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I N T E R N A T I O N A L D I S C O V E R Y S E R V I C E S & C O N S U L T I N G

Commercial Valuations and Due Diligence

As a biotech company, you want to get the most value possible for your products from potential partners. In order to control negotiations with potential partners and achieve your goals, you must perform increasingly more comprehensive valuations of your products at different points along the development continuum. Performing product valuations do not have to be the domain of “big-pharma” or your potential partner. With the appropriate data and due diligence, it is possible for biotech and small innovator companies to have timely, realistic, and defendable valuations performed cost-effectively by an experienced consultant.

The first step you must take in estimating the value of your product is to determine the valuation methodology that is preferred by the potential partner company you are targeting. Valuing your products using the methodology your potential partner prefers helps assure that you are speaking the same language and adds credibility to your organization and business development activities.

1According to a recent survey of biotech and pharmaceutical companies regarding their business development practices, nearly 90% of pharma companies with more than $1 billion in annual revenue use Risk-adjusted Net Present Value (rNPV) as their preferred valuation methodology, and more than 70% of pharma companies with annual revenues exceeding $5 billion prefer that methodology as well.

Net present value (NPV) is defined as “the cash flow at each point in time

Estimating the Value of Your Product

IDSC White Paper Series: Commercial Valuations and Due Diligence

March, 2011

Part of IDSC’s continuing White Paper series designed to help you deliver innovative medicines to the clinic faster.

By Jeff Simpson, Director, IDSC

1 Nature Biotechnology, vol. 27, no. 11 Stewart, J. et al.

discounted back to the present.” For example, an investment of $1.0M today at an annual rate of return of 10% (also referred to as the “discount rate”) will yield $1.1M in 12 months. Hence, the present value of $1.1M 12 months from now at the desired rate of return (or discount rate) of 10% is $1.0M ($1.1M ÷ 110% = $1.0M). The amount of the investment ($1.0M in this example) is deducted from the present value ($1.0M in this example) to arrive at the NPV, which in this case is zero ($1.0M − $1.0M = $0.0). A NPV of zero means the project repays the original investment plus the required rate of return. A positive NPV means a better return and a negative NPV means a worse return. Using the same investment amount ($1.0M) and discount rate (10%) from our previous example, but increasing the value of the investment in 12 months by 20% to $1.2M, the NPV is now $0.09M ($1.20M ÷ 110% = $1.09M − $1.00M = $0.09M).

Three inputs are needed to calculate a NPV: revenue, costs and the discount rate. To calculate the rNPV, the probabilities of success for each phase of the development program for your product will also be required.

Revenue. Revenue is what you expect your product to return annually if it reaches the market. In valuing your product, your revenue estimate starts with your sales forecast. There are numerous methods to forecast sales. A common approach is to use a combination of epidemiological data, adoption rates, price estimations, and an assessment of the competitive landscape.

�Epidemiological data, that is studies of the incidence of disease in specific populations, are available from many sources, including government agencies, advocacy groups, and private sector companies, and will help you identify the patient group(s) you intend to target with your product. Much of the epidemiological information needed for forecasting is available in the public domain and can be secured from various government agencies and advocacy groups at little to no cost. The additional expense to you will include the cost of the time to locate, request, and format the data collected into a useable form. There are private vendors that specialize in collecting and compiling data from these same government agency and advocacy group sources who then sell these reformatted data to pharma companies. Costs for these reports vary. The data included in these reports can be very helpful when forecasting, however, one can end up paying for more data than is actually needed because these reports are often not limited in their scope or customized to the specific needs of the pharma customer.

�Adoption rates are the percentages used to determine the number of therapy days for your product. These rates vary and can be unique for different disease areas. There are no diseases for which 100% percent of patients seek a diagnosis, nor will there be 100% diagnosis of those patients with the disease who seek treatment, nor do 100% of patients diagnosed receive drug therapy. Other considerations include the rate at which prescriptions are filled by patients receiving a prescription and the various reasons for either filling or not filling a prescription, including whether or not the prescribed drug is on the payer's formulary, the amount of the patients' co-pay, etc. And, then there is the compliance rate among patients who filled their prescription, that is what percent are actually taking the medication as prescribed. Data on adoption rates for some diseases are scarce and sometimes outdated, however, potential sources include recent publications in professional journals and the possibility to commission primary research.

�Price estimations include not only the average wholesale price (AWP) but requires insight into contracting strategies with government and private sector payers, an understanding of wholesaler and retailer margins, and the amount of out-of-pocket costs (co-pays) patients are willing to pay for your product. Much of the information required to establish a price estimate can be found in publications and via on-line subscription sources.

�The competitive landscape is dynamic and will likely be very different when you expect to launch your product versus today. You will need to know when patents expire on today's leading brands and what brands will still have patent protection and for how long. Several vendors collect and compile this information from publications, government sponsored reports, company filings required by government agencies, company press releases and other company communications, which they in turn sell to pharma companies. Costs for these studies vary, and as with the epidemiological data above, often more information than what is needed is included in these reports. Big pharma companies often purchase these reports, however, a biotech or innovator company can often secure and format adequate information from numerous public sources to evaluate the competitive landscape.

Costs. Costs are the amount of your investment. In other words, what you expect to spend in order to develop, produce and commercialize your product.

�Development costs include all pre-clinical and clinical trial costs plus marketing authorization (FDA, EMEA, etc.) filing fees. Methods for determining development costs include estimates based on previous experience, researching costs of similar clinical trials, or comparing subject numbers in earlier studies and multiplying those numbers times an average or acceptable per-subject cost currently used in other clinical trials in the therapy area. Costs per-subject will vary considerably depending on the duration of the study and the procedures required for each study subject.

�Commercialization costs include all costs associated with marketing, selling, and manufacturing and distributing your product. Marketing costs will begin to be incurred prior to launch, peak during the launch year and continue over the life of the product. Specific line item costs will include market research, positioning and message development, creative development, advertising and promotional materials, as well as the personnel costs of the marketers assigned to the brand. Selling costs will include the cost of the sales force promoting your drug and will vary depending on the number of sales representatives required to achieve an appropriate “reach and frequency” with your target audience. Sales costs will be higher at launch. Methods used by pharma companies to calculate selling costs vary, but being transparent in your methodology will allow you to defend your selling cost estimates. When manufacturing is scaled-up, costs of producing your drug will decline significantly. Manufacturing costs, or cost of goods sold (COGS), varies depending on the delivery system (oral solids, oral liquids, injectables, etc.) and is often expressed as a percent of gross sales in valuations. Likewise, distribution costs vary slightly based on the delivery system and are also often expressed as a percent of gross sales.

Discount Rate: The discount rate, or interest rate, will be used to discount each annual cash flow over the life of the product. The discount rate can also be described as the annual rate of return a company expects on their investments. A lower discount rate yields a higher valuation and each company sets a different threshold for their rate of return, therefore, it is recommended that you use the discount rate you anticipate your potential partner will use.

With your estimated annual revenues and costs, along with your discount rate, you have all the inputs you need to estimate annual net cash flows (Fig. 1) and a NPV curve (Fig. 2) for your product.

Annual Net Cash Flows and a NPV Curve

Risk-Adjusted Annual Net Cash Flows and the rNPV CurveNext, you will need to adjust each of the annual net cash flows for risk (Fig. 3) and determine the “risk-adjusted NPV” or rNPV (Fig. 4). The rNPV is calculated by assessing the risk of each individual year of both the development and commercial periods, and then multiplying that probability by each year's respective cash flow. The rNPV takes into account the probability that any year's cash flow will actually occur, which is dependent on the outcome of previous year's events. Information regarding risk at various stages of the development continuum is available in publications and from industry organizations and government agencies.

w w w . i d s c b i o t e c h n e t w o r k . c o m

FROM HIT TO THE CLINIC: IDSC IS YOUR DRUG DISCOVERY & DEVELOPMENT PARTNER

Jeff Simpson

A skilled marketing and sales executive with proven accomplishments at The Upjohn Company, Pharmacia and Pfizer, Jeff advises biotech and pharmaceutical companies on business development, commercialization strategies, product assessments and valuations, portfolio planning, lifecycle planning, advisory boards, competitive intelligence, and launch planning for new products, indications and formulations, for both the US and non-US markets. During his 29 years in the pharmaceutical industry, Jeff's commercialization experience includes products for psychiatry, neurology, pain management, sleep disorders, womens health, infectious diseases, inflammation, metabolic diseases, urology, immunology, and dermatology.

Conclusions

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As the product innovator, due diligence in completing a valuation for your product will help you understand the cash flows, their timing, and how risk and inflation affect those cash flows and the value of your product, both from your perspective and your potential partner's perspective. As the innovator, you must be in the best position to describe how the opportunity you are presenting to a potential partner is a good strategic fit for both parties, and to substantiate the estimated value of your new product. The next step is to model allocations of the value between the partners before you begin entertaining offers from potential partners.

John Booth, Ph.D.Director, Business DevelopmentInternational Discovery Services and Consulting, LLCe-mail: tel: 1.734.646.8707

johnbooth@idscbiotechnetwork.com