Congratulations! You have successfully advanced your drug candidate to the point where it is ready for out-licensing (or so you believe, anyway). You believe that now is the time to perform a full drug candidate valuation for out-licensing purposes. But what exactly is a valuation? And why should you bother with it? Are there any pitfalls or risks? This brief article answers these questions.
What is a valuation?
In its simplest form, a valuation is a calculation of the risk-adjusted net present value of a drug candidate. It takes all revenues and expenses into consideration, then adjusts everything for risk and the time value of money. Transaction expenses, such as upfront payments, milestone payments, and royalty payments, are also included. The net result of these calculation is “The Pie,” which is a simple pie chart showing how the project value is divided between a licensee and a licensor. Once a base case version is established, different scenarios can be prepared, examining different assumptions regarding patient share capture, pricing, development costs and timelines, and many other factors. These models can be relatively simple at first, and increase in complexity and sophistication as negotiations with prospective partners evolve.
Benefits of performing a valuation
1. Question Key Assumptions
The overall structure of a valuation takes many variables into account, such as project revenue, development expenses, and so forth. Each one of these variables will have its own set of assumptions. Some of these assumptions may play a minimal role in the overall calculation, but some may be quite important, such as product price and patient share capture.
The process for preparing a valuation will (or should) force you to question all assumptions, and it is the questioning that is the critical benefit in this process. Obviously, the initial draft of a valuation can be rough and full of placeholders, but the process should be one in which these placeholders are gradually refined and clarified primarily through primary research (i.e., physician surveys and interviews) and consultation with experts in their respective fields. This is certainly not the time or place for personal opinions, even when those personal opinions are based on experience.
2. Portfolio & Strategic Planning
The questioning of key assumptions during a valuation exercise may have an interesting side effect for companies looking to out-license a drug candidate. That is, it may suggest to corporate executives that other internal drug candidates are more valuable and/or more license-able. It is often the case that companies assume that the most advanced drug candidate is the most attractive one from an out-licensing perspective. This may not always be true.
Different therapeutic areas and indications have different licensing “requirements,” and a properly questioned valuation should bring some of these trend and issues to light. For example, a solid valuation will incorporate an assessment of the current approved products for that indication, as well as an assessment of how that treatment paradigm will evolve over time as new therapies are developed and approved. This assessment could be reflected in the underlying assumptions regarding launch date, patient share capture, and even clinical development timelines and costs. The net result may be a shift in the out-licensing campaign from one candidate to another, thanks in part to a thorough analysis underlying the valuation assumptions.
3. Bi-Directional Negotiations
A solid valuation model can be used to assess and respond to term sheet offers from prospective licensees. This much is obvious. But what are “bi-directional” negotiations? By “bi-directional” we refer to negotiations which occur both with prospective licensing partners and Board members / Investors.
For example, consider the following scenario. You are out-licensing a drug candidate, and you are fortunate enough to receive two offers. Offer A includes a $50 million Upfront payment, Development and Launch milestones totaling $100 million, plus future Commercial milestones and Royalties. Offer B includes a $150 million Upfront payment, and milestone at Launch, and Royalties. Both opportunities have the potential of $380 million in cash flow (unadjusted). Which Offer should you accept?
There are pros and cons to both. Offer B, with its $150 million Upfront, will likely be very attractive to Board Members / Investors. But Offer A may have better cash flow and tax benefits, and under certain circumstances may even be monetizable. How do you square these circles? This is exactly where a tool like a robust valuation model(s) can be used to capture these details into a single framework for comparison purposes.
Valuation Pitfalls
1. Uncertainty
For every variable and assumption in a valuation model, there is an element of uncertainty associate with it. Quantitatively speaking, we can think of each variable as having a mean and a standard deviation. But is that mean accurate? How large or small is that standard deviation? Is it skewed in one direction or the other? Sophisticated approaches such as Monte Carlo simulations can provide a great deal of insight into identifying and understanding which variables have the greatest impact on the project value and its standard deviation. But it should be recognized that an entire valuation model, even a solid one, is largely based on a series of interrelated uncertainties.
The more important question is therefore not the “correctness” of the final answer. This is not a math test where there is only one correct answer. Rather, it is an exercise in understanding and living with various levels and sources of uncertainty, and not all management teams and investors have the experience to live with this comfortably.
2. Complexity
As this article suggests, valuation is not a simple exercise. There is a lot of detail and nuance that must be captured in an easy-to-follow spreadsheet. Questions will arise, arguments will ensue, and a potentially painful process will continue until a deal is signed or interested parties walk away.
The pain emerges, in part, from the myriad of interrelated assumptions and endless scenarios. What if we increase price and lose share in the process? What if our CRO cannot recruit patients fast enough and trials are delayed. How will that our impact our time to launch and peak year sales assumptions? How confident are we that our API supplier can handle our requirement for our initial commercial batches at the assumed price points? How do we risk-adjust for a Preclinical drug candidate? And so on and on and on…
3. The Feynman Principle
Richard Feynman allegedly said, “The first principle is that you must not fool yourself, and you are the easiest person to fool.” This precept is important, and especially so when it comes to valuation. Valuations are the perfect opportunity to craft overly optimistic financial models with large market share captures, aggressive pricing, rapid development, and generous Upfront and Milestone payments. Painting rosy pictures with a financial model can drive all sorts of delusional behaviors on the part of corporate management, which frequently result in lost jobs and gapped LinkedIn profiles.
This is often seen in situations where fanciful promises are made to the initial FFF investors (Family, Friends, and Fools), perhaps based on oblique references to comparables. Fast forward a few years, and these “comparables” now must be reconstructed and captured in a detailed valuation. But with the Feynman Principle in full sway, a rather sloppy valuation model is assembled to reflect the aforementioned promises, resulting in unsuccessful fund raising, partnering, and even careers.
Conclusion
It is abundantly clear that the benefits of the valuation process far exceed any risks or concerns. Indeed, we cannot conceive of a single reason why a valuation should not be performed when preparing for an out-licensing campaign. But a valuation is a complex process, filled with details, assumptions, and uncertainty. There is no single correct answer to the question(s) being asked through this exercise. But, while the lack of a conclusive answer to a math problem may seem unsettling to some, it is the actual assembly of the valuation which is the valuable, crucial part of the entire exercise. As Dwight Eisenhower once said, “Plans are useless, but planning is invaluable.” Could he have been thinking about drug candidate valuation at the time? Unlikely, but the sentiment is perfectly appropriate for valuations.