Translation: Original published in Finnish on 12/19/2024 at 07:44 am EET

The fourth part of our series of articles focusing on investing in Life Science companies deals with value creation in drug development companies through M&As and licensing agreements (see previous articles on clinical stages of drug development, probabilities of success and regulation). The valuation of drug development companies is traditionally based on the likelihood of commercialization of the drug candidate and sales forecasts. Based on these, the present value of future predicted cash flows is calculated using the discounted cash flow (DCF) model. However, the short- and medium-term return on investments is also strongly influenced by possible M&As and licensing agreements, which we will discuss in this Article.

M&As as value creators in drug development

The synergies achieved through M&As or licensing agreements are greater in drug development than in most other industries. Synergies are created when the innovation of an early-stage drug development company is combined with significant frontloaded financing of a larger partner. A drug development company can also benefit from the expertise of a larger partner in clinical trials and regulation and, naturally, from the sales and distribution resources during the commercialization phase. From a sales and distribution perspective, partnering is practically essential for a small development company sooner or later.

From a drug development company's perspective, becoming an acquisition target or signing a licensing agreement can mean accelerated value creation. It can be difficult to arrange financing for a clinical trial without a partner to implement the entire planned development program. In practice, after the agreement is signed, drug development is no longer dependent on obtaining external financing. Securing financing and possible expansion and acceleration of the development pipeline could, if successful, mean earlier market entry of a drug or drugs. Rapid commercialization, in turn, increases the total value of the development pipeline as cash flows move closer in time and as the high-margin sales period extends within the patent protection. Early market entry also increases the likelihood of achieving a higher market share, as drugs with earlier market penetration on average gain a higher market share (David).

From the buyer's perspective, the motive for the acquisition may be to compensate for declining revenue caused by patent expiry or to pursue inorganic growth in general. The acquisition rationale can be based on complementing the existing product portfolio and medical focus area, acquiring new innovations, expanding the partner network or geographic expansion (Ascher). The probability of becoming an acquisition target can thus be raised if the target company fits well into the acquirer's product portfolio, develops a lot of innovations, or operates in new markets from the acquirer's perspective.

Estimates of the premium paid in acquisitions relative to the share price vary significantly. According to Mikulici, the premiums in 2010-2019 were about 97% and according to Kengelbach  about 30%. In any case, if a company in your portfolio becomes an acquisition target it is likely to result in a significant return for the investor.

The value creation of M&As relies on the development phase of the drug candidate

The value of acquisitions in drug development companies at different development stages has been studied in more detail in a study published in 2022, based on acquisitions in the field in 2005-2022 (Michaeli et al.).

The most important factor explaining the value of the acquisition is the development stage of the spearhead drug, which explains 44% of the deal value. The average historical value of transactions for Preclinical Phase companies was 88 MUSD, of which about half was advance payment. Transactions for Clinical Phase III companies amounted to approximately 1.8 BNUSD and the advance payment accounted for 80%. The remainder of the contract value consists of maximum milestone payments based on the progress of development and commercialization. Milestone payments may not materialize fully or at all if drug development is, for example, abandoned before the milestone payment conditions are met. In addition to the advance and milestone payments, contracts usually include a royalty linked to sales, which typically is around 15% of sales.

The number of indications for the spearhead drug candidate was associated with the total contract value. If the candidate was suitable for several indications, the contracts were higher in value. Contracts on biological drugs and gene therapies were more valuable than agreements on micromolecules. Any additional products alongside the spearhead candidate increased the total value of the contracts by approximately 15% per product. Geographically, US companies were more valuable than companies located elsewhere. Large companies (market cap over 10 BNUSD) sign more valuable contracts on average.

Licensing agreements are typically more limited and lower in value compared to M&As

Licensing agreements alone are clearly more common than M&As and also of lower value (Michaeli). The average contract values ranged from 20 MUSD in Preclinical Phase to 140 MUSD in Clinical Phase III. Lower values are based on contracts for individual drugs rather than entire companies. Licensing agreements often also concern a limited geographical area, which reduces their commercial potential.

In licensing agreements, advance payments typically account for about 20% of the total contract value, i.e. a much smaller proportion compared to acquisitions. In addition to advance and milestone payments, sales-based royalties constitute a significant part of the value creation of licensing agreements. As for M&As, the average royalty rates for licensing agreements are around 15%.

A second study shows that the average total value of licensing agreements in 2010-2020 was around 150 MUSD (Frei & Neuendorf), which is slightly higher than the above estimate. However, together, the studies provide a rough range of the average values of licensing agreements.

Sources used in this article:

Ascher et al. “Five ways biopharma companies can navigate the deal landscape.”

2023, McKinsey.

David: The Pharmagellan Guide to Biotech Forecasting and Valuation, 2016. Pharmagellan.

Du: Valuation and Investments in Clinical-Stage Biopharmaceutical Companies, 2024.

Frei & Neuendorf: Trends and facts on licensing deal, 2020, Venture Valuation/Biotechgate.

Kengelbach, et al. “The 2019 M&A Report: Downturns are a Better Time for Deal Hunting.” BCG, 2019.

Michaeli, et al. Value drivers of development stage biopharma companies, 2022, Eur J Health Econ.

Mikulic. “Premiums for public U.S. biopharma company trade sales 2010-2019.” Statista, 2022.