Risk Diligence: A Case Study

Most people consider net present value (NPV) to be the best valuation method for assessing pharmaceutical transactions. It is defined as the value—in today's dollars—of the cumulative annual after-tax net cash flows directly stemming from the product deal. NPV is adjusted for risk by multiplying cash flows by the probability that those cash flows will actually occur. There is an easy way to do this calculation, and a hard way. In this instance, the hard way is well worth the trouble, as demonstrated through this case study.

In a pharmaceutical partnership deal made in early 2004, a pre-clinical drug candidate was licensed from one party (the "originator") to another party (the "partner"). It was a relatively straightforward licensing deal, in which the partner agreed to develop and market the product, while the originator received upfront, milestone, and royalty payments. (See "Terms of the Deal".) Although there are generally accepted averages for the probability of a drug surviving to launch, we conducted a custom risk assessment for this particular deal.

The easy way to adjust NPV for the probability of success is to multiply the deal NPV by the probability of launch—in this case, 11 percent. To begin with, we calculated the NPV using an itemized cash flow forecast, which is a familiar accounting procedure. The NPV was just over $1 billion ($1.002 billion). Multiplying by 11 percent, we arrived at a risk-adjusted NPV of $110 million.

The hard way to calculate a risk-adjusted NPV is to assess the risk of each individual year of the eight-year development program and commercial period, and then to multiply that probability by each year's respective cash flow. This calculation takes into account the probability that any year's cash flow will actually occur, which of course depends on the outcome of events in previous years. It helps to know this probability if a large milestone payment is due in a particular year. This calculation results in a risk-adjusted NPV of $91 million. (See Figure 1.)

Many might say there's only about a 20-percent difference between the number derived using the hard-way calculation and the number derived using the easy way. However, the difference in these numbers merits close examination, for it provides insight into the value of the deal going to each partner.

Clearly, the easy way to probability-adjust NPV yields a misleading answer. It overstates the likelihood of success and the value of the deal to the partner. Whether the partner makes the upfront payment, pays R&D expense, and makes the Phase III milestone payments must be considered discreet events, with different probabilities, because each depends on success in the previous stage. So they cannot be accurately reflected in a single calculation of the adjusted NPV, as in the easy way.

Now let's return to the case study. Figure 3 on page 29 shows the annual cash flows of our deal. Two things are immediately apparent. First, the deal lifecycle has two very distinct phases. The first phase is dominated by negative cash flows—payments made by the partner during the development process—and the second phase shows the positive cash flows during the lifecycle of the commercialized product. The partner makes cash payments to the originator whenever an event, such as a trial success, reduces risk during development. After approval, the partner makes royalty payments to reward the originator for discovering a drug candidate with commercial value. In Figure 3, you can see that royalty payments are small relative to the returns on the drug, which rewards the partner for the risk assumed during development. If the deal succeeds, the share of cash going to the partner seems very large. But because the risk of failure far outweighed the chance of succcess, this sort of payment was necessary to persuade the partner to assume the risk. The art of the deal is to find the correct mix and timing of payments during the development stage, and royalty distributions during the commercial phase, to equitably distribute the risks and rewards.