Valuation of a Pharmaceutical Licensing Contract

It is quite common for boutique pharma companies, biotech firms, and university labs to license their intellectual property (a new compound) to large pharmaceutical companies. In such cases, the big pharma companies finance and manage the R&D process and, if successful, market the drugs. In exchange for use of their intellectual property, the outlicensing organizations receive licensing contracts that promise some combination of fixed payments, event‐specific milestone payments, and revenue‐ or profit‐based royalties. The authors show how to estimate the expected present value of the future cash flows promised by such licensing deals. The complicating factor in such valuations is that the licensing contracts are essentially derivative contracts written on drugs in development, which as the authors showed in a paper published in this journal a year ago, are themselves compound options on marketed drugs. The authors use the valuation example from the earlier paper, along with a proposed licensing deal, and walk the reader through the process of valuing the licensing deal's cash flows.