Factors to Consider in the Relief from Royalty Method to Valuing Pharmaceutical Patents

Introduction

The pharmaceutical industry is currently undergoing structural changes related to new product development. These changes are a result of the “pipeline problem” confronting most large drug companies. That is, the patents on many widely prescribed drugs are about to expire, and there are not enough new drugs in development. The number of new molecular entities (i.e., drugs not yet brought to market) approved annually by the FDA has declined 60 percent since 1996. And, during the same period, new drug applications have decreased nearly 40 percent.¹

According to Lehman Brothers, all of the “Big Pharma” companies launched (on average) 59 new drugs per year between the years 1998 and 2002. For the years 2002 to 2006, however, Lehman Brothers estimates that these same pharmaceutical companies will launch only 50 drugs per year.²

While the pipelines of the Big Pharma companies are decreasing, smaller biotech companies (which are not encumbered by the vast internal bureaucracies of the Big Pharma firms) are flourishing. In recent years, the engines of pharmaceutical innovation and discovery have been more evident in these smaller biotech companies. These companies can concentrate on a few promising avenues of research. And, these companies can offer enterprising scientists the freedom and reward of working as entrepreneurs.³

Furthermore, the overhead structure of the Big Pharma companies (e.g., it costs approximately $900 million to bring a new drug to market) make investment in non-blockbuster products prohibitive.⁴ In contrast, smaller biotech companies can commercialize non-blockbuster products that treat less prevalent and pervasive medical conditions at lower cost (i.e., between $100 million and $200 million).⁵

As a result of these structural changes, there is currently a two-way flow of intellectual property rights in the pharmaceutical industry:

1. Big Pharma companies, with pipelines drying up, are purchasing the patent rights to development stage drugs from smaller biotech companies.

2. Smaller pharmaceutical companies are purchasing the patent rights to non-blockbuster, niche drugs from the Big Pharma companies that are divesting their smaller, non-core products.

This increased activity in pharmaceutical patent sale/license transactions provides both opportunities and challenges for valuation analysts. This is because the transferred patents are subject to valuation for financial accounting and/or income tax reporting purposes.

This article will (1) describe the general application of the market approach/relief from royalty method of intellectual property valuation and (2) discuss several specific pharmaceutical industry factors that influence the analyst’s selection of the appropriate royalty rate. The selection of the appropriate market-derived royalty rate is often the most controversial issue in a patent valuation analysis.

Market Approach—Relief from Royalty Method

In the relief from royalty (RFR) method, a pharmaceutical patent is valued by reference to the amount of royalty income the patent would generate if it were licensed in an arm’s-length transaction.⁶ The following discussion presents a simplified summary of the RFR patent valuation method.

In applying this intellectual property valuation method, first, the analyst identifies a set of arm’s-length license agreements involving pharmaceutical patents that are comparative to the subject patent. For this purpose, intellectual property is assessed from an investment risk/expected return perspective.

Second, the analyst projects the annual net revenue related to the expected revenue from the pharmaceutical product. The product unit/dollar revenue projection is made over the expected remaining useful life (RUL) of that drug product. Consideration of the shape and slope of the new drug’s product life cycle is an important component of this analytical procedure.

Third, the analyst selects the appropriate market-derived royalty rate for the subject patent. This selection is based on both a qualitative and quantitative assessment of the terms of the selected arm’s-length license agreements related to comparative patented drug products.

Fourth, the analyst multiplies (1) the selected royalty rate times (2) the projected product revenue. The product of these two valuation variables is the projection of the hypothetical annual royalty income stream.

Fifth, the projected hypothetical royalty income stream is capitalized using an appropriate present value discount rate. The appropriate discount rate (or yield capitalization rate) is a function of (1) the level of economic income projected (e.g., before tax versus after tax), (2) the risk of the royalty income projection, and (3) the selected premise of value (e.g., value in use versus value in exchange). Often, the selected discount rate is the patent owner’s/operator’s weighted average cost of capital (or WACC). Finally, the resulting present value is an indication of the value of the pharmaceutical patent.

Identification of Arm’s-Length License Agreements

A fundamental procedure in the RFR method is the identification of arm’s-length agreements. These license agreements (1) should be between unrelated parties and (2) should involve the license of a pharmaceutical patent comparative to the subject patent. Again, comparability is assessed from an investment risk/expected return perspective. To identify such arm’s-length patent license agreements, the analyst has several data resources available.

One direct data source is the “Exhibit 10—Material Contracts” section of publicly traded company SEC filings. These exhibits, which are filed as attachments to Forms 10-K, 10-Q, 8-K, proxy statement, and registration statements, include all contracts and agreements that represent a material portion of the filing company’s business.

For the best results, the analyst should focus on the SEC filings of publicly traded companies categorized under primary Standard Industrial Classification (SIC) code 2834 (pharmaceutical preparations), or more broadly, code 283 (drugs). The Exhibit 10—Material Contracts section of publicly traded company SEC filings can be searched using popular databases such as LexisNexis™ or Global Security Information Inc.’s LivEdgar.

In addition to SEC documents, there are several subscription-based and fee-based sources that track and compile royalty rate information across various industries. Two examples of these services include: (1) AUS Consultants’ RoyaltySource® and (2) its affiliated bi-monthly journal, Licensing Economics Review.

Despite the availability of effective research tools, there are considerable obstacles to identifying arm’s-length intellectual property license agreements for use in the RFR method. The most significant challenge is the scarcity of published royalty rate information. Most intellectual property license agreements included in the Exhibit 10—Material Contracts section of publicly traded company SEC filings are redacted as to remove the details regarding specific payment terms.

For example, a survey conducted by Media Associates Ltd., a business development consultancy for the pharmaceutical industry, estimates that only three percent of the publicly disclosed license agreements reveal specific information about royalty rates.⁷

Moreover, the publicly available license agreements that do disclose royalty rate information often do not provide any descriptive information about the licensed patent. Therefore, it may be difficult for the analyst to assess whether the patent covered by the arm’s-length license agreement is comparative to the subject patent from an investment risk/expected return perspective.

Due to the scarcity of available royalty rate and other descriptive information, it is often difficult to identify a sample of “perfectly comparable” arm’s-length license agreements for use in the RFR method. Therefore, the analyst will often (1) identify a broad sample of arm’s-length guideline transaction royalty rates, and (2) select a royalty rate from within this broad range. This selection is typically based on certain characteristics of the subject patent. These characteristics (and their impact on the selected royalty rate) are discussed in the following section.

Factors to Consider in the Selection of Pharmaceutical Patent Royalty Rates

According to Licensing Economics Review, a review of 458 license agreements in the pharmaceutical and biotechnology industry over a 16-year period reveals an average royalty rate of 7.0 percent.⁸ The range of observed royalty rates, however, extends from zero percent to 50 percent. An analyst searching for arm’s-length license agreements using the previously described procedures may encounter a similarly broad range of royalty rates.

What royalty rate, then, should the analyst select when applying the RFR valuation method? While the selected royalty rate (or range of royalty rates) is ultimately a matter of the analyst’s professional judgment, there are certain factors that affect general royalty rate levels in the pharmaceutical industry. The analyst should consider these factors with respect to the subject patent when selecting the royalty rate to apply to the pharmaceutical product revenue projections.

Stage of Development

The pharmaceutical product’s stage of development is often considered to be the most important factor impacting the royalty rate. The life cycle of a development stage drug can be broadly categorized into five distinct stages:

• Pre-clinical trials constitute the fist stage of development of an experimental drug. These trials are performed (1) in vitro (i.e., in test tubes) and (2) in vivo (i.e., in live animals) before testing commences on human subjects.

• Phase I clinical trials involve up to 100 healthy human volunteers and are intended to evaluate the safety profile of a new drug.

• If Phase I trials are successful, Phase II clinical trials are conducted. Phase II trials, which involve up to 300 ailing human subjects, are undertaken to evaluate the efficacy of the new compound as a treatment for one or several medical conditions. During Phase II trials, the optimal dosage and frequency of administration are established.

• Phase III clinical trials, which can involve a few hundred to several thousand human subjects, test the new drug’s effectiveness in relation to (1) existing pharmaceutical treatments for the target medical condition and (2) a placebo. Phase III trials are the last set of trials before a new drug is approved (1) by the Federal Drug Administration (FDA) or (2) by non-U.S. regulatory agencies.

• Phase IV trials are typically conducted subsequent to regulatory approval and product launch. These post-approval trials are intended to further demonstrate the drug’s efficacy and therapeutic benefits, as well as to study potential adverse reactions to the drug. Phase IV trials can also be conducted to differentiate the drug in the marketplace by (1) offering new dosage formulations and strengths, (2) targeting new patient populations, or (3) registering new indications.

In general, the later the development stage of a drug, the higher the license royalty rate. This is because it is more difficult to ascertain the safety, efficacy, and the commercial viability for an early-stage drug than it is for a late-stage drug. In other words, the commercial risks and remaining development costs for an early stage compound are very high, resulting in a lower royalty rate.

According to Medius Associates, the average pharmaceutical industry patent license royalty rates, by stage of product development, are as follows:

Pharmaceutical Industry Patent Range of License

Source: Medius Associates