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Helpful WSO Posts

Merger Model/LBO (7xEBITDA)

People have a tendency to overcomplicate merger models, and template examples on the Internet are also
very complex in order to generalize and cover every esoteric contingency there is. It is difficult to build a
general M&A model because every company, every capital structure, etc. can be wildly different, which
means most generalized models are too long, too complex and too cumbersome for most actual
investment banks in practice, especially during live deal situations.

The bulge bracket bank I worked at had this ridiculous general M&A model that we used for pitches. The
thing was probably 5 megs with nothing in it, which is unacceptable. My FactSet would crash ~40% of
the time when I opened it. I then worked for an EB where models were extremely streamlined, fast, and
(in my opinion) far better. But they were custom-built for each situation. I now also create custom models
for each situation on the buyside.

Assuming you have a solid foundation in corporate finance (e.g. can build a DCF), there are really only
two things to keep in mind when you're building an M&A model from scratch:

What's the objective? Most times, it's public buyer accretion/dilution, but this can vary (for example, if
you're modeling a private-public acquisition and trying to see how this will impact your returns)

The ONLY thing that matters in each line item is "how does this impact the pro forma math?" In other
words, if you're trying to determine public buyer accretion/dilution, every line can be intuitively deduced
with the question of "how is this impacting accretion/dilution"?

Your pro forma items (PF revenue, EBITDA, etc.) are just acquirer + target, add synergies if you want to
include those assumptions (for your first model, just make it simple and don't add any. Or just add 10% of
sales if you desperately want to). Operating line items (GP, EBITDA, EBIT) are a little bit trickier - there
are companies that report EBITDA differently (for example, pre- or post-stock based compensation
expense, since EBITDA is a non-GAAP metric), so you'll want to make sure your target metrics have
been adjusted to conform to buyer methodology (if your buyer is pre-SBC, you should adjust your target
to be pre-SBC, as everything in your model should conform to the buyer's perspective). But again - just
simple addition (buyer EBITDA + target EBITDA(conformed to buyer reporting methodology) +
synergies = pro forma EBITDA).

When you get to non-GAAP EBIT, you should net out non-GAAP adjustments to arrive at GAAP EBIT
(check your acquirer's and target's 10Ks and 8Ks to see definitions - for tech companies, this mostly
amounts to whether or not companies add back stock-based compensation and amortization of
intangibles). This way you can take out interest and arrive at a GAAP pre-tax income, which you can use
to figure out GAAP taxes.

Your interest expense is the pro forma interest expense. People go overboard on this line item in
particular but you should make it as simple as possible. What's the acquirer's existing capital structure?
How is the acquisition being financed? What's the go-forward capital structure post-transaction? When
you're building your first model, please don't go through the effort of creating multiple new tranches of
debt (for example, this many turns of senior debt and that many turns of mezz, etc.) - that's
overcomplicated. Just throw on a single new illustrative tranche of debt with no early prepayment
(therefore you don't have to model optional repayments) at 5% interest and call it a day. You can add
complexities as your modeling skills mature. If you don't yet know how to build an LBO model, just take
existing interest expense, keep it constant and layer on the interest expense from new debt. I know that's a
shortcut, but the cash flow waterfall down through debt paydown requires the most work, so avoid if you
want to get a general idea of how to build an M&A model before getting more advanced technical skills.
That's pro forma interest.

Take out taxes. Just use the buyer's tax rate, and assume the historical tax rate remains consistent, and (for
your first model) pick a company that is profitable and pays normal taxes. Or just use 35% as an
assumption. Please don't pick a company with NOLs, as that will just trip you up.

Now you have GAAP net income. Here's a tricky part - add back tax-affected non-GAAP adjustments.
You should have the numbers you used to go from non-GAAP to GAAP EBIT (you subtracted them,
remember?), just add them back, but post-taxation (multiply by 1 minus the tax rate).

Now you have non-GAAP net income. Divide by pro forma shares outstanding (did you issue shares to
pay for the transaction?) and voila, you have PF EPS and accretion/dilution.

There's a reason a lot of banks will ask for paper accretion/dilution models in interviews. They're not
difficult. You can even just start with EBIT, layer in the pro forma capital structure using some fake
assumptions and arrive at an acc/dil result.

By far the most complex portion of a "full" M&A model is the debt paydown, which requires a more
fundamental understanding of cash flow. Honestly, in that case, you should learn to build an LBO model
before tackling this.

Again, even with LBOs - start with the very basic fundamental skeleton of a model just to understand
how everything flows before adding complexity. When adding features, just ask yourself "how does this
flow through?" and you'll be alright.
I know the above is convoluted and long and confusing, so if you have questions I'd be happy to answer
PMs. Also feel free to send me an initial model (if you think it's too bad to send, trust me I've seen worse
so don't worry about that) and I can review.

Paper Accretion/Dilution (7xEBITDA)

Sorry for the late response. Here's how:

Pro forma (PF) EBIT = EBIT from Acquirer + EBIT from Target + Synergies
PF Interest Expense = Acquirer Interest Expense Pre-Transaction + Interest Expense of New Debt from
Transaction (if any). This line item requires a debt paydown model to project over time, although it can be
as simple as Interest Rate x Total Debt for back-of-the-envelope calcs.
PF Tax Expense = Acquirer Tax Rate x PF Pre-Tax Income

Then you have net income. To figure out accretion/dilution, divide net income by the PF shares
outstanding.

The only real input in this process that is not immediately obvious is the debt vs. equity mix (which will
determine your interest expense and PF shares outstanding).

Here's an example:

Acquirer

 Acquirer EBIT = 100

 Acquirer Existing Debt = 200, Interest Rate = 5%

 Acquirer Tax Rate = 40%

 Acquirer Diluted Share Count = 100

 Acquirer Current EPS = (100 - 200(0.05))(1-0.4)/100 = 0.54

 Acquirer Share Price = $10


Target

 Target EBIT = 50

 Synergies = 10

 Target is acquired for 10x EBIT, or 500, with 50% stock and 50% cash (paid for with 250 of new
debt at 10% interest)
Pro Forma Math:
1. PF EBIT = 100 + 50 + 10 = 160

2. PF Interest = 10 [calc: 200 * 5% = 10] + 25 [calc: 250 * 10% = 25] = 35

3. PF Pre-Tax Income = PF EBIT - PF Interest = 160 - 35 = 125

4. PF Net Income = 125 * (1 - 40%) = 75

5. PF Diluted Shares = 100 + 25 [calc: 250 / 10 = 25] = 125

6. PF EPS = 75 / 125 = 0.60, +11% accretion vs. 0.54 standalone EPS [calculated as 0.60/0.54 - 1]
Common DCF Mistakes (hominem)

The DCF is pretty simplisitc. But my former analysts used to always trip up on the same things:

 Mid-year convention

 Discounting when the valuation date is not year end

 Properly discounting the terminal value

 Capitalizing unusual swings in working capital into perpetuity

 Not knowing how to pick an appropriate terminal multiple to use

 Not sanity checking what growth rate their terminal value implies

 Getting signs mixed up when calculating changes in working capital.


If you can avoid these, you'll avoid like 90% of the most common mistakes in putting together a DCF.

"The most valuable skill you can have is learning to build relationships with those above you." Unless
you work for yourself, you can advance only so far in your career based on your skills before you hit a
ceiling. How far you go beyond that will depend on how much those above you are willing to pull you
upwards and root for your success.

How to Get Sleep (hominem)

The key to getting more sleep is to get off to a good start, do good work, and develop a good reputation. It
will suck for the first 6-9 months, but I have found that people develop impressions quickly and the best
analysts not only got paid the most and worked on the best deals, but had more control over their
time/schedules. The other piece of advice I have is to develop a good relationship with the staffer and the
people on your deal teams. If you have a good relationship with them, they will "protect" you when you
need them to and ensure that you are not overstaffed. However, if you are just that nameless analyst in the
bullpen diligently grinding away, trust me, you will be in a world of hurt.

Loyalty to the firm (hominem)

Q: Answers from those in the Investment Banking industry and not students. Thank you.
 2017 graduate

 worked for a couple months

 a small boutique in new york

 haven't taken series exams yet

I love the culture, people, and deal-flow at my bank but like most people on this forum. I've always
wanted to chase the best opportunities available to me. I've worked for 5 months.

I've been approached by recruiters from the best groups @ EB's & decent groups atbulge bracket
bankslooking to poach and I'm wondering the following:

1. Am I a p.o.s. for wanting to lateral?

2. Will they contact my firm during the recruiting process?

A: Trust me. If the situation were reversed and they needed to fire you tomorrow, they would. There is no
loyalty. It's just business, and they will pretend to get angry but they would do the same if they were in
your shoes.

Fuck 'em. Never willingly cockblock yourself. Ever, in any context. Ya heard??? There is no greater
regret in life than looking back on an opportunity you didn't execute on. Everyone comes to point like this
in their life where they have to leave behind a relationship, job, etc. and move on to better. If you don't,
the people around you will.

What does it mean to be street smart in IB? (hominem)

I have given and received my fair share of reviews. If someone says that to you, as an analyst, it means
that you lack common sense...such as, thinking it is OK to practice Dalio's principles at the bank you're at.
That is not a good comment to get. The reason it's bad is because common sense is hard to learn. People
tend to be more forgiving if the person who lacks common sense is just starting out ("oh, he just doesn't
know any better" type of thing). But it becomes a real liability very quickly. For example, I had one
analyst who was very smart (3.8 gpa from top school, high test scores, hard working, great person) but he
lacked "street smarts". People thought he did fantastic work, but everyone was afraid to bring him to
meetings with clients or even with senior people internally because everyone was afraid what would come
out of his mouth. My best advice to you is...observe the people around you and copy what they do. If
nobody at work is practicing radical honesty and transparency, then don't go around doing it even if you
believe in it.

VP/D/MD Level in Banking (hominem)


1. If you get passed up for promotion, it's understood that the bank is effectively telling you that you
should quit. Usually, however, it's not a surprise. Many people voluntarily quit as an associate to
do something else, but I also know many people who have quit because they were given hints in
their second or third year that they would have a hard time making it to VP.

2. VPs / MDs usually go to another bank or they go into a corporate role.

3. MDs can get promoted to the head of a vertical within a group, then the head of the entire group,
then the global head of a group, then the head of a region, etc. There's always something to keep
people moving up.

4. There's no standard answer. But MDs have revenue targets that they have to hit every year. I've
heard that you are given more leash as a junior MD as you build your book of business, but after
that point, you either produce or you are asked to leave.

5. Banks usually don't promote people to VP unless they think they have the potential to be an MD
down the road. But it's obviously bank specific and highly dependent on the market environment
at the time. If times are good, then the bar will be lower because the bank just needs people to
execute all the deals that are going on.

6. It's a combination of all of those reasons. I would say that many of my associate classmates went
into the job knowing that they would not be career bankers. Many saw it as an opportunity to
spend a few years building a skill set that they can leverage for the rest of their careers. Others
realize that the opportunity cost is just not worth it, especially as they get older, or that the job did
not line up with expectations (nothing prepares you or the people close to you for being on call
24-7). And others don't make it because they were laid off when the economy soured, or did not
get promoted because they did not perform up to expectations, or were simply fired.
How soon to tell your mentor that you’re leaving the firm? (hominem)

Q: Background: I work at a middle market investment bank (less than 500 people nationwide). Joined out
of college, been here for nearly 3 years. I'm leaving the firm next summer to join a start up PE shop. Yes,
I will make less money in the near term, sure I will have less prestige, more uncertainty, all that jazz. Not
important to me.

I am having drinks with my mentor in a few weeks. This guy is the reason I joined the firm and partially
why I have remained so long. I don't want to just up and leave without giving him a heads up. I would
also like his mentorship, guidance, opinions, and potential investment moving forward. But I dont want to
tip off people in the firm too soon about my move (especially because I still want my bonus).
How soon do I tell my mentor? in a few weeks when we sit down or next year (before I tell anyone else
but close to my departure date)

A: Definitely closer to your planned departure date if you do no want to to get screwed. He is not your
best friend or college roommate. He is your mentor who has a business obligation to let other people
know if someone is leaving and could impact the business. Even if you trust him, don't put him a situation
where he has to keep a secret on your behalf.

Why do you pay off debt in an LBO exit? (Intern4ever)

Most LBO debt has a change of control clause, so when the company changes control (is sold), they are
repaid.

Depending on how early it is, they will get bonus fees along with repayment. It makes sense if you think
about it, because the debt investors committed their capital for a certain period of time, and now they're
going to have to find somewhere else to deploy it.

Why go from EB to BB? (mergersandacquisitions78)

There is a massive amount of misinformation on this thread.

Let me take some misnomers one by one.

1. EBs are not a new phenomenon. Lazard has existed as an M&A specialist for the past 50 years,
Blackstone had an M&A business for 30 years. In the 1990s, you had firms such as Wasserstein
Perella and Wolfenson & Co., which was every bit as highly regarded as your Centerviews and
Evercores. They had the same benefits and issues then as they do know.

2. It is almost impossible to become a great senior banker having grown up at a boutique investment
bank. It doesn't happen. You can count the exceptions on one hand (Antonio Weiss at Lazard and
Robert Pruzan at Wasserstein and almost no one else). The street is littered with the bodies of
really strong execution bankers who make Director or Jr. MD at a boutique firm, and can't get the
clients to be an effective partner. Even the ones who make MD and stick around are struggling.
These guys are often 40+ years, have no real clients of their own, carry the bags of the real
rainmakers who came from BB firms, and make maybe $1.5mm a year. Do you really want to be
that guy?

3. A bulge bracket firm offers a lot more than financing to an aspiring MD. There are many other
tangible advantages:
 the most significant is resources. When you are a sr. Vp or a Director or a junior MD at
a BB firm, you have an army of junior people at your beck and call. That means you can spend a
lot less time directing work yourself and call on a whole lot more clients, and develop a much
larger rolodex. The comparable banker in a boutique is always bogged down on deal execution or
putting their own pitchbooks together

 you have a far greater network of information about what is happening in the market, which
makes you more relevant to clients as you are making your bones. Never underestimate how
lonely it is a boutique where you don't have a large group of colleagues around the world
gathering relevant information

 sponsor relationships. Sponsors really care very little about boutiques because the driving factor
in any sponsor deal is leveraged finance. Its all very to be doing large corporate deals when you
are an established MD but sponsor business is the lifeblood of one's career when its being built,
and that accrues primarily to the BBs

 finally, financing matters, a lot. Unless you are Frank Quattrone, you are not a relevant
technology banker without the IPO product. I've discussed the leveraged finance product above.
Its hard to really understand all forms of M&A without understanding financing, and most
homegrown boutique bankers come up short

4. Conflicts of interest are part and parcel of life in banking. The way you answer the question on
conflict of interest to a client is to say, "you have a lot of different ways to pay me, so I can be
more objective about any single transaction given the long-term relationship". At boutiques, the
only way you get paid is a successful M&A deal, so I'd argue the incentive is worse to push bad
deals. But as I said earlier, there are always conflicts of interest. Good bankers manage them. Bad
bankers don't know how. Good bankers get paid. Bad bankers don't.

5. I don't deny the advantages of working at a boutique as an analyst or associate, but all of those
advantages become disadvantages the day you turn VP and become career killers the day you
progress beyond VP. The truth is there is no real credible banking career path outside
the BB (maybe some smaller or regional firms like William Blair or Stephens, etc., but that's a
different kettle of fish)

6. Comp is higher at the boutiques at the analyst and associate level, probably equal at the VP level,
and lower at other levels unless you are absolutely successful at the eat what you kill model. If a
good group head at a BB is making $5-6mm a year annually, it is very hard to do that consistently
at a boutique. That said, the upside is a lot higher at a boutique for the very top echelon (Blair
Effron, Simon Robey, etc.)

IB Career: 30s, 40s, and Beyond (mergersandacquisitions78)

I've been meaning to comment on this, as a 30-something who has spent their career in banking, and with
no immediate plans to leave.

1. I have said it before and I will say it again. Your career in investment banking only really begins when
you make MD. It may be hard for someone just starting out to swallow, because its a long road to make
MD, but the truth is: that's the step that really allows you to play the game. Everything before that is
simply a well paid apprenticeship. So I while I think people should feel proud of making MD and perhaps
look up to MDs, its no differently than completing your fellowship in a specialized area of medicine.

2. The variability of compensation as an MD is extremely high, and not necessary easy for junior bankers
to fully fathom as they are paid effectively in a lockstep. I know MDs who average $20mm a year, and I
know MDs who average $1mm a year. I don't know any BB NY MDs who average less than a $1mm
(they would be forced out which is another reality of the job) and I would say post financial crisis average
is around $2mm. As an aside, I always find it interesting that when people on this board compare careers,
they look at the absolute top 5% of PE guys or HF guys who pull down $10m+ and compare them to the
median BB MD. If you took similar percentile outcomes, except at the very top (top 1%), the
compensation converges and I'd say median is still higher in banking.

3. Is $1mm a rich or upper middle class lifestyle? Depends on your perspective I guess. Certainly, even in
NYC, it can give you a comfortable lifestyle with everything one could possibly need and more. Its not an
extravagant lifestyle, but who really needs extravagances. Certainly, the top half of MDs pulling between
$2mm-$20mm a year can quite quickly afford extravagances if one is so inclined.

4. As far as the long-term career path and lifestyle go, I certainly work very hard, but no harder than my
peers in private equity or the senior corporate executives I cover (and there are MDs who work a lot less
harder than I do). Another thing people tend to ignore that in corporate careers, people tend to work
harder as they get more senior (vs. banking where the pyramid creates the opposite effect). But the fact of
the matter is that people in successful corporate jobs tend to work hard wherever they are.

5. As far as the personalities go, amongst banking MDs, there are difficult individuals and good, well
rounded people. But I don't think people should put MDs on a pedestal. Being an MD is essentially an
upper mid level corporate role. Some of us will make it to the very top, others won't (there are many
different grades of MDs). The good part of banking though is that even the ones who don't make it make
good money, and the ones who do make it, make outstanding money.
6. I personally think being a successful MD is one of the most interesting jobs out there. I obviously still
have to pitch for business but the more I do it, I choose my clients, not the other way around (i.e., if I put
my time onto something, I will win it. The constraint becomes where I choose to spend my time). At any
given point, I'm working with 10+ of the most interesting companies in my industry, advising on their
most important strategic matters or raising critical capital. If I pick up the phone and call any of the top
executives in my industry, I'm dealing with them on an equal playing field. And I have the time and
running room to really dominate if I work hard for another 5-7 years.

7. Nothing good comes without sticking to it for a relatively long period of time. Successful careers in
your 30s and 40s are built by working hard and developing real valuable skills in your 20s.

Never eat Alone (Keith Ferrazi)


The Start Up of You (Reid Hoffman)
Influence (Robert Cialdini)
Merchants of Debt
Drive (Daniel Pink)

James Altucher

Antonio Weiss (Lazard)


Throwing the Elephant (Stanley Bing)
What got you here, won't get you there (Marshall Goldsmith)

When they ask, 'how's everything going today' especially if its on Monday, I tend to reference something
similar to:

"Still feeling good off a 2nd place finish this past week at a golf tournament." if I can sense they like golf
or if I can sense they follow football I'll mention "Still trying to get over the loss the Cowboy's had this
weekend" and also ask 'wbu'.

If they like the sport, or enjoy it, they'll get more into it and ask you about it.
The Chimp Paradox (Steve Peters)
The One Thing (Gary Keller)

Biotech Valuation (biotech212121)

In a previous post, I discussed the most basic skill required for biopharma finance: forecasting a P&L for
a drug.

In this post, I'll discuss the next step -- valuing biopharma companies. This is intended for people who
understand basic finance and valuation but aren't too familiar with biotech. If you work in a biotech
group, you probably already know this. Subsequent posts will cover topics that you'll need on the buyside
(not sure when i'll get around to those however, this one was a bit longer than i anticipated).

How Does Valuing Biopharma Companies Differ From Valuing Other Companies?

Drugs have short and explosive life cycles, with new products growing from nothing to billions of dollars
of high-margin revenue in just a few years, and then going to zero overnight when patents expire. Newly
launched competing products can erode what once seemed like lasting franchises. Even $100B+
companies can lose 40% of their market cap almost overnight when one study of an unapproved product
doesn't go as planned (look at Bristol Myers in summer 2016).

The drug industry is characterized by high growth, high profits, binary risk, and volatility. In many cases,
significant portions of a company's valuation don't show up in financial metrics - late-stage unapproved
drugs can be valued at tens of billions of dollars before they even enter the market.

To value biopharma companies, you need to do more than dig into the financials -- you need to dig into
the products. And that means you need to get into the science.

But valuing products is a subject for another post. This post will be a "stepping stone" on the way from
the traditional finance techniques you are familiar with to more science-oriented concepts you'll need to
become familiar with in order to evaluate products. Specifically, in this post I'll provide an overview of
the valuation methodologies commonly used in biopharma, and highlight a few biopharma-specific
modeling considerations.

Valuation Methodologies For Biopharma Companies

DCF / sum-of-the-parts

DCFs are tricky in any industry, as they are very sensitive to assumptions, and it can be hard to nail down
key assumptions.

In biopharma, DCFs are even more difficult, as they layer on even more assumptions than DCFs for
companies in other industries. Despite this lack of accuracy, they play a larger role in biopharma
valuation than many other sectors, and are often the main method for determining a company's valuation,
especially for earlier stage companies.
For many (if not most) pharma companies, significant value lies in the pipeline of unapproved drugs, or
drugs at the earliest stages of commercialization. It is tough to use multiples for these products, as they
don't generate revenues or profits. You can use forward multiples to try to capture the value of early-stage
products, but that can get complicated quickly: do you use revenue or P/E multiples? What year's revenue
or earnings do you apply the multiple to? Should you use an NTM multiple, or 2-year multiple, or
discounted 5 year multiple? These answers will be different depending on the company.

You'll still use multiples based approaches, but rely a bit more on the DCF to give you more granularity.
In some cases, you'll do a sum-of-the-parts DCF valuation, sometimes you'll do a SOTP and use different
multiples for different products. If you are evaluating a $50B+ company, you can probably just use LTM
and NTM P/E, but the earlier stage the company, the more you'll need to explore using revenue multiples,
discounted forward multiples, 2+ year forward multiples, or some combination of those.

Forward P/E

In biopharma, P/E is used more often than EV/EBITDA. In most cases for larger, commercial-stage
companies, LTM and NTM P/E are used, but often people will use a longer-term forward P/E or a
discounted forward P/E for earlier-stage companies. The rationale for this is that a company may have
valuable products that are either not launched or are in early stages of launch, so the products will
generate little or no earnings for years, so using NTM P/E would not accurately capture the value of the
products. So you pick a year in the future where these products become more mature and can be valued
using P/E, then put a multiple on those forward earnings, then discount it back.

For example, if you have a product that you think will be a $1B revenue product in five years with 60%
contribution margins, but that product is only expected to generate $10M in revenue next year, you might
use earnings in year 5 for your P/E. Then you would look at comps, figure out the mean and median NTM
P/E for those comps, multiply that by your year 5 earnings, and then discount that back four years
(because you are using NTM P/E on year 5 earnings, so you are effectively using year 4 as your valuation
date).

If that sounds confusing, it's probably because it is a somewhat contrived approach. It makes theoretical
sense, but in practice it is pretty squishy. What year's earnings do you apply the multiple to? In the above
example it's year 5, but could it be year 4, or year 6? Let's say you want to look at year-5 earnings; should
you use an NTM P/E on year 5 earnings and discount it back four years, or a 2-year forward P/E on year 5
earnings and discount it back three years? Or use an LTM P/E on year five earnings and discount it back 6
years? What comp set should you use?

Each of these could yield significantly different valuations, and there isn't really a "standard"
methodology as far as I can tell. Your VP may end up asking you for 15 different permutations, all of
which are semi-justifiable but none of which are that great.

Like all valuations, you'll use a combination of different methodologies, but these complexities make it a
bit trickier to figure out "reasonable" multiples to use for a biopharma company.

Revenue multiples

Using revenue multiples can get around some of those issues and can be a "cleaner" way to use multiples
to capture the growth potential of early-stage products. Typically a product will generate a meaningful
amount of revenue before it generates a meaningful amount of profit, so you can put revenue multiples on
earlier years than you can for P/E multiples (ie, if a product generates $100M revenue but only 20%
contribution margins in year two, and "mature" margins are expected to be 50% starting in year 5, you
may need to use year 5 for a P/E multiple but could potentially get away with year 2 for revenue
multiple). However, if a company has high-growth products as well as material earnings from "mature"
products, it's probably better to use P/E, or a sum-of-the-parts approach with different multiples for
different products.

Of course it is still a very imperfect method. As discussed in the prior post, forecasting the sales trajectory
of a new drug launch is very difficult. It's also not straightforward to pick which year's revenue to use - do
you use 2-year forward revenue, 3-year, 4-year?

One way you can get around this is to use a "peak sales" multiple. Pick some comps that were bought at a
similar stage to your company, figure out the peak sales of their main product(s) (assuming there are only
a few major products), then divide equity value ("tech" value, assuming a company has no debt) by peak
sales and there's your multiple. This way, you don't have to guess about the sales trajectory, and you don't
have to worry about picking a year for your forward multiple. Of course the downside is that you may not
have a great comp set, and this doesn't really account for how quickly / slowly your product will ramp.

Strategic / exit value


In the current market, many small or mid-cap companies are valued more on likelihood of getting
acquired by big pharma than on conservative estimates of expected value of their cash flows. In the last
five years pharma companies have shown extraordinary appetite to buy companies at very high premiums
that can only be justified by very optimistic projections. In some cases, a pharma company will pay
whatever it takes to get the deal done for assets that their science team deems highly strategic. So there
has existed an "M&A thesis" that many investors follow, where they try to identify the next M&A
candidate and then more or less value the companies based on a probability-adjusted discount to M&A
comps.

You probably shouldn't use this technique much if at all, as it is difficult to justify with traditional
fundamental valuation methodologies, but it is helpful to be aware of this because it reflects a current
market reality. Many valuations are difficult to explain using traditional techniques, but that doesn't
necessarily mean that they are wrong (at least in the short-term) - just that investors are betting on
pharma's willingness to pay up for strategic assets.

If you look at models in equity research reports that use DCF or multiples methods to value companies,
you will often see that there are a few pretty aggressive assumptions hidden in there. Without these
aggressive assumptions, a reasonable DCF in many cases would get you a valuation below the current
market price. In these cases, what's likely going on is that the market views the company as a takeout
candidate.

VCs use a framework that is sort of similar to this when valuing early-stage companies. The idea is that
you focus on the few assumptions that matter and "outsource" to the market assumptions that don't move
the needle. You're giving up some precision in return for better accuracy. For example, probability of
technical success at a given stage (preclinical development, Phase 1, etc) is probably the biggest
determinant of value for early-stage companies, assuming there is a large enough market. Getting 50%
smarter on probability of success will inform your valuation much more than getting 50% smarter on
steady-state contribution margin. Consequently, startup valuation becomes more about diligencing
technical risk than doing complex financial analysis (which is why most VCs are PhDs, not bankers).
More on this in another post.

Biopharma-Specific Modeling Considerations

Beyond differences in valuation frameworks, there are a few finance and accounting idiosyncracies
unique to biopharma. Many of these are very complex and technical, and you won't be expected to master
them - you'll just need to know how to make reasonable assumptions and, in live deal or bakeoff
situations, consult specialized lawyers, accountants or consultants for their take.

Terminal value and patent expiry

Most drugs have a terminal value of zero: when key patents expire, generics flood the market, and
revenue drops 90%+ basically overnight. For these products, it is incorrect to model much if any terminal
value. Rather, you can often model out sales every year until key patent expiry, then assume the drug is
worth nothing.

For small molecule drugs, you should almost always assume that once patents expire, the drug is
worthless. FDA has well-established regulations for enabling fast approvals of "generic" small molecule
drugs.

For large molecules, however, "genericization" is less black and white. Due to the more complex nature
of these molecules, it is harder to prove a large molecule is "biosimilar" to another large molecule. FDA
only recently established a pathway for approval of "biosimilar" large molecules that are substitutable for
pioneer large molecules, and this pathway is harder and more expensive than the pathway for small
molecules. I'm not super current on the biosimilar world, but basically large molecules have longer and
larger "tails" than small molecules when patents expire, so it is not always appropriate to forecast
significant revenue erosion upon patent expiry. You need to look into the details of the particular drug
you are forecasting.

So while you generally won't include a terminal value for products, sometimes investors place a terminal
value on a platform (though you really need to exercise caution when doing this). The idea here is that a
company has some fundamental scientific competency that makes it possible for them to discover and
develop lots of new drugs, or a BD competency that gives them an advantage in identifying and licensing
promising assets. So you could include a terminal value to account for the value of products the company
has not invented / acquired yet, but is likely to invent / acquire in the future.

If you do this, you should have a good reason for it, and this should not be a big part of the value. The
value of a drug increases exponentially as it advances in development. At the earliest stages, a drug
candidate has a 1/10,000 chance or less of getting approved, thus very little value. Most of the value of a
platform is determined by one or two products, and the value of the rest of the platform is typically almost
meaningless.
"Biobucks"

The deal terms in the press releases around biopharma M&A or licensing deals are often pretty complex.
You'll often see an "upfront" payment of some smallish amount, maybe combined with an equity
investment, and then some development, regulatory or commercial milestones, and then royalty rates.
You might also see that the licensor has agreed to pay x% of all development expenses for a particular
product, or has an option to license rights to a few products in certain geographies, or even an option to
acquire the whole company.

These contingent payments are referred to as "biobucks" (although often royalties are excluded from this).
Nearly all partnering deals in biopharma have some sort of "biobucks". Biobucks are important because
they enable companies to structure around risk. Sellers want to get paid if their products work, but buyers
don't want to pay up for risky drugs that will most likely end up worthless. Biobucks enable companies to
structure deals that bridge this gap.

However, this can make valuation more complex. For one, it adds another dimension of complexity to
M&A comps. Often you'll have a column in your comp set for "upfront" value, and a column for "total"
value. These numbers can be very far apart.

It also makes modeling more difficult in some cases. In addition to forecasting and valuing a P&L, you
need to account for any deal-specific terms that alter the P&L or balance sheet. A few common terms to
look out for:

 Upfront fee: pretty self-explanatory, this is just cash that acquirers / licensees give a company in
exchange for rights to an asset. This fee can be distributed to shareholders of the recipient
company or re-invested into the company.

 Equity investment: sometimes licensees will invest in a licensor's equity, and you'll need to
account for this. How you account for this will depend on the structure of the transaction and the
resulting ownership level.

 Option payments: often licensees will pay the licensor for the option to license a particular
product, or a particular set of rights (ie commercial rights in Greater China). Companies can also
negotiate options to acquire entire companies at pre-negotiated terms.

 Milestone payments: these will need to be accounted for, often as licensing revenue for the
licensor or as a liability / expense for the licensee. Often you'll need to make some estimation as
to the probability that these milestones occur. The details of this can vary depending on the
particular deal, so take a look at whatever's available in the SEC filings and press releases.
** Development milestones: money paid upon achievement of certain clinical or preclinical
milestones (IND filing, Phase 2 study initiation, lead candidate selection, etc)
** Regulatory milestones: typically FDA approval, can be other regulatory milestones (IND
filing, End-of-Phase-2 meeting, or equivalent milestone in another country)
** Commercial milestones: these are one-time payments based on achievement of certain sales
thresholds (annual or aggregate sales). These are distinct from royalties.

 Profit / cost sharing: sometimes companies will enter into profit sharing agreements, or share
development expenses. Sometimes a licensor will pay for development expenses up to a certain
point, like Phase 1, and then the licensee will take over a percentage or all of the expenses. These
are common terms but will vary based on the specific deal.

Modeling all of this can get pretty complicated, but it is important not to gloss over these terms. In some
cases I've seen investors get this wrong and value a company as if they had nearly all the economics for a
key asset, when in reality the company owns only a fraction of these rights. Don't do that :).

Discount rate

Discount rates in pharma are tricky, which is problematic because DCFs play such a large role in
valuation. Traditional methods of calculating discount rates like CAPM don't really yield usable numbers
in biopharma. The risks associated with biopharma companies are often unique to the company itself, and
this can make it hard to compare risk and volatility across companies. Volatility for biotech stocks,
especially pre-revenue companies, can be crazy and beta values are often useless.

In practice, investors will typically bucket companies into different groups based on development stage
and size, and then apply progressively lower discount rates to larger companies. Figuring out the right
discount rate when a big company buys a small company can be tricky - do you use the small company's
discount rate, or the big company's discount rate? Should they be that different in the first place if the
risks are diversifiable?

Taxes

This is a very complex area and for live deals or bakeoffs you may need to consult with lawyers and
accountants. I'll just highlight a few pharma-specific issues, and then let you do further research to figure
out how to model these factors.
The first issue is NOLs. Many pharma companies accrue a lot of net operating losses when they are
developing their drugs, and these losses can be valuable tax shields. In M&A, you'll want to pay close
attention to how NOLs are valued. This is an area where you'll want to figure out how your group
typically handles this accounting, and get feedback from lawyers and accountants on important deals. For
the purposes of this post, I'll just flag it as something to look out for.

The next major tax issue is understanding how various corporate structures and IP domiciles influence tax
rate. Many pharma companies have historically domiciled much of their core IP in low-tax countries like
Ireland, so profits from drugs using this IP is taxed at a very low rate. These laws are complex and rapidly
changing, and when you need to get sharp on this, usually for a live deal, consult with lawyers.

IP domiciling and tax can be a really interesting and important area, and while it isn't expected you know
much about this, if it piques your interest and you learn about it then it can be a nice way to differentiate
your skill set.

IP

This is another very complex topic that is also very important, and one you aren't expected to know much
about as an analyst (or probably even as an MD). Being wrong about IP is often a costly mistake, so if
you are in a position where you need to make assumptions about IP in a live deal context, talk to a lawyer
or consultant. It is also a highly technical intellectual rabbit hole, and if you find that you like this area, it
can be a valuable way to differentiate your skillset.

When you are modeling drug revenues, it can be important to have good assumptions about patent expiry,
and you probably can't get away with spending a couple grand on a lawyer for your pitchbook model. In
these cases it's probably best to read equity research reports, company presentations or SEC filings to
figure out where the market is bounding patent risk, and just run sensitivities on that.

Sensitivities

One major takeaway from all of this is that "garbage in, garbage out" applies even more in biopharma
than for many other industries. You don't have historical financial information to anchor estimates for a
substantial part of most businesses. There are a lot of assumptions, and they stack up very quickly. You
need to be very diligent about your assumptions, and you will often have to make assumptions that you
don't feel 100% confident about, because you just don't have data.
In addition to doing the usual sensitivities, spend extra time thinking through 1) which assumptions move
the needle the most, 2) your "confidence intervals" for each assumption and 3) where you differ most
from the market and your conviction level around that (you should do all of this for any valuation work
you do, but it is especially important for biopharma). This is probably less important for banking than for
the buyside, but it's never a bad idea to be extra diligent about your assumptions.

Selecting a comp set

Especially for pre-revenue companies, you won't select comps based on sector, size and other financial
metrics. You determine your comp set based on factors like disease being treated (the more specific the
better), stage of development, type of drug (what is the molecular target of the drug, mechanism of action,
how good is the data), and commercial factors like price, number of patients who are candidates for the
drug, and sales channel / reimbursement (are you selling to hospitals, primary care physicians,
dermatologists, etc). CapIQ and FactSet aren't great for this, although you can use tools like Evaluate
Pharma, or just do a ton of googling.

How To Learn This

If you can find a fairness opinion for a relevant biopharma deal, that can be a helpful resource. Equity
research reports can also be useful as a framework, although you should obviously take a critical look at
their models. A helpful exercise for learning is looking at a bunch of ER models, seeing where they have
divergent assumptions, and then developing your own view on the fundamentals and appropriate
valuation methodologies.

Putting your money where your mouth is can also be a great incentive to learn quickly. Treat it like
bitcoin -- only invest as much as you can afford to lose, and expect a wild ride. And beware of shorting -
it can work, but many stocks are hard to borrow, and it is not unheard of for companies to get acquired for
300-600%+ premiums, so you may lose more than you bargained for.

What Next?

Eventually, you'll start asking questions that are critical to your valuation but that you don't have answers
to. Will FDA approve this drug? How likely is it that the upcoming Phase 2 studies are positive? Will a
generic company invalidate a key patent next year? Is this drug better than a competing drug? Answering
these questions is at the heart of the work you will do on the buyside, and requires learning enough
science to have intelligent discussions with physicians and scientists. You don't need a PhD or MD to do
this, but there is a fairly steep learning curve. I'm not aware of many good articles / books on these topics,
so I may write other posts on these in the future if I can find time.

Response

Great post. A lot of very useful stuff in here. That said, I have to quibble with a few points:

On discount rates:

The discount rate should only capture market risk and not subject entity risk. Ideally, the subject entity
risk should be captured in the defined scenarios. Biopharma forecasting is scenario-based forecasting. The
valuation analysis should consider multiple IP scenarios in the situation where there's significant IP risk
(not sure about the strength of a formulation patent?). The same is true for other, non market risk factors
(R&D, regulatory, etc).

Also, the proper discount rate is always the target's discount rate (not your own).

On not needing a PhD or MD:

I have to disagree here. At the end of the day, your forecasts must be supported, if not provided, by
someone with the proper technical background. You simply cannot understand (and therefore adequately
quantify) the regulatory and development risk without an understanding of the product's chemical/clinical
attributes and benefits. Sure, at an early stage, you can rely on IMS analogs, statistical benchmark studies
and/or ER reports, but all of those are estimates that are too high level for an actual transaction - they
don't consider the entity specific attributes. In addition, you simply wont understand the true clinical
benefit of the product relative to the competition and thus will have difficulty understanding physician
prescription dynamics (i.e., the uptake curve) as well as the appropriate marketing strategy.

At the end of the day, the forecasts really come from the PhD's at any reputable organization.

Biotech212121 response

Thanks for your comments, those are fair points. My main point about the discount rate is that in many
cases it is hard to get useful betas in biotech, esp for low liquidity stocks, and that while the market risk
premium is supposed to reflect non diversifiable risk, in biotech the market risk premium in reality
(incorrectly) often includes risk that is actually diversifiable. This shows up in many M&A scenarios. But
i was sort of sloppy in that section adn your points are fair

Think we will agree to disagree on the MD / PhD point. You are absolutely right that you need to
understand a drug's chemical and clinical attributes to estimate probability of success and market
adoption. But i dont agree you need an MD or PhD to do that. I know investors at all levels from analyst
to partner at all kinds of funds (11-figure AUM hedge funds to the most prestigious early stage venture
funds) who don't have an MD or PhD. The most successful biotech entrepreneur I know is an MBA, not a
PhD or MD, and he is a better judge of the value of science than any PhD I know (and the PhD VCs I
know tell me the same thing). I have a friend who is a pharmacology Phd and runs a VC backed
hematology company, and she says that she knows finance people with no science background who know
more about hematology than she does (and she knows a lot about hematology).

This is because ultimately, you do diligence by talking to people. To properly evaluate a drug you need
PhD-level expertise on 5-10 different topics, and no single person has all of that expertise. Even if they
did, evaluating science involves so much uncertainty that you can't rely on a single person's assessment.
Your job as an investor is to identify key risks, solicit the opinions of leading experts to better understand
those risks, then synthesize that info and make business judgments. An investor should rely on others for
technical expertise, but rely on him / herself for judgment and decision making

You need a baseline level of scientific and clinical knowledge in order to rapidly learn enough about a
given area to identify key risks and have intelligent conversations with domain experts, but beyond that
baseline level, technical knowledge is less marginally useful than 1) ability to learn quickly 2) ability to
conduct efficient, productive, unbiased interviews with domain experts and 3) good judgment and critical
thinking skills

If you do a PhD in molecular biology, cell biology or pharmacology, you will have some but not all of
that baseline level of technical knowledge, but you don't need to do a PhD to get that knowledge
(however you need to work very hard and be very self-directed to learn this stuff w/o a phd).

The reason that an MD / PhD is a good filter for hiring biotech investors is that there aren't that many non
phd-mds who do the work to get up to speed on science, so the false negative rate for the filter is pretty
low.

While Using a DCF and WACC, Where do I input my own required rate of return? (Junior FI)

Q: Hi everyone,

From an investors perspective while calculating a DCF(FCFF using WACC), where do I put in my own
required rate of return? Do I replace the cost of equity with my own return in the WACC formula?

**Wacc Calculation **
Target Capital Structure
Debt to Total Capitalization 29,1%
Equity to Total Capitalization 70,9%
Debt to Equity Ratio 41,8% O

Cost of Equity
Risk-free rate (2) 2,5% Interpolated Yield on 10-year Treasury bond
Market risk Premium (3) 7,1%
Levered Beta (4) 1,22
Size Premium (5) 1,7%
Cost of Equity 12,8%

Cost of Debt
Cost of Debt 12,0%
Corporate tax rate 22,0%
After Tax Cost of Debt 9,4%

WACC 11,8%

Let's say that I want a yearly return of 20% on this investment to cover the rate I believe I can get
longterm from indexfunds and a riskpremium in this specific company. Would the WACC to use then
be 20%(My required rate of return)+9,8%(Cost of debt) = 29,8%?

A: Almost correct. It will be 9.8% * [preferred debt ratio] + 20% * [1 - preferred debt ratio]. Debt is
supposed to make your return higher (or allow you to offer a higher price for the same return). Think
of it from the following perspective:

When you make a 100% equity transaction, you require a certain rate of return, say 20% (these days
in practice it is way lower, think 15%). If you put leverage on that same transaction, you will still
require the 20% return on the equity-financed part of the investment, but the entire investment also
includes debt, which requires a different (lower) rate of return. In practice this is usually the interest
you will pay on the leverage for that investment. Hence your rate of return on your investment will
be the weighted average of 20% on the equity part and 9.8% on the debt part.

This is why your return increases for debt transactions. Instead of discounting with the 20%, you can
discount with a lower %.
Q: rom your formula you need to remove taxes for debt too I guess?

A: Correct

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