A Real Options Analysis of Pharmaceutical-Biotechnology Licensing

By Kharabi, Darius | Stanford Journal of Law, Business & Finance, Spring 2006 | Go to article overview

A Real Options Analysis of Pharmaceutical-Biotechnology Licensing


Kharabi, Darius, Stanford Journal of Law, Business & Finance


Introduction

In today's drug development environment it is common for large pharmaceutical companies to turn to biotechnology companies to replenish their drying therapeutic pipelines. Biotechnology companies, in turn, rely on the greater resources of pharmaceutical companies to help fund their research and development and to market and distribute their products. These collaborations, which take the form of licensing agreements, can range from a simple license of intellectual property to a complex co-development and co-marketing alliance.

Very often, lawyers play an integral part in biotechnology licensing deals. Traditionally, the function of a lawyer in negotiating a license has been to transform his or her client's intentions into a clear, written agreement that complies with the applicable legal and regulatory structure. While this function has not diminished in importance, many licensing attorneys today, because of their experience in brokering numerous deals in the industry, also play a significant role in shaping the financial terms of the deals they negotiate.

This paper suggests that a lawyer, in his or her role as a business advisor, can add value to a biotechnology license negotiation by utilizing real options theory to analyze the financials of the deal. Real options theory is a promising method to evaluate biotechnology licensing opportunities since, unlike the traditional net present value method, it takes into account the fact that the decision to develop licensed intellectual property can be delayed until more information is available or abandoned if market conditions or scientific advancements do not go as anticipated, and that during this delay the licensed technology may unlock unforeseen additional profitable opportunities. While, as described later in this paper, there are important limitations to the application of a quantitative real options analysis to a biotechnology licensing decision, real options methodology serves as a valuable tool alongside more conventional valuation techniques by treating a biotechnology license as the purchase of a bundle of options to develop and market one or more biotechnology innovations rather than simply as a project with an expected return.

In a recent survey of senior managers at pharmaceutical companies conducted by McKinsey & Company, 65% of those surveyed felt that complexity was the aspect of deal making most likely to change over the next two to five years, with future deals becoming more complicated.1 With biotechnology licensing agreements growing more complex and more important to the survival of the worldwide drug industry, it is necessary for the lawyers that negotiate these deals to use every tool at their disposal to make sure that their clients are evaluating licensing opportunities accurately. This paper presents one such tool by describing a framework that lawyers can use for recognizing and valuing the real options in a biotechnology license. Although a variety of players in the life sciences industry can license different categories of biotechnology intellectual property, this paper focuses on the relatively common scenario of a small biotechnology company licensing some or all of its intellectual property rights in a potential therapeutic compound to a pharmaceutical company.2 Parts I and II provide a brief background of the biotechnology industry as well as the basic structure of a biotechnology licensing agreement and the role lawyers often play in its negotiation.3 Part III describes real options theory and introduces the Black-Scholes method of option valuation. In Part IV the types of real options commonly found in biotechnology licensing agreements are identified. Finally, Part V examines a recent large biotechnology licensing agreement in detail and outlines an approach a biotechnology licensing attorney can use for evaluating the agreement as a bundle of real options using the Black-Scholes model.

I. …

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