Discovery CROs: what is the “balanced business model” and how is this valued?
Discovery Contract Research Organisations (“CROs”) essentially provide lab-based discovery services such as medicinal chemistry, biological screening etc to pharma companies and biotech, and this business segment has exploded in size, sophistication and value in recent years and is now a focus of both M&A and PE investment. This is covered in our forthcoming white paper entitled “CRO Sector: M&A drivers and market trends Q1 2022”.
Along with this, some of these companies have developed the concept of the “Balanced Business Model” (term coined by Dr Mario Polywka), which means that in addition to the service revenue, the Discovery CRO will take equity in the drug compounds they are discovering on behalf of their clients in the form of a share of future revenues (including upfronts, milestones and royalties), or alternatively take shares directly in the biotech). These options are normally accepted in lieu of full-service revenues and/or recognition of the use of proprietary technologies in the discovery project.
When looking at a public listed business such as Evotec we find that equity analysts employ a sum-of-the-parts approach to derive a valuation for the business. In the case of Evotec this is broken down into the “Execute” (i.e. service) and “Innovate” (i.e. proprietary development) elements.
The service element can be addressed by a relatively traditional multiple of EBITDA, the multiple based on various factors, including the company business plan and wider industry benchmarks. In a Balanced Business Model, any additional value derived from contingent milestones and/or royalties can be carved out of the transaction and left with the seller, to be paid out in full to the seller upon realisation. However, this may not always be the best approach in a competitive sale process as it arguably fails to account for the IP within the company. A solution may be to use a biotech approach to valuing any pre-commercialised assets or IP, calculating a net present value (NPV), which has been risk adjusted for the probability of those future revenues being realised, and adding this to the service segment valuation which is calculated using EBITDA multiples.
However, the challenge for analysts looking from the outside of the company is that they sometime struggle to calculate the full intrinsic value of the development elements, especially for early stage compounds given the limited amount of information that is shared by companies.