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Article Excerpt
We describe a research and development project-valuation model developed for Phytopharm plc, a pharmaceutical development and functional food company based in Cambridgeshire, United Kingdom. Phytopharm uses the model to value the projects in its research and development portfolio, and in licensing negotiations with potential product development and marketing partners. We include different valuation methods, including net present value, decision analysis, and Monte Carlo simulation. We also consider the technological risks of product development, as well as the uncertainty of commercial success. In addition to determining a value for a product in development, the model proposes appropriate licensing contract structures. A typical licensing contract specifies milestone payments and royalties to be paid by the licensee to the licensor. The contract structures adhere to an agreed-upon equitable split of the project value between the two parties. The model also generates critical information during the negotiation meetings, including break-even analyses, trade-offs, and bargaining zones. Phytopharm is currently deploying the model for use with its entire project portfolio.
Key words: project valuation; negotiation; pharmaceuticals; decision analysis; Monte Carlo simulation; real options.
History: This paper was refereed.
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The structure of the pharmaceutical industry is changing as many large pharmaceutical companies struggle to fill their product pipeline. Rather than relying on in-house research projects, these companies are increasingly relying on small biotechnology companies to provide innovative and novel therapeutic approaches resulting in more licensing arrangements. This allows the larger pharmaceutical companies to focus on their core strengths, such as manufacturing, distribution, marketing, and sales. For instance, in 2002, Merck reviewed thousands of licensing opportunities and completed 32 deals (Drug Week 2003). Meanwhile, several factors have contributed to a rise in the cost of pharmaceutical development, making it beyond the capabilities of smaller companies. These include (1) tighter regulation, (2) dedicated and sophisticated production facilities required by the new generation of biochemical pharmaceuticals, and (3) the huge marketing efforts necessary for a successful worldwide launch of new products. These changes have prompted smaller companies to turn to the major players in the industry and to offer licensing opportunities.
Phytopharm is a pharmaceutical development and functional food company, based in Cambridgeshire, United Kingdom and is listed on the London Stock Exchange. Established in 1990 and floated in 1996, it specializes in the development of plant-based medicines as pharmaceutical products or functional foods. Figure 1 shows its research and development (R&D) strategy. Phytopharm's product pipeline includes single-chemical pharmaceutical products targeting Parkinson's, Alzheimer's, and asthma, as well as plant-extract functional food products for skin health and weight control. Phytopharm actively reduces its risk by out-licensing its products in development, and seeking early commercialization of its functional food and veterinary products. Phytopharm's extensive outsourcing of its laboratory work and clinical testing to specialists, and the systematic licensing of its projects, allows it to maintain a strong focus on its core competencies, namely, preclinical and clinical strategy and management.
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Phytopharm typically performs the first steps of product research. These include isolating the active compound if possible, identifying the mode of action, and taking the new compounds through the development process until the successful completion of proof of principle, i.e., the preclinical and toxicology phase and Phase I and initial efficacy clinical trials. If the product passes the proof-of-principle stage, Phytopharm licenses the project out to partners with the financial, R&D, and marketing resources to further develop and launch it in the market. Phytopharm's revenues come predominantly from licensing agreements for its projects. A licensing agreement typically contains a down payment at contract signature, lump-sum payments on successful completion of specific milestones, and royalties based on sales. Although Phytopharm develops pharmaceutical products using single chemicals and develops functional foods using plant extracts, the development process is similar.
When Phytopharm's management team contacted us in October 2003, it was preparing to start negotiations for a number of its products including the Hoodia extract, a novel functional food product for weight control, and Phytopica, a veterinary functional food product for skin health. Phytopharm had successfully achieved proof of principle in clinical trials of healthy overweight men in 2001 with a concentrated extract of Hoodia. (Note: Interfaces, INFORMS, and the authors express no opinion on the scientific case for or against Hoodia. Phytopharm's claims regarding its effectiveness have not been reviewed for the purpose of this article, which only describes the use of decision tools in aiding R&D licensing negotiations.) In May 2004, Phytopharm was preparing to start negotiations to outlicense a less concentrated extract of Hoodia as a functional food with multinational food companies. Although management was confident that the product could be a blockbuster, i.e., generate annual sales over US$1 billion, it needed a comprehensive and flexible methodology to rigorously predict and value the product's potential. In addition, Phytopharm wanted a model to support the licensing negotiation for its products--the determination of upfront payments, milestone payments, and royalties--that would enable it to appraise the value of its projects, and to improve shareholder value and portfolio management.
We present the model we developed for Phytopharm in this paper. Throughout the text, we combine the model description with an account of our interactions with Phytopharm, and with the model's impact on project valuation. The section The Pharmaceutical and Functional Food Development Process provides background information on this process and highlights the risk and potential for these products; The Valuation Model provides valuation details; Sensitivity and Simulation Analysis briefly describes the sensitivity and simulation functionalities included in the model; and Negotiations Model describes the tools designed to support Phytopharm in its negotiations. Before concluding, we report on Phytopharm's internal and external use of the model.
Ruback and Krieger (2000) present a study for a similar product, and propose a decision analysis model to value a licensing opportunity that uses the given project parameters. We expand on this by performing the complete model cycle: problem definition, data collection, model design, project valuation, sensitivity analysis, negotiations support, and model implementation in practice. Other papers present a real-options approach to project valuation (Herath and Park 1999, Lewis et al. 2004). However, these papers mainly present theoretical developments and may not be directly accessible to practitioners because they do not provide details on how to develop such a model or the impact of applying the valuation methodology....
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