Risk Management & Real Options IX. Flexibility in Contracts

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

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

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 © Scholtes 2004

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? © Scholtes 2004

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? © Scholtes 2004

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

7. Taking downstream decisions into account © Scholtes 2004

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

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

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? © Scholtes 2004

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 © Scholtes 2004

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 © Scholtes 2004

13. The effect of uncertainty © Scholtes 2004

14. The effect of uncertainty © Scholtes 2004

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 © Scholtes 2004

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 © Scholtes 2004

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 GREED CAN DESTROY VALUE © Scholtes 2004

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 © Scholtes 2004

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 © Scholtes 2004

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 © Scholtes 2004

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