The Valuation Of Drug Development Projects—Part 1

Sangeeta Puran, Mayer Brown International, Senior Associate, London, UK E-mail: spuran@ mayerbrown.com

I. Introduction To Valuing Drug Development Projects

Drug discovery, research and development (“drug development”) follows a sequence of distinct stages, each of which aims to generate “economically valuable specific knowledge” about the drug candidate in question. In this way, the implementation of a drug development project generates intellectual assets capable of transfer or licensing. Determining the monetary value of these intellectual assets is central to internal research prioritisation, investor funding decisions, business development negotiations and equity analysis in the pharmaceutical and biopharmaceutical sectors. Valuation can involve a market, cost or income approach. This section provides a basic introduction to valuation theory. We start with Net Present Value (“NPV”), which considers the cash flow opportunities of the asset in question and incorporates the income approach.

1.1 Summary of project lifecycle and cash flows.
Figure 1 shows the typical project lifecycle from a cash flow perspective. During the early research stage, project cash flows tend to be negative. Early stage research can take several years, but is not as expensive as clinical development. The drug is launched upon marketing approval being issued, followed by relatively fast market penetration. A stable period of revenue generation follows. Finally, revenues decline following patent expiry. The project lifecycle is such that, even though the basic term of patent protection lasts 20 years from the date the application for the patent was filed, the period during which revenues can enjoy patent protection is effectively reduced to the patent term remaining after regulatory approval.
Financial models vary on how far into the project lifecycle they forecast. Patent expiry is a typical endpoint, based on revenues facing erosion after patent expiry. A famous example is Eli Lilly’s anti-depressant Prozac, where patent expiry in 2001 paved the way for regulatory approval of Barr Laboratories’ generic version, Fluoxetine. Prozac reportedly lost 73 percent of market share within two weeks of generic launch.
The extent and rapidity of sales and price erosion can vary. A product owner may use patent term extensions and regulatory exclusivities to extend the period of protection. The introduction of generic competition may also be delayed, for example:
• a drug may operate in a niche category that is too small, or with a brand presence too strong, to attract competition on patent expiry;
• a drug may be too complex to produce, particularly where the manufacturing processes are also protected; or
• in the case of competition from follow-on biologics, the current lack of clarity on regulatory requirements (especially in the United States) poses a key challenge to their launch.
The endpoint of a forecast period may also be the point beyond which information required to forecast is unavailable or unreliable.

1.2 Cash Flow Modelling– NPV
NPV is also known as discounted cash flow or DCF. NPV, when applied to a drug development project, involves deriving cash flows over a forecast period by projecting the costs of development and the revenues from commercialisation activities. These cash flows are then discounted in accordance with finance theor y to derive a net present value of the drug development project.

Forecasting costs of drug development
The costs associated with drug development can be broadly grouped as follows:
• Discovery and pre-clinical development costs: These include costs relating to discovery (resulting in the synthesis of a drug candidate) and testing in assays and animal models. Assessing pre-clinical costs for a specific development project is difficult because pre-clinical costs are usually incurred as part of wider R&D programmes involving multiple projects.
• Clinical development costs: These include costs relating to trial design, patient recruitment, investigator and clinician costs, monitoring costs, data analysis, close-out and reporting results, and those related to the production of the clinical trial supplies and animal testing during the clinical period. Clinical development costs will vary depending on the therapeutic indication, with increased costs associated with chronic and degenerative diseases. This increase is driven by the number of patients needed in a clinical trial, the treatment costs per patient (e.g. outpatient versus intensive care treatment, cost of diagnostic procedures and co-medications, durations of treatment and requirements of follow-up) and the length of the clinical trial. Of the stages of drug development, Phase III is the most expensive and time-consuming.
• Regulatory review costs: The costs of marketing approval need to be considered on a territorial basis, with most drugs at least aiming for approval in the major markets. The costs of preparing submissions in connection with marketing approvals can vary depending on the amount and quality of data.
• Launch, manufacturing and marketing costs: Marketing expenses start well before marketing approval. Launch, manufacturing and marketing costs are usually projected on the basis of conventional assumptions (e.g. the marketing expenses for year one,100 percent of the revenues, the marketing expenses for year two, 50 percent of the revenues etc). The specific requirements of the target market are also important. For example, hospital products are characterised by lower marketing costs than products promoted to specialists or primary physicians.

Forecasting revenues
Forecasting the likely eventual revenues of a drug candidate, once developed, involves determining the size of the target market, the market share likely to be attained and subsequent market growth.
• Market size
The bottom-up5 approach focuses on the number of patients and calculates market size by evaluating the following parameters:
- number of patients;
- number of patients receiving treatment; and - price of treatment per patient.
The other approach used is a top-down approach6 which involves extrapolating from existing sales data of products in the same therapeutic class as the drug candidate of interest.
• Market share
Commentators will typically include the following in a list of factors influencing a new product’s ability to penetrate a market:
- competition from available treatments and products, as well as those in development;
- pricing;
- relative advantages compared with current treatments (i.e. cost/benefit analysis);
- dosage and formulation of the candidate;
- clinical evidence of efficacy and safety; and
- patient/physician product loyalty.
This is by no means an exhaustive list of the factors relevant to assessing market share. The distinction between volume market share (based on number of treatments) and value market share (based on sales value) is also relevant.
• Market growth
The current market growth will only be a guide to future growth prospects. The factors behind market growth need to be identified and the distinction between volume and value growth is also relevant. Sales volume growth will be affected by changes in population growth, spread of an illness, frequency of occurrence, frequency of diagnosis, and treatment practice. Sales value growth depends on changes in pricing and product mix (older products may have significantly lower prices than newer, more efficacious ones).
Standard sales evolution curves are also used. By looking at historical peak sales of drug products, different scenarios of rates of ramp-up to peak sales and rates of market erosion can be analysed.
• Price premium
Novel products that are more efficacious than existing products are typically priced at a premium. However, this must be balanced against the number of patients/physicians who will switch to a more expensive product. Also, during the forecast period other products may lose patent protection and become subject to competition from generics. Patient/ physician switch to generics needs to be considered. Pricing regulations and policies are also relevant in pricing analysis.

Discounting to adjust for time and risk
An amount of money received today is worth more than the same nominal amount of money received in the future. Conversely, a dollar received tomorrow is worth less than a dollar received today. Applying this principle to forecasted cash flows means that not only are future revenues worth less today than in the future, but also future investments will “cost” less today. Finance theory requires that a discount rate be used to translate the future cash flows into today’s value.
Finance textbooks illustrate how discount rates account for risk. By way of example, the capital asset pricing model calculates the discount rate on the basis that investors require a project to generate at least the same return as would be expected from investing in risk-free investments and a premium for accepting the risks of investing in assets whose value is highly volatile. In the case of drug development, the key risk relates to failure of the drug candidate to meet the required safety and efficacy profile. Drug development may also be abandoned for economic reasons, e.g. change in market conditions resulting in a reduced commercial market.
Whilst not qualifying as a discount rate in the strict textbook sense, VCs tend to set discount rates representing the internal rate of return expected by their fund investors.
Once a discount rate has been identified, the present value of the net cash flow at each relevant time point (i.e. stage of development) can be calculated. Despite being widely used, the use of NPV in valuing drug development projects is not without limitations. The remainder of this section considers the key limitations of NPV and the valuation methods seeking to overcome these.

1.3 Risk adjusted NPV (“rNPV”)
NPV does not properly account for technical risk Technical risk (e.g. scientific or technological risk) is mitigated as a drug candidate advances through each phase of development. The use of discount rates in NPV to simultaneously adjust for time and technical risk is argued to penalise long term projects relative to short term projects.7 rNPV takes technical risk outside discount rates, instead accounting for it by adjusting the cash flows at each stage of development by the probability of the drug candidate successfully reaching launch from such stage. In turn, a lower discount rate applies.

Limitations
The calculation of probability rates is problematic, particularly in relation to the pre-clinical stages. Many unsuccessful pre-clinical projects are quietly discontinued. Available probability rates tend to be presented as industry averages. The challenges of applying these rates to a specific therapeutic indication are well understood. Where the drug mechanism is understood (such as in hypertension, diabetes and asthma), the relevant probabilities of technical success are likely to be higher than industry averages. Similarly, projects dealing with lesser understood diseases (such as cancer) may be associated with lower probabilities of technical success.

1.4 Scenario analysis, decision-tree modelling and Monte Carlo simulation
NPV does not account for different outcomes
NPV valuation is based on a single projection of inputs, which are impossible to calculate with any certainty. Scenario analysis, decision-tree modelling and Monte Carlo simulation seek to deliver a range of values based on likely variations to more than one input.
Scenario analysis
Scenario analysis models the outcome of different scenarios on value. For instance, different revenue scenarios, based on the probabilities of the scenarios eventuating, can be modelled to examine the effects on value. Other examples include scenario analyses of different development options (e.g. development for indication X versus indication Y) and different commercialisation options (e.g. the stage to which the drug candidate should be developed before outlicensing or partnering).
Decision-tree modelling
Decision-tree modelling considers the impact on project value of different scenarios (e.g. technical failure or success) at nominated decision points along the development path. Typically, decision points occur at the completion of each stage of the development path. The relevant impact on value can be pictorially represented together with relevant pay-offs if the project is abandoned at any decision point in the event of technical failure.
Monte Carlo
Monte Carlo methodology simulates adjustments to multiple inputs (e.g. market size, expenditures, pricing and time to market) to produce an overall distribution of possible outcomes. This is achieved by defining the statistical probability distribution of each uncertain input of interest. Software simulation is then used to repeatedly sample values from the probability distributions of each input. Each simulation generates a single NPV estimate. The end result of the repeated simulation (as shown in Figure 2) is a range of possible NPVs and their respective probabilities of occurrence.
Limitations
The value derived depends on the choices of scenarios and the associated probabilities of occurrence, which are largely subjective. Although the methods are useful for assessing the spread of values for a project, they still do not assist in yielding a more reliable single value.

1.5 Real Options
NPV does not properly account for the value of managerial flexibility in the face of economic uncertainty
In addition to technical risks, drug development projects face economic (or market) uncertainty. These include uncertainties that affect all projects (e.g. loss of freedom to operate or loss of market share due to aggressive competition) and uncertainties specific to a project (e.g. lack of organisational and financial resources).
Real options methodology aims to address the impact of economic uncertainty on project value by applying financial options theory to the drug development process. This approach views the process as containing a series of options in the face of unpredictable economic developments. For example, once a project has passed Phase I, the option-holder has the option to invest in Phase II. The start of Phase II will require an investment outlay, which is the exercise price for that option. If the option-holder decides to invest, it will acquire the option to invest in Phase III, together with an option on the future commercialisation of the project.8 It may also be that technical success in Phase III is accompanied by unfavourable market conditions. The option-holder in such circumstances may abandon the project, which limits the downside exposure to the exercise price of the option. In comparison, NPV based methods assume that once a decision to invest is made, all investments will occur. Projects can be modelled to include other options such as the options to expand, defer and license. Rational investors are assumed to place a value on those options and consequently, the value of the project is linked not only to its cash flows but also to the presence of the options.
Different methodologies exist for valuing options contained in a drug development project. In the methodology known as the binomial tree, the project returns are adjusted by a represents the standard deviation of project returns due to economic uncertainty.
Limitations
Even proponents of the approach acknowledge that much work remains in developing a practical application of the real options theory. Difficulties also exist with accurately estimating the volatility parameter because the market data needed to estimate it is typically not available. Other criticisms include many of the options not necessarily being exercisable in practice.

1.6 Comparables
NPV modelling is theoretical
Cash flow based methods require forecasting inputs which are impossible to calculate with certainty. Consequently, assigning values by studying prices paid for comparable drug development projects in recent comparable transactions is considered a more accurate and reliable measure of value.
Limitations
A comparable project is a project involving a similar product with similar market potential and at a similar stage in development. In the case of a novel candidate with no obvious counterpart, finding comparable projects becomes very difficult. Even if a comparable project can be identified, care must be exercised in drawing valuation information from it because the market conditions and bargaining powers of relevant parties may have been different or the comparable project may not have been properly valued.

2. Findings On The Methods Currently Used To Value Drug Development Projects
Having introduced valuation theory, the remaining sections of this article will consider what happens in practice.
The participants were asked to specify which of the following methods they used to value drug development projects: rNPV, comparables, scenario analysis, decision-tree analysis, Monte Carlo or real options.9 Overall, most participants tended to only use the more conventional tools of rNPV and comparables, with only a few participants (namely pharma participants) regularly using other methodologies.
Of course, the scenario and the purpose for which and for whom the valuation exercise is undertaken, remains important to determining the method that is used. As one participant remarked:
“Valuation is the function of what you want to achieve so consider why you are doing it, which side you are doing it for and for what scenarios … the scenario is terribly important. The drug development industry is a science-based industry, which does a lot of analysis …there is a feeling that valuation methods are valid and correct. At the end of the day, the correct value is what someone else is willing to pay for a project.” (biotech)

3. Findings On The VC Approach To Valuing Early Stage Projects
The VC approach focuses on:
• Qualitative “business plan” like factors:
“What we look at is: how novel is the science, is it addressing a major market sector, what freedom do you have to operate in that sector, is it a really hot target? We really look at management. Are these people who have been there and done it before? Is management going to be able to adapt and change? Do regulatory issues raise an additional cost burden? What are the clinical issues? What is the business model?” (VC)
“We look at whether the market size is sufficient, competition, whether the proposal is sensible, whether management have done it before and whether we can we get a trade sale.” (VC)
• The costs of developing a drug candidate to the point of exit:
“When VCs value early stage development, this tends to be a simple ‘return on capital’ methodology , i.e. how much will it cost to take it to the next stage and whether a 5 to 10-fold return is possible.” (consultant)
• The exit horizon:
“You only know the internal rate of return when you exit. Therefore the time horizon of investment must be assumed. This is why the exit horizon is so important.” (VC)
• What the value will be at the point of exit: “The VC will look at what the value is to an acquirer.” (biotech)
“VCs are seen as now being very active with their portfolios. Ultimately a VC wants to get his or her money back and whatever multiple.” (VC)
“In an acquisition, the value will depend on who is doing the acquiring. VCs from day one will be grooming the company for acquisition and will have set a return on capital value and then adjusted to what they can get in the market.” (consultant)
Not surprisingly, the exit strategy is key to the VC investment decision:
“The starting point of the investment is: how do we get out of this?” (VC)
One of the VC participants considered that, even if IPOs return, they are no longer considered to offer a complete exit. The participant saw VCs as now more focused on trade sales and becoming cleverer at how they position the companies that they invest in. From a trade sale perspective, VCs do not want to position a portfolio company as a “one product” company, but nor can a company be too diverse:
“The key challenge lies in how to position the company with products and technologies that are compatible.” (VC)

End note
Complex science, long development times, the high risk of technical failure and changing regulatory and market conditions make it difficult to ascertain reliable values of a drug development project solely through the application of valuation methodology. Based on the views of the participants of this study, the current market conditions create new uncertainties and limitations around the tools used to value drug development assets.
For example, in pricing negotiations, valuing drug development projects by comparison with prices paid in recent comparable commercial transactions for similar projects at similar stages of development is used. We now have reports of the effective disappearance of biotech IPOs and a fall in the number and value of private equity deals in the sector, together with the public bio/pharma market currently having a low value. In these conditions, even if a comparable project can be referred to, there is the additional uncertainty relating to the extent to which previous values can be drawn upon.
Given funding constraints, some participants consider outright acquisitions of drug development projects as now more popular than complex licensing and partnering deals. Participants in the study reported seeing biotech rights owners using auctions on lead products to push up the value of upfront payments in a proposed licence deal as a prelude to suggesting an outright disposal. From a valuation perspective, these negotiating practices may further muddle the pool of comparable transactions.
The current market conditions include shifting categories of projects of interest to buyers and investors. Some point to an increase in early stage deals. Aside from comparables, rNPV is the other tool predominantly used to value drug development projects, but the values yielded from it have long been considered unreliable because of the greater guesswork involved in forecasting cash flows and risk at an early stage of drug development. At the same time, the current market uncertainties also point to “good quality assets” being less constrained by previous values, with such assets seen as continuing to secure high prices.
In any event, the purpose and scenario for which a valuation exercise is undertaken, and by whom it is undertaken, ultimately explains the method used to assign a monetary value to a drug development programme. In the case of VCs assessing the investment propositions offered by early stage projects, NPV modelling is not favoured. VCs instead focus on “business plan” type factors and what the value will be to an acquirer. Paramount to the VC investment decision is the exit strategy. Some consider that even if IPOs return, these no longer offer the complete exit sought by VCs, who are now focused on an exit by trade sales. Consequently, VCs are having to be cleverer in how they position their portfolio companies. The key challenge is seen to lie in how to position the company with products and technologies that are compatible.
In the second and final part of this article, the approach of analysts will be considered, together with an analysis of the valuation issues in acquisition, licensing and partnering negotiations and further consideration of the true function of quantitative valuation issues.

Sangeeta Puran, Mayer Brown International, Senior Associate, London, UK E-mail: spuran@ mayerbrown.com