1. Risk Management & Real Options IX. Flexibility in Contracts Stefan Scholtes Judge Institute of Management University of Cambridge MPhil Course 2004-05

2. 2 September 2004 © Scholtes 2004Page 2 Course content I. Introduction II. The forecast is always wrong I. The industry valuation standard: Net Present Value II. Sensitivity analysis III. The system value is a shape I. Value profiles and value-at-risk charts II. SKILL: Using a shape calculator III. CASE: Overbooking at EasyBeds IV. Developing valuation models I. Easybeds revisited V. Designing a system means sculpting its value shape I. CASE: Designing a Parking Garage I II. The flaw of averages: Effects of system constraints VI. Coping with uncertainty I: Diversification I. The central limit theorem II. The effect of statistical dependence III. Optimising a portfolio VII. Coping with uncertainty II: The value of information I. SKILL: Decision Tree Analysis II. CASE: Market Research at E-Phone VIII. Coping with uncertainty III: The value of flexibility I. Investors vs. CEOs II. CASE: Designing a Parking Garage II III. The value of phasing IV. SKILL: Lattice valuation V. Example: Valuing a drug development projects VI. The flaw of averages: The effect of flexibility VII. Hedging: Financial options analysis and Black-Scholes IX. Contract design in the presence of uncertainty I. SKILL: Two-party scenario tree analysis II. Project: Valuing a co-development contract

3. 2 September 2004 © Scholtes 2004Page 3 Co-development contracts: Risk Sharing Contracts are the building blocks of business Example: Co-development contracts between biotech & pharma Exploit core competencies, IP Share responsibilities Share required capital Share risk Further example: Production sharing contracts between BP and national oil company

4. 2 September 2004 © Scholtes 2004Page 4 Co-development contracts: Risk Sharing Risk in a phased project: Technical risk of phase failures Long lead time until revenues occur Market risk after launch Typical contract terms: Investment split ̵ Share capital commitment Milestone payments upon successful phase completions ̵ Reward for taking technical risk Royalty payments (e.g. % of sales revenue) ̵ Share market risk What is the effect of payment terms on contract value?

5. 2 September 2004 © Scholtes 2004Page 5 Co-development contracts: Control Two parties take downstream decisions to cut losses and amplify gains Contract specifies feasible actions through “control structure” Loosing control increases exposure to risk and lowers the contract value Cure: Understand the interest of the partner and incentivise through contract terms to take actions in your interest Maintaining or gaining control increases value What is the effect of the control structure on contract value?

6. 2 September 2004 © Scholtes 2004Page 6 2-Phase example 2 Phase example Development phase Sales phase Let’s value this first as a 100% in-house project

7. 2 September 2004 © Scholtes 2004Page 7 Taking downstream decisions into account

8. 2 September 2004 © Scholtes 2004Page 8 “Market uncertainty level” Taking downstream decisions into account

9. 2 September 2004 © Scholtes 2004Page 9 The effect of uncertainty From here NPV at launch is negative in downside scenario: Cut downside – profit from upside

10. 2 September 2004 © Scholtes 2004Page 10 Co-development contract Biotech does not have sufficient cash and expertise to launch Search for large pharma company to co-develop Contract negotiated on the following basis 50/50 split of development costs After development, project goes to pharma for sales against milestone / royalty payments for biotech What should the milestone / royalty terms be?

11. 2 September 2004 © Scholtes 2004Page 11 Co-development contract Traditional approach: “We are carrying 50% of the development costs, so we want 50% of the product value if and when it is developed” Estimated value at time of launch: $100-$80=$20 Construct the deal so that its total value to biotech in case of successful development is $10 Suggestion $5 upon successful completion of development 5% royalty on sales = 0.05*$100=$5

12. 2 September 2004 © Scholtes 2004Page 12 Value of the deal Value of the deal, taking account of other party’s downstream decisions Launch and get Revenue – launch cost– royalties- milestone Don’t launch and pay milestone

13. 2 September 2004 © Scholtes 2004Page 13 The effect of uncertainty

14. 2 September 2004 © Scholtes 2004Page 14 The effect of uncertainty

15. 2 September 2004 © Scholtes 2004Page 15 The effect of different royalty rates Market uncertainty level 10% Contract terms: 10% or revenues but no milestone payment Biotech argues that it wants more than 50/50 since it is the opportunity seller

16. 2 September 2004 © Scholtes 2004Page 16 The effect of different royalty rates Market uncertainty level 10% Contract terms: 10% or revenues but no milestone payment Biotech argues that it wants more than 50/50 since it is the opportunity seller

17. 2 September 2004 © Scholtes 2004Page 17 The effect of different royalty rates Market uncertainty level 10% Contract terms: 10% or revenues but no milestone payment Biotech argues that it wants more than 50/50 since it is the opportunity seller CAN DESTROY GREED VALUE

18. 2 September 2004 © Scholtes 2004Page 18 The effect of different royalty rates Market uncertainty level 10% Contract terms: 10% or revenues but no milestone payment Biotech argues that it wants more than 50/50 since it is the opportunity seller

19. 2 September 2004 © Scholtes 2004Page 19 Summary Gaining or maintaining control has significant value Launch decision Milestones and royalties have different associated risks Milestone payments are sunk at time of launch and have no impact on launch decision Increasing royalties gives disincentive to launch and can destroy total value of co-development deal

20. 2 September 2004 © Scholtes 2004Page 20 Key messages Traditional valuation techniques have severe limitations when applied to the valuation of multi-stage projects Need to take downstream flexibility into account Have seen Monte Carlo simulation and scenario tree approaches Effect is magnified in contract valuation Need to take account of your own as well as your contract partner’s flexibility Need to understand incentives provided by contract terms Have seen how scenario tree approach can be used

21. 2 September 2004 © Scholtes 2004Page 21 Course content I. Introduction II. The forecast is always wrong I. The industry valuation standard: Net Present Value II. Sensitivity analysis III. The system value is a shape I. Value profiles and value-at-risk charts II. SKILL: Using a shape calculator III. CASE: Overbooking at EasyBeds IV. Developing valuation models I. Easybeds revisited V. Designing a system means sculpting its value shape I. CASE: Designing a Parking Garage I II. The flaw of averages: Effects of system constraints VI. Coping with uncertainty I: Diversification I. The central limit theorem II. The effect of statistical dependence III. Optimising a portfolio VII. Coping with uncertainty II: The value of information I. SKILL: Decision Tree Analysis II. CASE: Market Research at E-Phone VIII. Coping with uncertainty III: The value of flexibility I. Investors vs. CEOs II. CASE: Designing a Parking Garage II III. The value of phasing IV. SKILL: Lattice valuation V. Case: Valuing a drug development projects VI. The flaw of averages: The effect of flexibility VII. Hedging: Financial options analysis and Black-Scholes (not covered) IX. Contract design in the presence of uncertainty I. SKILL: Two-party scenario tree analysis II. Case: Valuing a co-development contract X. Wrap-up and conclusions