Valuation and design of pharmaceutical R&D licensing deals

Abstract In today's intensely competitive business environment, pharmaceutical companies are augmenting their product pipelines by both developing drugs on their own and in‐licensing proprietary compounds or drug discovery–related technologies from smaller biotechnology companies. In this work, the OptFolio model of pharmaceutical R&D portfolio management is extended to evaluate partnership opportunities as real options and determine the optimal timing and investment policy for proposed alliances in the face of technological and market uncertainties and budgetary restrictions. Licensing deals are modeled within a decision tree as a series of continuation/abandonment options for the pharmaceutical company, deciding at each stage of R&D whether to make a predetermined milestone payment to continue the alliance or terminate the alliance because of unfavorable market conditions and/or internal resource limitations. Results indicate that early stage alliances become more valuable as market uncertainty and the ability of pharmaceutical companies to enhance the value of the licensed drug increase because of the ability to control downside risk by the abandonment option. © 2004 American Institute of Chemical Engineers AIChE J, 51: 198–209, 2005