© Peter-Jan Engelen

Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms

FUR XII, LUISS, Roma, Italy, 22-26 June 2006

Cassimon, Engelen and Yordanov

Slide nr.2 © Peter-Jan Engelen

Valuation of pharma companies Financial analysts typically split the value of a pharmaceutical company in three building blocks:

(i) existing marketed products;

Valuation is problematic with current models

(ii) new products in the mid to late stage of development (phase II and III of the clinical testing);(iii) early R&D.

Slide nr.3 © Peter-Jan Engelen

Real option characteristics of projects Financial option: right (not an obligation) to buy

or sell a certain asset at specific moments at a predetermined price

What are real options? Recognizing the project itself or certain components

as options A project is an option, whereby the company obtains

the right to all future FOCFs the project generates, in exchange for a predetermined price (investment cost of the project)

Different types of real options Growth options, options to delay, etc.

Slide nr.4 © Peter-Jan Engelen

Real option approach to R&D Benefits of real option approach

compared to traditional models:Can handle operational flexibility with

respect to investment decisions• Abandonnement, delay or adjustment of

projects, e.g. stop R&D of particular drug Takes into account the strategic

value of a project because of its interdependence with future projects• R&D give option to follow-up projects• Real option models are better suited to

value R&D

Slide nr.5 © Peter-Jan Engelen

Typical example of a growth option

success

large project

I

FOCF

failure

Project’s value = NPV(pilot) + ROV (follow-up) if >0, then invest

Pilot projectstart

typical: NPV < 0

t T

Follow-up project?

Real option value (ROV)

Slide nr.6 © Peter-Jan Engelen

Extending the growth option

Growth option

Sequential option

Sequential drug development option

Extension to multiple growth options

Application to a ‘regulated’ sequential option

Slide nr.7 © Peter-Jan Engelen

The drug approval process

Discovery(2-10 years)

Preclinical TestingLaboratory and animal testing

Clinical Phase I20-80 healthy volunteers used todetermine safety and dosage

Clinical Phase II100-300 patient volunteers used tolook for efficacy and side effects

FDA Approval

Additional Post-Marketing Testing

Clinical Phase III1000-5000 patient volunteers used tomonitor adverse reactions to long-term use

0 3 7 10 14years

© Peter-Jan Engelen

Opening the R&D black box

Slide nr.9 © Peter-Jan Engelen

Development of a new drug

success

success

success

success

failure

failure

failure

failure

pre

-cli

nic

al t

est

ph

ase

clin

ical

tes

t p

has

e 1

clin

ical

tes

t p

has

e 2

app

rova

l by

gove

rnm

ent

com

mer

cial

isat

ion

success

failure

NPV1

NPV2

fundamental research

success

failurecl

inic

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est

ph

ase

3

Slide nr.10 © Peter-Jan Engelen

R&D on new drug as a chain of options (a)  first option – decision to start preclinical

phase;

(b) second option – decision to start first clinical trial phase;

(c) third option – decision to start second clinical trial phase;

(d)  fourth option – decision to start third clinical trial phase;

(e) fifth option – decision to file for regulatory approval;

(f) sixth option – decision to launch the new drug on the market.

Slide nr.11 © Peter-Jan Engelen

How to value this chain of real options? Chain of real options in drug development

can be seen as a case of compound option models

Geske (1979) – 2-fold compound option (option on an option)

R&D of new drug – 6-fold compound option

We use the extended n-fold compound option model of Cassimon et al. (2004)

Programmed in Matlab

© Peter-Jan Engelen

Case-study

Xandee Biochemical, Ltd.

Slide nr.13 © Peter-Jan Engelen

Its research and product portfolio

preclinical clinical I clinical II clinical III FDA approval commerciali-zation

INS-84

FR-242

DIVE-4

MF-164

interim products

JR-32

MV of product portfolio is the sum of:•assets in place (interim products)•unexercised compound growth options (pipeline)

Slide nr.14 © Peter-Jan Engelen

Valuation of R&D and product portfolio

Product Phase Valuation model

INS-84 Preclinical 5-fold compound option model

JR-32 Preclinical 5-fold compound option model

FR-242 Clinical I 4-fold compound option model

DIVE-4 Clinical III 2-fold compound option model

MF-164 Approval 1-fold compound option model

Interim products

Commercialization

Discounted cash-flow model

Slide nr.15 © Peter-Jan Engelen

Details of its drug development pipeline Option ti Ki V n-fold COV

Panel A – Product JR-32 ( = 0.81; wacc = 23%) – Preclinical phase

1 1.5 8.3    

2 2.5 29.1    

3 4 55.7    

4 6.5 14.1    

5 8 50.6 81.7 30.4

Panel B – Product INS-84 ( = 0.64; wacc = 18%) – Preclinical phase

1 3 15.8    

2 4 48.5    

3 6 96.4    

4 8.5 25.3    

5 10.5 107.2 72.7 15.6

Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the compound call option Ci,; V is the current value of the underlying project; is the instantaneous standard deviation of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.

Slide nr.16 © Peter-Jan Engelen

Panel C – Product FR-242 ( = 0.78; wacc = 21%) – Clinical I phase

1 0.5 10.2    

2 2 33.7    

3 5 8.3    

4 6.75 60.0 65.8 19.4

Panel D – Product DIVE-4 ( =0.63; wacc = 18%) – Clinical III phase

1 2 8.5    

2 3.5 29.4 61.1 33.4

Panel E – Product MF-164 ( = 0.46; wacc = 15%) – Approval phase

1 1 25.2 43.8 16.2

Details of its drug development pipeline

Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the compound call option Ci,; V is the current value of the underlying project; is the instantaneous standard deviation of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.

Slide nr.17 © Peter-Jan Engelen

Decomposition of its market value

39%

15%12%

20%

14%

Preclinical

Clinical I

Clinical III

Approval

Launched

39% of its MV comes from early stage R&D86% of its MV comes from drug development pipelineOnly 14% of its MV comes from existing products

Slide nr.18 © Peter-Jan Engelen

Conclusions Product portfolio of a pharmaceutical firm

consists of exercised (assets in place) and unexercised (growth opportunity) real options

Real option component can be valued using generalised n-fold compound option models

Benefits:possible to decompose MV of product

portfolio in different components linked to specific phases of drug development process

Better insight in different value blocks of pharmaceutical firm (over the full range of phases of drug development)

Slide nr.19 © Peter-Jan Engelen

Contact informationIf you have …

•comments or suggestions,•proposals for research collaboration, or•proposals for consulting work,

… please contact us at:p.engelen@econ.uu.nlPeter-Jan EngelenUtrecht University, Vredenburg 1383511BG Utrecht, Netherlands