk profile as highlighted on Diagram 3, with 94% chances of being positive NPV-wise.
An additional strategic benefit of the whole methodology can be derived from looking at tables 1 and 2. At the start of the project it is most likely that the effective profile of the compound on the market will not be assessable with a great probability. However, the table shows that as one progresses through the project and invests money into gathering more information, the other scenario become financially attractive. This does not mean that one should throw good money after bad, it means that flexibility and scenario planning add real value to the project.
It also means that the hypothesis sustaining the scenarii and the model parameters such as the discount rate have to be discussed at the board, given their strategic importance on the results.
3. Structuring licensing deals and/or funding rounds
3.1. Funding requirements
The methodology developed to come up with the results in tables 1 and 2 above is useful to derive negotiation road-maps.
Suppose that in our example the management of the small biotech has run out of love money and needs to raise the funds to perform phase I clinical trials, say € 15 million. Suppose as well that the results of the first development phase are such that scenario 2 and 3 can be excluded.
Finally suppose that the investors requires a 25% annual return, compoundable. How much of the company will they request in exchange of the funds? Based on the values and probabilities associated to the future scenario, we would come up with an equity share of 43%.
3.2. Licensing deal
Based on the results of POC as exposed in the preceeding paragraph the inventors contemplate, next to a fund raising exercise, to license the project as is to a larger company. The 2 parties have agreed to share the global proceeds 30%-70% licensor-licensee shares, and they have also agreed to share risks in the form of milestone payments and royalties on sales. Based on the results of the valuation team, the smaller company is now able to argument a comprehensive set of payment options for each partner.
4. Conclusions
Throughout this serial of articles focusing on the relationship between company governance and valuation models, we have shown that the key elements that boards should focus upon are the assumptions linked to the uncertainties of the key value drivers.
We have highlighted the methodologies to develop estimates that will take uncertainties in account, and models that will incorporate technical risk and business development options.
We have finally developed the tools to use the results of the models for strategic decision making, for fund raising negotiations and as licensing decision support tools.
If we can have a last word summarizing this work, it would be that one should never take a point estimate for granted, and should be aware of the fallacy of averages in decision making.
About the author: Jean-Louis Roux Dit Buisson owns an MSc from MIT and an MBA from INSEAD and can be reached at rouxbuisson@alum.mit.edu
He is lecturer of Entrepreneurship at the Grenoble Management School in France. He is founder of Foro Ventures, a company dedicated to provide assistance and interim management for top-line growth projects and turn-arounds. Jean-Louis has experience with B2B industries and high technology sectors.
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