1. © 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

2. © Peter-Jan Engelen Slide nr.2 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.

3. © Peter-Jan Engelen Slide nr.3 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.

4. © Peter-Jan Engelen Slide nr.4 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

5. © Peter-Jan Engelen Slide nr.5 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 project start typical: NPV < 0 t T Follow-up project? Real option value (ROV)

6. © Peter-Jan Engelen Slide nr.6 Extending the growth option Growth option Sequential option Sequential drug development option Extension to multiple growth options Application to a ‘regulated’ sequential option

7. © Peter-Jan Engelen Slide nr.7 The drug approval process Discovery (2-10 years) Preclinical Testing Laboratory and animal testing Clinical Phase I 20-80 healthy volunteers used to determine safety and dosage Clinical Phase II 100-300 patient volunteers used to look for efficacy and side effects FDA Approval Additional Post- Marketing Testing Clinical Phase III 1000-5000 patient volunteers used to monitor adverse reactions to long-term use 0 371014 years

8. © Peter-Jan Engelen Opening the R&D black box

9. © Peter-Jan Engelen Slide nr.9 Development of a new drug success failure pre-clinical test phase clinical test phase 1 clinical test phase 2 approval by government commercialisation success failure NPV 1 NPV 2 fundamental research success failure clinical test phase 3

10. © Peter-Jan Engelen Slide nr.10 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.

11. © Peter-Jan Engelen Slide nr.11 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

12. © Peter-Jan Engelen Case-study Xandee Biochemical, Ltd.

13. © Peter-Jan Engelen Slide nr.13 Its research and product portfolio preclinicalclinical Iclinical IIclinical IIIFDA 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)

14. © Peter-Jan Engelen Slide nr.14 Valuation of R&D and product portfolio ProductPhaseValuation model INS-84Preclinical5-fold compound option model JR-32Preclinical5-fold compound option model FR-242Clinical I4-fold compound option model DIVE-4Clinical III2-fold compound option model MF-164Approval1-fold compound option model Interim products CommercializationDiscounted cash-flow model

15. © Peter-Jan Engelen Slide nr.15 Details of its drug development pipeline Optiontiti KiKi Vn-fold COV Panel A – Product JR-32 (  = 0.81; wacc = 23%) – Preclinical phase 11.58.3 22.529.1 3455.7 46.514.1 5850.681.730.4 Panel B – Product INS-84 (  = 0.64; wacc = 18%) – Preclinical phase 1 315.8 2448.5 3696.4 48.525.3 510.5107.272.715.6 Legend: t i is the maturity date for the compound call option C i (expressed in years), K i is the exercise price for the compound call option C i,; 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. K i,, V, I and COV in million USD.

16. © Peter-Jan Engelen Slide nr.16 Panel C – Product FR-242 (  = 0.78; wacc = 21%) – Clinical I phase 1 0.510.2 2233.7 358.3 46.7560.065.819.4 Panel D – Product DIVE-4 (  =0.63; wacc = 18%) – Clinical III phase 1 28.5 23.529.461.133.4 Panel E – Product MF-164 (  = 0.46; wacc = 15%) – Approval phase 1 125.243.816.2 Details of its drug development pipeline Legend: t i is the maturity date for the compound call option C i (expressed in years), K i is the exercise price for the compound call option C i,; 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. K i,, V, I and COV in million USD.

17. © Peter-Jan Engelen Slide nr.17 Decomposition of its market value 39% of its MV comes from early stage R&D 86% of its MV comes from drug development pipeline Only 14% of its MV comes from existing products

18. © Peter-Jan Engelen Slide nr.18 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)

19. © Peter-Jan Engelen Slide nr.19 Contact information If you have … comments or suggestions, proposals for research collaboration, or proposals for consulting work, … please contact us at: p.engelen@econ.uu.nl Peter-Jan Engelen Utrecht University, Vredenburg 138 3511BG Utrecht, Netherlands