How do you determine the discount rate you need
to calculate the current value of a biotech company
that hasn’t generated revenues yet?

The meaning of a “discount rate” is best understood by making a parallel with the interest rate you get from the bank on your savings account. While the interest rate is a % you use to calculate what 100 Euros on your account will become after a number of years, the discount rate is a % to convert future cash into today’s money.

A life science biotech with a compound in phase I, for instance, will (hopefully) generate revenues in the future, and the revenues in years x, x+1, x+2 etc. need to be converted into today’s money with a discount rate in order to have a number that sums up all future revenues that the company will generate.

By first deducting future expenses from all future annual revenues, you get the Free Cash Flow in each year and when discounted those future free cash flows back to today, you will get what is called the company’s Discounted Cash Flow.

The discount rate will thus have a huge impact on the calculation of the value of a biotech company. It is a % that will need to be determined in the valuation process, and it is not just the interest rate you get on a bank’s savings account, but needs to also incorporate several risk factors. There are three kinds of risk factors that will need to be taken into consideration in the case of a life science biotech company with no products on the market:

• The risk associated with the characteristics of the company, of which its management definitely is the most important one.
• The risk correlated to the stage of the project: a development project in phase I is obviously much riskier than a phase III project. Often, this risk (attrition) is applied separately for a risk adjusted net present value calculation.
• The risk of equity, which also depends on the source of money.

In other words, these are risk factors that determine whether the investor will ever see his/her money back, and collectively they will drive up the discount rate to a much higher % than the interest rate you get from the bank.