Risks and Rewards: How to Protect the Hand You're Dealt

Oct 01, 2005

Poker has become one on the most popular attractions on television and the Internet, right up there with online auctions. And if the two were ever combined—so that players could auction off their hand early in a game, with several rounds of cards remaining to be dealt—bidders might seek advice from folks in pharmaceutical business development. Because that's what we do. When we buy or sell the rights to a compound in development, we are putting a price on a gamble.

A poker player can tell you, for instance, that even with five unknown cards to come, two jacks will have a better chance of winning the pot than, say, two sevens. But they may not know how much more the better hand would be worth if, in our fanciful blend of poker and auctions, they could sell their seat at the table in the middle of the game. In the end, the hand with the two jacks may not win the pot (one or two more sevens might come along for the other player), so the new player who pays for the hand and continues to invest in it through additional rounds of betting, may receive no payout at all.

This is the usual state of affairs in pharma, where companies buy or sell the rights to develop a compound early in the clinical-trials process, when crucial outcomes that determine the value of the drug remain unknown. They may invest tens of millions in a drug that is never approved, and thus receive nothing in the end.

Of course, pharma players do buy, sell, or even share their seats at the table. And they must always ask, like two poker players wanting to share the risks and rewards on a hand in progress, what value to put on a potential compound. The rewards are huge, but the probability of surviving to final FDA approval—and cashing in their chips—is quite low.

So, at the considerable risk of overextending our poker metaphor, the upfront payment reflects the size of the ante (research costs borne by the deal originator) and the value of the hand (how good the compound is and how large the winning "pot" might be, given the number of players at the table).

Research and development expenses and milestone payments correspond to the additional bets made as the cards continue to fall. Royalties, of course, are a percentage of the winner's pot. Throw in equity positions, special debt issues, and strategic operational alliances, and the game becomes infinitely more complicated than poker. But it is still a betting game, so it's critical to understand the wagers, odds, and payoffs of a pharma-product deal.

Another factor complicates the relationships between pharmaceutical players. Not all the bets, risks, and payoffs are evenly divided. For instance, the cost and risk of just one aspect of the deal may be borne wholly by one partner, while the payoff may be shared by both. Also, partnerships extend over long periods, making the value of money over time a significant factor. Development could go on for a decade, and royalty payments could go out for another decade or two. So it's important to compare the value of money, at the time the bets are made, to its value at the time of payoff.

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Tracking investments is especially important in licensing deals for products in development. Unless the product is in Phase III, the most likely scenario is that the project fails in development and no positive cash flows ever occur. Therefore, it's critical to forecast who will have what cash on the table, should the game end prematurely. Once players clearly understand these components of the game, or of the pharmaceutical deal in our case, they are in an excellent position to negotiate a deal structure that delivers the best chance of creating value within a pharma organization.

Achieving this level of understanding requires due diligence. Pharma players who sit at the poker table with the other companies need to figure the odds if they want to place smart bets. To illustrate the process, let's look at how an actual deal breaks down to its parts. This is the easiest way to understand how risks and rewards can best be shared in a quest for value.