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

Risk Management & Real Options

IX. Flexibility in Contracts

Stefan ScholtesJudge Institute of Management

University of Cambridge

MPhil Course 2004-05

2 September 2004 © Scholtes 2004 Page 2

Course content

I. IntroductionII. The forecast is always wrong

I. The industry valuation standard: Net Present Value

II. Sensitivity analysisIII. The system value is a shape

I. Value profiles and value-at-risk charts

II. SKILL: Using a shape calculatorIII. CASE: Overbooking at EasyBeds

IV. Developing valuation modelsI. Easybeds revisited

V. Designing a system means sculpting its value shapeI. CASE: Designing a Parking Garage

III. The flaw of averages: Effects of

system constraintsVI. Coping with uncertainty I:

DiversificationI. The central limit theoremII. The effect of statistical

dependenceIII. 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


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


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?


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?


2-Phase example

2 Phase example• Development phase• Sales phase

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


Taking downstream decisions into account


“Market uncertainty level”

Taking downstream decisions into account


Deal value as a function of market uncertainty

-1

0

1

2

3

4

5

6

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Market uncertainty level

Exp

ecte

d N

PV

of d

eal (

in $

Mio

)

Expected value of in-house project

The effect of uncertainty

From here NPV at launch is negative in downside scenario:Cut downside – profit from upside


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?


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


Value of the deal

Value of the deal, taking account of other party’s downstream decisions

Launch and getRevenue – launch cost– royalties- milestone

Don’t launch and pay milestone



-1

0

1

2

3

4

5

6

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Scenario deviations from projected sales

Exp

ecte

d N

PV

of d

eal (

in $

Mio

)

Expected value of in-house project




-1

0

1

2

3

4

5

6

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Scenario deviations from projected sales

Exp

ecte

d N

PV

of

deal (i

n $

Mio

)

Expected value of in-house project Deal value for biotech Deal value fo pharma



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

Expected value of deal as a function of royalty rate

-1

-0.5

0

0.5

1

1.5

2

6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16%

Royalty rate

Exp

ecte

d N

PV

($

Mio

)

Total value of in-house project Value to biotech Value to pharma




seller


-1

-0.5

0

0.5

1

1.5

2

6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16%

Royalty rate

Exp

ecte

d N

PV

($

Mio

)

Total value of in-house project Value to biotech

Value to pharmar Total value of co-development deal




seller


-1

-0.5

0

0.5

1

1.5

2

6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16%

Royalty rate

Exp

ecte

d N

PV

($

Mio

)


Value to pharma Total value of co-development deal

CANDESTROY

GREED

VALUE




seller


-6

-5

-4

-3

-2

-1

0

1

2

3

4

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 34%

Royalty rate

Exp

ecte

d N

PV

($

Mio

)


Value to pharma Total value of co-development deal


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


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


Course content

I. IntroductionII. The forecast is always wrong

I. The industry valuation standard: Net Present Value

II. Sensitivity analysisIII. The system value is a shape

I. Value profiles and value-at-risk charts

II. SKILL: Using a shape calculatorIII. CASE: Overbooking at EasyBeds

IV. Developing valuation modelsI. Easybeds revisited

V. Designing a system means sculpting its value shapeI. CASE: Designing a Parking Garage

III. The flaw of averages: Effects of

system constraintsVI. Coping with uncertainty I:

DiversificationI. The central limit theoremII. The effect of statistical

dependenceIII. Optimising a portfolio

VII. Coping with uncertainty II: The value of information

I. SKILL: Decision Tree Analysis

II. CASE: Market Research at E-PhoneVIII. 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

Documents

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