In 2001, Enron set records with its $63.4 billion bankruptcy and catalyzed hawkish regulation: the American Jobs Creation Act (AJCA) of 2004. The AJCA included section 409A of the Internal Revenue Code that tightened the rules surrounding deferred compensation, a feature of Enron executives’ misconduct.

Stock options are a common feature of executive compensation, especially for biotech start-ups. But to be considered deferred compensation, and to take advantage of the associated tax benefits, these options must be issued at fair market value. However, determining the value of a private company like a biotech start-up has its challenges.

Section 409A analyses help determine the strike price for these options. To arrive at a fair market value, biotech start-ups require specialized valuation approaches that require a technical understanding of the subject company.

Understanding Rules Around Deferred Compensation

Deferred compensation can include retirement plans, pension plans, and stock-option plans that are common for biotech start-ups.

The value of an option is governed by its strike price, the price at which the option holder has the right to purchase stock. If common stock exceeds the strike price, the option has value (“in-the-money”). Conversely, if common stock is below the strike price, the option has little to no value in current day terms, but still may have upside (“out-of-the-money”).

Per Section 409A of the Internal Revenue Code, stock options must be granted at fair market value (“at-the-money”), when the strike price is equal to the common stock price on the date of issuance, to qualify as deferred compensation.

For private companies, there is no liquid market to observe the price of common stock, so it must be independently assessed. Determining the common stock price of a biotech start-up is often further complicated by the absence of present or near-term cash flows.

Valuation Methodologies for Biotech Start-Ups

While performing 409A analyses on biotech start-ups, practitioners are typically unable to utilize the common methods of business valuation, income and market approaches, as those approaches rely on historical and projected revenues and cash flows.

Biotech start-ups are unique in that they typically do not generate revenues until a candidate is approved and commercialized, a high-risk development endeavor that can take over a decade and hundreds of millions of dollars in investment (series financings) and is subject to regulatory hurdles that are based on the unpredictable results of clinical trials.

Thus, income approaches, such as the discounted cash flow method, and market approaches, including the guideline public company method and the standard guideline transaction method, are complicated given the stage of development. When regulatory approval is 10-15 years away, and commercial revenue and profitability follow years after, typical valuation models may not apply or may be viewed as overly speculative in the early stages.

In lieu of more traditional valuation metrics such as enterprise value implied by way of revenue or EBITDA multiples, specialized valuation techniques are employed. These techniques include the Precedent Transaction method (“Backsolve”), the Return on Invested Capital (ROIC) method, and the Adjusted Net Assets Value method, where in-process research and development (IPR&D) may be valued separately using a structure like a Relief from Royalty method.

While still in the development stage, biotech companies also require recurring capital raises to sustain operations. This constant capital raising cycle provides regular bookends on implicit valuation as the companies progress through venture-priced rounds.

However, venture value per se includes an element of “blue-sky” valuation that can often differ from the fair market value of common stock in today’s dollars. The aforementioned methodologies, along with others, can provide a calibration point against these venture valuations, but also take into consideration the differential return between the preferred stock being invested in versus subordinate securities, namely common stock and its derivatives.

Valuation Best Practices

Achieving a quality 409A analysis in the biotech space requires an understanding of the company’s underlying science and the nuances of valuation methodology as applicable to pre-revenue, private start-ups.

For example, compiling a set of comparable transactions not only requires the ability to understand the subject company’s technological basis and context, but the ability to seek parallels and analogies outside of a company’s immediate space in the absence of direct comparisons. This often exceeds the scope and ability of typical add-on valuation offerings from cap table management providers.

The ideal partner will have significant experience in this area and will provide timely and quality analysis catered to the individual needs of each company and management team.

Ted Yu wrote this article with the assistance of Brent Glova.