Some Simple Economics for Early Stage Drug Development

Friday, 14 February 2014
Regency D (Hyatt Regency Chicago)
Bruce Lehmann , University of California, San Diego, La Jolla, CA
There are three key elements of investment decisions in early stage drug development programs: (1) the nature of the risks at different stages; (2) the probabilities associated with those risks; and (3) the associated discount rates or opportunity costs of capital appropriate for those risks. There are two unrelated types of risk in early stage drug development: the technical risks associated with success and failure at each stage of development or clinical testing and the valuation risks associated with the prospects for the drug should it survive the development and testing process. Technical risks depend on outcomes in the development process and clinical trials and thus are unrelated to market conditions. Simple economic reasoning suggests that the appropriate discount rate is thus the riskless rate for such risks. Valuation risk could impinge on early stage market value assessments if market conditions strongly affected them and if costs could substantially exceed them but neither circumstance is likely, leaving valuation risk with virtually no impact on early stage investment decisions. Late stage valuation risk does involve market conditions, although probably less than that implicit in the opportunity costs of capital of large pharma because the impact of market conditions on the risk of managing approved drugs exceeds that of developing drugs. Taken together, this reasoning suggests that the present value of costs is higher than typically thought since the riskless rate is lower than the typically assumed opportunity cost of capital but that the present value of a successful drug is higher because the assumed discount factor is typically too high as well. The analysis also suggests that the trend toward prepackaged structured exits with contractual milestones serves to shift valuation risk away from early stage drug developers to large pharma and biotech, which is probably their comparative advantage. Hence, early stage drug development projects with prenegotiated prepackaged exits based on contractual milestones should have prospective costs and revenues discounted at the riskless rate, which is far from current practice. The reason is likely investor and managerial suspicion about projected costs and revenues and expectations about the probability of success and failure. As is the case with corporate finance in general, better decision making would result from use of the correct opportunity cost of capital coupled with realistic and unbiased projections.