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Risk Management & Real Options IX. Flexibility in Contracts. Stefan Scholtes Judge Institute of Management University of Cambridge MPhil Course 2004-05. Introduction The forecast is always wrong The industry valuation standard: Net Present Value Sensitivity analysis

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risk management real options ix flexibility in contracts

Risk Management & Real OptionsIX. Flexibility in Contracts

Stefan Scholtes

Judge Institute of Management

University of Cambridge

MPhil Course 2004-05

course content
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

co development contracts risk sharing
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

co development contracts risk sharing4
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

co development contracts control
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

2 phase example
2-Phase example

2 Phase example

  • Development phase
  • Sales phase

Let’s value this first as a 100% in-house project

© Scholtes 2004

taking downstream decisions into account8
Taking downstream decisions into account

“Market uncertainty level”

© Scholtes 2004

the effect of uncertainty
The effect of uncertainty

From here NPV at launch is

negative in downside scenario:

Cut downside – profit from upside

© Scholtes 2004

co development contract
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

co development contract11
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

value of the deal
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

the effect of different royalty rates
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

the effect of different royalty rates16
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

the effect of different royalty rates17
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

the effect of different royalty rates18
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

summary
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

key messages
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

course content21
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