The Partnering Process – Deal Structure: Part 18 of Valuation and Other Biotech Mysteries
[Ed. This is the eighteenth part in Wayne's series. You can access the whole thing by clicking here. Please leave comments or questions on the blog and Wayne will address them in future posts in this series.]
Assuming that a partnering deal is signed, what are the usual financial components?
- Up-front cash usually has no conditions and is a non-dilutive financing. Big pharma generally does not want equity as it just clutters up their balance sheets and is an even bigger problem if the partnership gets terminated.
- Clinical and regulatory milestone payments are fairly standard. The basic milestones are the initial U.S. and E.U. approvals but may include approvals of additional indications if they increase the market potential.
- Sales milestone payments have become more common in the last decade. If the pharma partner does not believe the market potential, milestones can be included for reaching certain annual or cumulative sales milestones.
- Royalties on sales are generally no longer a simple X% on net sales. They can be tiered, increasing after annual or cumulative sales milestones are reached.
- If there is an R&D program, who conducts it and who pays for it?
- Who executes and pays for the clinical and regulatory programs?
- Some companies would like to retain or have an option on some sales and marketing rights in specific territories. These rights may cease to exist if there is a change of control at the smaller company.
The only way to learn about deal structures is to create a fictional deal, make the spread sheet and start looking at the impact of structural changes on the product NPV. The following assumptions have been used to create the attached Excel workbook.
- Small molecule chemotherapeutic
- Currently in the middle of a Phase 3 trial (only one needed for approval)
- Phase 3 for a second clinical indication will be started after initial approval
- Assume 10 years of market exclusivity, followed by generic competition
- Approval in second half of year 2
- Sales and marketing at full speed starting in year 3
- No sales & marketing synergy with other products
- No R&D costs
- Up-front payment of $250 million
- Biotech pays for completion of initial Phase 3
- Pharma pays for second Phase 3
- Pharma has all sales and marketing responsibilities
- Milestone payments
- FDA approval $50 M
- EU Approval $50 M
- Sales reach $1 billion annually $50 M
- Royalty on sales
- Before annual sales reach $1 B 20%
- After annual sales reach $1 B 25%
There are four sheets in the attached workbook. Sales assumptions are the same in all models – sales peak at $1.65 B in year 12 followed by generic competition which reduces sales to $100 M by year 16 (last year of the model).
- Internally developed at pharma: net product cash flow over 16 years is $6.03 B with an NPV of $2.256 B (10% discount rate).
- Internally developed at biotech: net product cash flow over 16 years is $5.598 B with an NPV of $2.039 B. The basic difference in the assumptions is that the biotech company will have higher costs to build a company and achieve the same sales results. It is possible that a private company could do this and just dividend the cash flow out to its small shareholder base. However, it is likely that a public company would try to grow through R&D and acquisitions or be acquired.
- Partnership – pharma perspective: pharma is paying $250 M up-front to acquire an exclusive option on a potential product cash flow of $3.890 B with an NPV of $1.292 B.
- Partnership – biotech perspective: the biotech company is mitigating corporate financial risk and the product specific risks of clinical failure and market competition for $250 M up-front. Including corporate costs, it will receive a net product cash flow of $1.718 B with an NPV of $776 M. These reductions from the go-it-alone scenario, when viewed in isolation, seem to be too much to give up. However, this analysis needs to include a per share analysis which would take into account shareholder dilution from equity financings to fund the building of the company. If equity financings are done before the Phase 3 data, the dilution could be substantial if the market is sceptical about the product. If the equity or debt financings are delayed until after the Phase 3 data, it could delay the product launch and slow the sales growth.
This is not meant to be a perfect, detailed model, or even realistic. I have never seen a company release saying ‘we did it once, we are unlikely to repeat this success, so we are going to dividend the cash flow’, although this action might be in the best interests of shareholders. This is a model where you can question and change assumptions and see what the impact is on the cash flow and NPV. Do this yourself – I will look at some of the questions and options in the next blog post.