Valuation Analysis in Pharmaceutical Licensing and M&A Transactions A Tutorial By Tim Opler, Benj Garrett and Susan Langer

January 2014

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AG

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A Agenda

Discuss role of valuation and project assessment

Introduce valuation tools

Show how to use the tools in business development

Go over a variety of cases

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Table of Contents

1. Value Creation and Business Development

2. Valuation of Pharmaceutical Projects

3. Revenue Forecasting

4. Cost Estimation

5. Risk Estimation

6. The Discount Rate

7. Valuation Considerations in Licensing

8. Valuation Considerations in M&A

VALUE CREATION AND BUSINESS DEVELOPMENT

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Typical Value Creating Profile

-100

-50

0

50

100

150

200

250

300

350

1 2 3 4 5 6 7 8 9 10 11 12 13

Revenues and Costs Over Time ($ millions)

Acquisition Cost R&D Launch Cost

Selling Cost Other Cost Revenue

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PR

OC

ESS Value Creation Process

Finding projects that fit

Assessing the projects

Negotiating deals for the projects in the face of competition

Delivering on the potential of the projects

Realizing the value

Assessment and negotiation calls for strong valuation and analysis work. This is our focus today.

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LYSIS FITS IN

TO S

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TEGY

Where Financial Analysis Fits into Business Development Strategy

Financial Analysis

What is the time horizon to peak revenues for each product?

What will sales and marketing costs be?

What are the total cash requirements?

What is the value of each product opportunity?

Ability to Execute / Risks

How achievable are the returns and how significant are the risks?

Do we have the competencies to succeed?

Can we control the key success factors?

Fit with Future Strategy

How does each product fit with our long-term vision?

Are there other products in the pipeline to realize our goals?

What is the opportunity cost of pursuing these initiatives?

Perception of Wall Street / Shareholders?

Is Wall Street likely to invest in a company pursuing these products?

How has Wall Street responded to other companies that have adopted this strategy?

Evaluation Criteria

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Identify the

Opportunity

Initial Technical Evaluation

Commercial Due

Diligence

Contract Negotiations

Technical Due

Diligence Detailed Technical

Evaluation

Detailed Commercial Evaluation

Final Approval

Example: Licensing Process at Bristol-Myers Squibb

Source: Talk by BMS: The Role of Licensing / Business Development in the Pharma Industry, 2004.

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Product Profile / Pricing / Competition

Sales Forecast

P&L Assumption (COGS, S&M, R&D)

Deal Terms

Manufacturing / Tax Considerations

PTRS

Risk Adjusted NPVs & IRRs

BR

ISTOL-M

YERS S

QU

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Bristol-Myers Squibb Deal Valuation Process

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Assets

Opportunity ID PTRS ENPV EIRR

Assets

Opportunity ID PTRS ENPV EIRR

1 92% 370 535% 25 6% 3 29%

2 78% 120 345% 26 48% 411 29%

3 20% 250 318% 27 25% 129 27%

4 80% 182 301% 28 10% 71 27%

5 74% 80 230% 29 82% 837 26%

6 58% 80 230% 30 63% 288 26%

7 30% 250 210% 31 40% 12 26%

8 85% 80 90% 32 14% 116 24%

9 27% 90 83% 33 21% 137 24%

10 53% 18 83% 34 21% 132 24%

11 81% 23 76% 35 43% 183 24%

12 26% 214 59% 36 14% 80 23%

13 59% 582 58% 37 35% 151 22%

14 72% 87 54% 38 45% 12 20%

15 62% 1,400 48% 39 35% 8 19%

16 36% 77 42% 40 46% 230 19%

17 40% 27 41% 41 19% 28 19%

18 24% 371 40% 42 60% 3 19%

19 26% 102 40% 43 42% 123 19%

20 89% 1,538 35% 44 8% 15 18%

21 55% 633 34% 45 31% 52 18%

22 7% 100 33% 46 7% 22 17%

23 24% 152 31% 47 18% 7 15%

24 64% 272 30% 48 38% 6 13%

Bristol-Myers Squibb Ranking of Potential Licensing Deals

PTRS = probability of technical and regulatory success eNPV = expected NPV eIRR = risk-adjusted internal rate of return

Illustrative Table by Kazuo Edaza of BMS

Source: Talk by Kazuo Ezawa, Bristol-Myers Squibb, Pharmaceutical Portfolio Management, DAAG, February 2004.

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Our Approach

The approach that we will discuss today is very similar to that used by Bristol-Myers Squibb.

In fact, almost every large pharmaceutical company uses the same approach to deal valuation.

Consulting firms like BCG, Campbell Alliance, LEK, Mattson Jack and McKinsey have standardized the industry in this way.

A key area of emphasis from us is to keep an eye on risk-adjusted returns in transactions.

There are numerous fine points and ways in which firms differ in approach.

We will discuss many of these but the key focus will be on the hands on how to approach to valuation.

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General View: Go Big and Go for IRR / ROI to Create Value

The key to creating lasting value is to bet big and win.

ROI (IRR)

Scale of Project

Big Project Big Payoff (The zone of shareholder bliss)

Big Project Low Payoff

Small Project Low Payoff

Small Project Big Payoff

Examples in Specialty Pharma Allergan Botox Biovail Wellbutrin XL Cephalon - Provigil ENDO lidoderm patch Forest Lexapro Gilead - Truvada King Altace Reliant - Lovaza Salix Rifaximin Viropharma - Vancomycin

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Some Key Differences Across Pharmaceutical Firms - Method

Sometimes employ real options tools in project assessment. The idea is to look at a drug development project as a sequence of choices or options. The most important insight is the option to abandon a project is valuable. A further insight involves the value of the option to expand indications. Focuses largely on pie splitting the sharing of the rNPV of a project. Other inputs like IRR are not looked at all. Have historically used higher discount rates for risky projects but without risk-adjustment.

Big Pharma A, B, C

Biotech A

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Differences Across Firms - Process

An organization called that carries out financial analysis of licensing and M&A projects. They have prepared an internal manual on how to value every aspect of a project which standardizes their approach. Tends to do careful valuation work with reasonable discount rates. Always have at least three scenarios. Organization tends to be intelligent but financially conservative in looking at opportunities. Will occasionally look at real options and offer option deals to biotechs. Has created a management science group that engages in sophisticated predictive modeling of pharma product performance. Their view is that good forecasts are the most important and most difficult aspect of pharma licensing. This group has been driving real options work but hard for organization to grasp. The focus is much more on simplicity, insight and medical soundness than say Big Pharma E. Every projects gets summarized on two pages (and not more ever) for either the head of commercial or the head of R&D. Once there is a preliminary approval an AIF (autorissation investiment financiere) is prepared (30 to 50 pages). This document does not skimp on commercial analysis but uses basic rNPV models.

Big Pharma D Big Pharma E Big Pharma F

VALUATION OF PHARMACEUTICAL PROJECTS

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NET P

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LUE

Q: Suppose we can invest $50 today & receive $60 later today. What is our increase in value?

Initial Investment

Added Value

$50

$10

A: Profit = - $50 + $60 = $10

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LUE

Q: Now suppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return?

This is the definition of NPV

55.4$1.10

60+-50=Profit

Initial Investment

Added Value

$50

$4.55

The idea of an expected rate of return or discount rate reflect the time value of money, otherwise known as the underlying cost of capital in society.

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NET P

RESEN

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LUE

NPV = PV - required investment

tr)(t

CCNPV

10For two

periods

N

tt

t

r

CNPV

1 )1(

Where N=Number of years

t = year

C = cash flow

r = discount rate

Sigma = Summation Symbol

or

t

t

r

C

r

C

r

CCNPV

)1(...

)1()1( 22

1

10

With multiple periods

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Net Present Value Rule

If the net present value of a project is positive then it creates value and should be carried out. If resources are finite and there are more positive NPV projects than time, money or other constraints would allow then the group of projects that maximize NPV should be implemented.

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Risk Adjusted NPV

Pharmaceutical cash flows are risky and the risk can be characterized based upon stage of development. Risk-Adjusted NPV or rNPV is a risk weighted NPV and should be used in assessing risky project.

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INP

UTS TO

RNP

V M

OD

EL Elements of Risk Adjusted NPV Model

Revenues Costs Other Cash Outflows

Net Cash Flow

- - =

Total Market Prescriptions

Written X

Penetration of Product

= Units Sold

X Price

= Revenue

COGS

+ Research and Development

Expense

+ Selling Costs

+ G&A / Other

Costs

+ Acquisition Costs

Capital Expenditures

+ Change in

Working Capital -

Cash Taxes

Risk Adjustment at Each Stage rNPV

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RNP

V F

OR

MU

LA The rNPV Formula

N

tt

t

r

CRrNPV

1

1

)1(

Where N=Number of years

t = year

t=1 (now)

C = cash flow

R1 = Probability of cash flow now r = discount rate

Sigma = Summation Symbol

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IRR

AN

ALYSIS The risk-adjusted IRR is the discount rate that would give an rNPV equal to zero.

In other words, it is the expected rate of return on a project. We refer to the rIRR as the risk-adjusted IRR.

rIRR

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Issue Equity

Partner Drug vs.

Both of the choices shown at left involve bringing cash today by causing current equityholders to give up future cash flow (either by sharing the cash flow through issuance of more equity) or instead by giving away product cash flows to a partner. There is an embedded opportunity cost which is computed in the rate of return given up in future cash flows for cash today. This is the internal rate of return or IRR. When derived from a probabilized model we refer to this as a rIRR (risk-adjusted IRR).

An Example Trade-Off

1 )1(

Licensee toGiven Up FlowCash Licensorby ReceivedCash

t

t

tt

r

The internal rate of return is the discount rate that is impounded in the equation comparing cash received to cash flow given up.

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How will the expense be amortized?

Straight-line amortization

Negative EPS impact in later years due to smaller profit share payments

Acquisition price set standard treatment

Amortize based on profit share payments

EPS accretive each year

What happens if we dont achieve projections? Write-down

Amortize in full each until asset is gone, then recognize full benefit

Most conservative approach

Not EPS accretive in the beginning years

Many pharma companies are highly focused on EPS management

Will prefer to use investment dollars over R&D dollars whenever possible

Will prefer to push out spending into the future

Accounting Considerations EPS Impact

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EPS

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

$0.02 $0.03 $0.05 $0.06 $0.07 $0.08 $0.04 $0.04 $0.01 $0.01 $0.01

Assumptions

Discount Rate: 10%

Amortization: Based on projected profit share payments

Tax rate: ~35%

Example of EPS Impact in a Transaction to Restructure an Alliance

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Building an rNPV Analysis of a Project

Revenue Forecasting

Cost Assumptions

Tax and Working Capital

Risk Cash Flow Estimates

Discount Rate Selection

rNPV Computation

REVENUE FORECASTING

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TH

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EVEN

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OR

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STS Approaches to Developing Market Sizes

Estimating Product Revenue Trajectory

Bottom Up Market Analysis

Analyst Reports and

Research Reports

Looking at Similar

Products

We believe the best approach is to have a good bottom up model and check the thinking by looking at external reports and similar product revenues.

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LYSIS Commonly Used Research Vendors

Market / Valuation Analysis

Full Service Analysis / Consulting / Support

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BU

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G A B

OTTO

MS U

P REV

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REC

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% Prescription of Drug

Price per Day of Drug

Penetration, Pricing Studies, Competitive Analysis, Compliance Analysis, Reimbursement Analysis and Utilization Patterns

% Diagnosed

% Treated for Disease

Addressable Market Size

Incidence/Prevalence

Total Population, Population in Target Markets

Potential Market Size

Use 10 year planning horizon: 2012-2022. Assume 2012 launch

Going from Market Size to Revenue Estimates (Bottom Up)

Actual Ave Days Used

Revenue Estimates over the Planning Horizon

It is very common to

build several scenarios

(good, poor, expected)

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EX

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DR

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Thin Pipeline of New Treatments Many Patients Poorly Controlled with Existing Treatments

U.S. Patients are Not Controlled with ACEs, ARBs and Beta Blockers Global Burden of Hypertension, Millions of Persons with Hypertension

0

100

200

300

400

500

600

700

800

DevelopedMarket

Economies

China India OtherEconomies

2000 2025

Source: Kearney et.al., Lancet, 2005, 365: 217-223

National Health and Nutrition Examination Survey

Percent

197680 198891 199194 19992000

Awareness 51 73 68 70

Treatment 31 55 54 59

Control 10 29 27 34

Trends in awareness, treatment, and control of high

blood pressure in adults ages 1874

Source: JNC 7

Diuretics, Beta blockers, Calcium Channel Blockers

ACEs, ARBs

Direct Renin Inhibitors

The only major recent innovation in anti-hypertensive therapy on the horizon is the direct renin inhibitor class (e.g., aliskiren/Tekturn) from Novartis.

Renin inhibitors are not more effective than ACEs and ARBs and may be unsafe.*

*Source: Sealey and Laragh,

American Journal of

Hypertension, May 2007

0

10

20

30

40

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DIFFER

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OP

PO

RTU

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Taking Share by Differentiation

Opportunity for Segmentation / Differentiation by Patient Subgroups

There are four important ways in which the novel drug can take share in the hypertension market:

1. Better efficacy and/or safety than current treatments

2. Synergistic with existing treatments (e.g., consider a triple ARB, HCT, novel combo)

3. Better outcomes in certain patient subgroups

4. Better marketing in the face of generics

Novel Anti-hypertensive

Better outcomes in nonresponders to existing anti-hypertensives

Better outcomes in salt sensitive hypertensives

Better outcomes in patients with inflammation

Better outcomes in obese patients

Better outcomes in cardiac patients

Better outcomes by genetic biomarker

Better outcomes in patients at risk of nephropathy

Better outcomes in patients on Cox-2s and

NSAIDs

Rationale for a Synergistic Effect with Current Treatments

The Novel drug is a vasodilator that operates independently of the RAAS cascade and is likely to be synergistic with RAAS inhibitors.

It is likely that a many uncontrolled hypertensive persons would be controlled with the novel drug given its mechanism.

Likely to be synergistic in salt-sensitive hypertension

The drug appears more effective than other meds in animals that are salt sensitive.

Salt sensitive patients are some of the poorest responders to existing medications.

Likely to be synergistic in obese patients The drug appears to be effective in the

presence of obesity.

Obese patients are some of the poorest responders to existing medications.

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Revenue Forecast for Novel Hypertension Drug

Key Assumptions Daily Cost of Therapy $4

ROW as % of US Market 80.0%

2010 2012 2014 2015 2016 2018 2019 2023 2028 2031

Hypertension - US Begin Year Patient No. 80,000,000 84,872,000 90,040,705 92,741,926 95,524,184 101,341,607 104,381,855 117,482,697 136,194,645 148,823,566

Growth in Patients 3% 3% 3% 3% 3% 3% 3% 3% 3%

Diagnosis Rate 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0%

Treatment Rate 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0%

# of Patients Treated 28,000,000 29,705,200 31,514,247 32,459,674 33,433,464 35,469,562 36,533,649 41,118,944 47,668,126 52,088,248

Compliance Rate 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0%

Penetration Rate 0.0% 0.0% 0.0% 0.0% 0.0% 6.0% 8.0% 12.0% 12.0% 12.0%

Patients on drug 0 0 0 0 0 2,128,174 2,922,692 4,934,273 5,720,175 6,250,590

Average Days of Therapy 250 250 250 250 250 250 250 250 250 250

Cost Per Day 0 0 $ 4.00 $ 4.20 $ 4.41 $ 4.86 $ 5.11 $ 6.21 $ 7.92 $ 8.73

Cost per Day * Days of Therapy 0 0 1,000 1,050 1,103 1,216 1,276 1,551 1,980 2,183

Total Revenues $0.0 $0.0 $0.0 $0.0 $0.0 $ 2,586.81 $ 3,730.18 $ 7,654.68 $ 11,325.56 $ 13,644.25

Probabil. Adj Revenues 5.0% 0.0 0.0 0.0 0.0 0.0 129.3 186.5 382.7 566.3 682.2

Hypertension - ROW Begin Year Patient No. 64,000,000 67,897,600 72,032,564 74,193,541 76,419,347 81,073,285 83,505,484 93,986,158 108,955,716 119,058,853

Growth in Patients 3% 3% 3% 3% 3% 3% 3% 3% 3%

Diagnosis Rate 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0%

Treatment Rate 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0% 70.0%

# of Patients Treated 22,400,000 23,764,160 25,211,397 25,967,739 26,746,771 28,375,650 29,226,919 32,895,155 38,134,501 41,670,598

Compliance Rate 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0% 50.0%

Penetration Rate 0.0% 0.0% 0.0% 0.0% 0.0% 6.0% 8.0% 12.0% 12.0% 12.0%

Patients on drug 0 0 0 0 0 1,702,539 2,338,154 3,947,419 4,576,140 5,000,472

Average Days of Therapy 250 250 250 250 250 250 250 250 250 250

Cost Per Day 0 0 $ 4.00 $ 4.20 $ 4.41 $ 4.86 $ 5.11 $ 6.21 $ 7.92 $ 8.73

Cost per Day * Days of Therapy 0 0 1,000 1,050 1,103 1,216 1,276 1,551 1,980 2,183

Total Revenues $0.0 $0.0 $ - $ - $ - $ 2,069.45 $ 2,984.14 $ 6,123.74 $ 9,060.44 $ 10,915.40

Probabil. Adj Revenues 5.0% 0.0 0.0 $ - $ - $ - $ 103.47 $ 149.21 $ 306.19 $ 453.02 $ 545.77

Total Worldwide Revenue $ - $ - $ - $ - $ - $ 4,656 $ 6,714 $ 13,778 $ 20,386 $ 24,560

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Defining the Market

Estimate Incidence and Prevalence

Prevalence:

Total number of potential customers at any one point in time

Best for products purchased by same customer on a recurring basis (chronic Rx)

Incidence:

Number of new potential customers each year

Best for products treating onetime acute event (heart attack)

Identify Segments

All potential customers are not alike

Segmentation helps refine penetration and share forecasts

It also allows you to refine estimates and focus efforts by identifying early adopters

Example in RA

Severely affected patients (25% of the market)

Moderately affected

Mildly affected

Change Over Time

Customer base and segmentation are influenced by factors that change over time

Growth driver analysis provides insight into changing and/or emerging markets

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IMP

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SC

ENA

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S Building Penetration Scenarios

1. Historical penetration of comparable products 2. Objective comparisons versus currently available treatments (efficacy, safety,

convenience) 3. Physician interviews to gauge acceptance and potential use versus competing

treatments (preference share analysis) 4. Analysis of likely reimbursement and factors related to achieving reimbursement

from key payor groups 5. Mapping of commercial effort into physician prescribing behavior (companies

often use IMS analysis) 6. Almost all bottoms up approaches to penetration analysis tend to overestimate

penetration in practice. Preference analysis tends to do a poor job of predicting actual prescribing behavior in the face of detailing and sampling

7. Comparison versus pipeline products and relative timing to market

Penetration is usually the main driver of revenue forecasts. There are a few different means to estimate the peak penetration that a new product can be expected to achieve:

Can then build low, expected and high penetration scenarios (important to understand limitation of forecasts in practice)

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IT IS PO

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Research Methods for Market and Penetration Analysis

Estimates of usage and dependence on pricing

Payor Research

P&T Committees

Physicians by Segment

By Physician Segment

By Disease State (e.g., first line,

second line)

Build demand curve, make pricing estimates

Primary Market Research (Structured Interviews)

Total Products on Market

1st 2nd 3rd 4th 5th 6th

1 100

2 58 42

3 43 31 26

4 35 26 21 18

5 30 22 18 16

6 26 19 16 14 13 12

Expected Product Market Share By Order of Entry

Research Sources: G. Kalyanaram,The order of entry effect in prescription (Rx) and over-the-counter (OTC) pharmaceutical drugs, International Journal of Pharmaceutical and Healthcare Marketing, 2008, pp. 35-46. Hans Bauer and Marc Fischer, Product life cycle patterns for pharmaceuticals and their impact on R&D profitability of late mover products, International Business Review, 2000, 703-725.

Historical Analysis of Impact of Order of Entry

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LYSIS AN

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Leads to suggested sales force sizing and territory coverage with a managed care strategy in light of a launch budget. This facilitates building a penetration forecast that is market based. Typically such forecasts are much lower than those derived from physician preference share analysis.

Target Payers*

Plan Type

Estim

ated

Com

mercial

Lives

New

Product

Januvia

Metform

in

Glipizide

Avandia

WellPoint/Anthem National 24,900,000 T3 T2 T2 T3 T3

Aetna/US Healthcare National 12,020,000 T3 T2 T2 T3 T3

United Healthcare National 10,960,000 T3 T2 T2 T2 T2

Prime Therapeutics Internal PBM 9,000,000 T3 F NF NF NF

Cigna National 8,990,000 T3 T2 T3 T3 T2

Kaiser Regional 7,290,000 NF NF NF NF F

RxSol / PacifiCare Internal PBM 3,340,000 T3 T2 T2 T2 T2

Coventry Regional 2,730,000 T3 T3 T3 T2 T2

HealthNet Regional 2,520,000 T3 T2 T3 T3 T2

Humana National 2,290,000 T3 T2 T3 T3 T3

Caremark PBM 69,000,000 T3 T2 NF NF NF

ExpressScripts PBM 49,000,000 T3 T2 T3 T3 T3

Medco PBM 49,000,000 T3 T2 T3 T3 T3

PharmaCare PBM 6,000,000 T3 T2 NF NF NF

MemberHealth Rx PBM 5,000,000 T3 T3 T2 T2 T2

Anthem PBM 3,300,000 T3 T2 T3 T3 T3

NMHCRx PBM 8,900,000 T3 T2 T2 T2 T2

Coventry PBM 1,200,000 T3 T3 T3 T2 T2PBM 275,440,000

Penetration Analysis Should Understand Prescriber Concentration, Sales Force Design, Prescribing Behavior and Reimbursement Positioning

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Historical Ramp Speed Analysis

Bauer and Fischer (2000) show that Early Movers Ramp Slowly

Source: H.H. Bauer, M. Fischer, International Business Review 9, 2000, pp 703725

COST ESTIMATION

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Estimating Costs

Research Costs / Clinical Development Costs

Identify remaining steps to IND (Toxicology, PK, etc.)

Estimate cost of remaining steps

Evaluate anticipated time and numbers of patients per phase

Examine patient enrollment issues, treatment length and cost, ease of establishing endpoints, long-term safety, regulatory complexity, etc.

COGS

Look at COGS estimates on comparable products

Use expected dosing and treatment length to generate unit sales. Estimate COGS at that sales volume

Important to be aware of fixed / variable elements of COGS

Review status and current data on scale-up issues

Sales and Marketing Costs

Examine concentration of customer base: hospital or office based physicians, etc.

Use IMS sales force sizing / penetration studies.

Evaluate potential market issues: requirements for physician training and education, patient education, direction to consumer marketing, etc.

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Estimating Costs

Pre-Clinical Costs Clinical Development Costs

From lead to IND: $5 to $15mm

From target to lead: $5mm to $50mm

Pre-Clinical Cost Drivers Difficult of chemically reaching target Existence of pool of potential targets Existence of predictive animal models Cost and complexity of pharmacology work Need for extensive animal toxicity work Need for formulation / scale-up work

Number of Patients in Trials

Complexity and Length of Protocol

Time in Trial

Demand for Patients / U.S. vs. ROW

Drug supply costs

A good rough benchmark is to assume $25,000 per patient and count the number of patients.

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COGS Factors

Input Costs

Raw materials

Inventories

Small molecular versus biologic

and production costs

Batch size

Production process (complexity, steps)

Storage and inventories

Delivery to customers

Estimating COGS can be based on a number

of factors

Similarity to other drug profiles

Complexity

Economies of scale

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Sales Force Costs: Example of Costing Grid

Level

Number of Personnel

Fully Loaded Cost

Total Annual Costs

Senior Management

2 $380,000 $760,000

Regional Managers

5 $260,000 $1,300,000

MSLs 8 $250,00 $4,000,000

Sales Reps 120 $180,000 $21,600,000

Support Staff 12 $80,000 $960,000

Total $28.6 million

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SG&A Typically is Typically Much Higher than Direct Sales Force Cost

It is important to estimate variable cost components of a new drug introduction beyond direct sales force costs.

Company Revenues

2006 ($mil)

SG&A Expense

($mil) SG&A

Margin Salesforce Cost ($mil) Revenue / Rep U.S. Reps

Worldwide Reps

Pfizer $ 48,371 $ 15,589 32% $ 4,140 $ 1,389,971 8,800 34,800

GlaxoSmithKline $ 45,500 $ 14,268 31% $ 4,375 $ 1,229,730 9,000 37,000

Sanofi-Aventis $ 38,934 $ 10,641 27% $ 3,342 $ 1,364,191 6,500 28,540

Novartis $ 36,749 $ 13,157 36% $ 1,940 $ 2,370,903 5,200 15,500

AstraZeneca $ 26,475 $ 9,464 36% $ 1,950 $ 1,765,000 6,000 15,000

Merck $ 22,636 $ 8,165 36% $ 1,900 $ 1,741,231 8,000 13,000

Wyeth $ 20,351 $ 6,501 32% $ 1,575 $ 1,695,917 5,000 12,000

Bristol-Myers Squibb $ 17,914 $ 6,270 35% $ 1,348 $ 1,628,545 3,300 11,000

Eli Lilly $ 15,691 $ 4,890 31% $ 2,175 $ 950,970 7,000 16,500

Schering-Plough $ 10,594 $ 4,718 45% $ 1,618 $ 827,656 4,500 12,800

King Pharmaceuticals $ 1,998 $ 714 36% $ 193 $ 1,816,364 1,100 1,100

Sepracor $ 1,196 $ 764 64% $ 333 $ 629,474 1,900 1,900

Reliant Pharmaceuticals $ 800 $ 550 69% $ 126 $ 1,111,111 720 720

Sciele $ 293 $ 145 49% $ 114 $ 450,769 650 650

Source: Cowen Pharma, Jan 2007 and Torreya Partners Analysis

46 I

AC

CO

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TING

T

REA

TM

ENT

Illustration of a Launch Budget for a Primary Care Product

New Drug Launch Costs 2011

Marketing

Travel 1,000,000

Advertorial Media 6,000,000

Patient Starter Kit 30,000

Launch Sales Aid 86,500

Launch Campaign Art 100,000

Small Science Flash Card 43,000

Patient Ed Booklet & Holder 98,750

Direct to Patient Concepts 58,000

Printing Sales Aids 250,000

Testing 12,000

Media to PCPs and GI docs -

Launch Journal Advertising 1,500,000

Launch Media 2,000,000

Launch Convention Panels 40,000

MDAlert 37,000

PharmAlert 32,000

Pharmacy Sell Sheet 27,000

Managed Care Sales Aid 37,000

Formulary Stickers 15,000

Shelf Talker 20,000

Web site 250,000

Direct Mail 205,000

Product Website Development 60,000

Premium Item Give-Aw ays 107,000

Launch Meeting (does not include hotel and flight arrangements) 1,000,000

Marketing Plan -Consulting

Sales Training Modules 120,000

Promo Items -

Rebate 20,000

Trade Show Booths 150,000

RCW Account service fee 630,500

Drug Med Ed 3,000,000

Sample packaging 568,000

Marketing Total 17,496,750

Regulatory & Prod Development

Surveillance system 250,000

800 number 20,000

Orange book costs 100,000

PDUFA establishment 50,000

Total 420,000

Personnel

Representatives (1500) including salary, benefits & f leet 262,500,000

Recruiting, Travel and Misc Personnel Expenses 75,000,000

Managed care organization (100) 15,000,000

Sales Management, MSLs, Outcomes Grp (80) 20,000,000

Total 372,500,000

Samples

Manufacturing, Packaging 50,000,000

Sales

Sales Incentive (trip/other) 3,000,000

Training 1,500,000

Inventory sample cost 1,000,000

Total 5500000

Shipping costs 1,000,000

Total

446,916,750$

RISK ESTIMATION

48 I

KEY C

LINIC

AL E

VEN

TS AN

D PO

TENTIA

L OU

TCO

MES

48

AR9281 Phase 1a Safety Trial

Phase 1b: Initial Proof of Concept

Phase 2: Dose and Safety Confirmed

Phase 3: Large safety confirmation

trial / write label

Drug Safe and Superior to existing

meds

Drug Safe, not Superior but adds to existing meds

Drug approvable but inferior to existing meds

Phase 3: Not Safe Terminate /

Consider Other Indications

Phase 1b: Not Safe Terminate /

Consider Other Indications

Terminate / Consider Other

Indications

Phase 1: Not safe Terminate

Development Terminate

Development Terminate

Development

Phase 1: Done Q3 2008

Phase 1b: Done Q2 2009

Phase 2: Done 2010

Phase 3: Done 2012

Drug Approval / Label: 2013

Opportunity to show range of doses

Opportunity to find clear efficacy and start to see safety profile. Hopefully, primate tox is complete and we have a backup compound in Phase 1.

Critical to get the dose right, establish a safety profile and begin to write the label. Animal carcinogenicity done.

Write the label, confirm the safety profile and dose. Consider head to head trials vs. standard of care, noting points of differentiation. Get QT study done.

If we can beat on efficacy and match safety we have a giant drug.

Important to Diagram Key Development Steps and Risks

49 I

MO

ST DR

UG

CA

ND

IDA

TES FA

IL TO B

E AP

PR

OV

ED Using Industry Average Failure Rates to Handicap Risk (PTRS)

0%

20%

40%

60%

80%

100%

Pre-Clinical SuccessfulIND

Submission

Phase I/IIaSuccessful

Phase IIbSuccessful

Phase IIISuccessful

NDASuccessful

100%

80%

52%

26%

18% 15%

Cumulative probability of success (percent)

Stage of Development

50 I

WID

E RA

NG

E OF S

UC

CESS R

ATE E

STIMA

TES

Probability of FDA Approval

Probability of FDA Approval for Products Entering (%)

STUDY Preclinical Phase I Phase II Phase III FDA Notes

Lehman Brothers (1997) 4 10 30 63 90

Myers / Howe (1997)(1) 22 24 32 64 75

DiMasi / Manocchia (1997) 90 (2)

Kaitin (1995)(1) 20 30 62 75

DiMasi / Hansen / Grabowski / Lasagna (1997, 1995) 23 31 64

Struck (1994 biotech) 38 69 79 92 100

Struck (1994 conventional NCE) 11 25 33 66 100

DiMasi / Seibring / Lasagna (1994) 83

Wenzel (1993) 30 63

Grabowski (1991) 23 31 64

Tucker / Blozan / Coppinger (1988) ? ? ? ? ?

Sheck / Cox / Davis et al. (1984) 17

Hansen (1979) 19 50

Recombinant Capital (o.D.) 19 30 60

Bienz-Tadmor / DiCerbo / Lasagna (1992) 29 (3)

Grosse / DiMasi / Nelson (1996) 21 (4)

Average 19 25 38 66 87

Average (excl. high and low) 18 23 34 64 87

Source: "Real Option Valuation in R&D Decision-Making in Pharmaceuticals" by Dr. Gunnar Pritsch, Associate Principal, McKinsey & Co.

(1) No empirical study, but conclusion estimates.

(2) Gastrointestinal: 79%; anti-infective: 84%; cardio: 90%; oncology: 92%; antiviral: 93%; endocrine: 94%; neuropharmacologic + radiologic: 100%.

(3) Peptide hormone analogous: 24%; antiviral 29%; antineoplastics: 33%; cardiovascular: 34%.

(4) Data 1980-89; number reflects average expected success for all recombiment protein and monoclonal antibody drugs; all recombinants: 19-43%;

new recombinants: 15-39%; therapeutic MAbs: 4-29%.

Studies of Drug Approval Risk

51 I

OV

ERA

LL SU

CC

ESS RA

TE OF D

RU

G A

PP

RO

VA

L: 21

%

Stage

Cost ($ million)

Success Rate / Transition

Probability (%)

Duration (Months)

Phase I 5 71% 12

Phase II 12 44% 26

Phase III 68 69% 34

NDA 3 NA 18

Total 88 21% 90

Success Rates from a Recent Study

Avance published a study in November 2009 of over 200 companies listed on public stock exchanges, tracking their clinical drug candidates from 2003-2009.

In biotech the success rate was even lower, averaging 9% for NCEs and 15% for biologicals.

52 I

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, Trends in Risks Associated With New Drug Development: Success Rates for Investigational Drugs, Clinical Pharmacology and Therapeutics, March 2010, pp. 272-277.

Another Updated Study: DiMasi March 2010

53 I

Success Rates Depend on Therapeutic Indication

Source: DiMasi, J.A., 2001, Risks in New Drug Development: Approval Success Rates for Investigational Drugs, Clin Pharmacol Ther, vol. 69, p. 297-307.

54 I

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, Trends in Risks Associated With New Drug Development: Success Rates for Investigational Drugs, Clinical Pharmacology and Therapeutics, March 2010, pp. 272-277.

Transition Probabilities by Therapeutic Class

55 I

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, Trends in Risks Associated With New Drug Development: Success Rates for Investigational Drugs, Clinical Pharmacology and Therapeutics, March 2010, pp. 272-277.

Small versus Large Molecule

THE DISCOUNT RATE

57 I

AC

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T

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ENT

Discount Rates Used in Industry

Company

Nominal / Real Discount Rate Source

Actelion Nominal 13.2% HY Report 2009

Large Pharma A Real 10% 2010 Interview

Spec Pharma A Nominal 12% 2010 Interview

Large Biotech A Nominal 10% 2009 Interview

Spec Pharma B Nominal 14% 2009 Interview

Large Pharma B Nominal 12% 2009 Interview

AstraZeneca Nominal 11% Annual Rpt 2008

Range 10 to 14%

58 I

AC

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TING

T

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TM

ENT

Nominal Versus Real Discount Rates

Nominal rates include the effects of inflation. Real rates have been adjusted for inflation. It is important to match cash flows in the forecast to the type of rate used: Nominal cash flows with nominal rates and real cash flows with real rates. Its an important distinction because many pharma revenue forecasts are real whether stated or not. Price increases that are modeled in are above and beyond normal inflation.

59 I

What is the Cost of Capital?

The cost of capital is a measure of the opportunity cost of capital in an economy. A companys cost of capital should equal the marginal return available to investors in the next best investment opportunity of similar risk available in the capital markets

The cost of capital should reflect:

The return available to investors in the economy on risk-free instruments

The return that investors require for taking systematic risk over and above the risk-free rate

Systematic risk is that which cannot be diversified away.

Traditionally measured as the weighted average of the cost of equity and debt. Known as the Weighted Average Cost of Capital (WACC).

The Cost of Capital is the opportunity cost of money in a competitive market economy and is a guide to the right discount rate.

Discount Rate Should Reflect the Cost of Capital

60 I

TH

E TR

AD

ITION

AL A

PP

RO

AC

H TO

WA

CC

WACC is a weighted average of cost of equity and debt, where the weights for cost of debt and cost of equity are determined by market values of equity and debt. Because a number of inputs to WACC are of statistical nature, WACC is a range rather than a point estimate.

Weighted Average Cost of Capital (WACC)

Cost of Equity Cost of Debt

Risk-Free Rate

Credit Spread

Country/ Political Risk Premium

Tax Shield Risk-Free Rate

Equity Beta

Equity Market Risk Premium

Country/ Political Risk Premium

Business Risk

Financial Risk

Estimating The Cost of Capital using WACC Approach

61 I

Because equity is a long-term investment, a risk-free rate representing a long-term horizon is most appropriate. Consequently, we utilize the 30-year U.S. Treasury as the risk-free rate in the CAPM.

The beta is a risk measure which represents the non-diversifiable risk associated with an equity investment measured relative to the overall equity market. It is a function of asset risk and financial risk.

The equity market risk premium is the excess return expected for the equity market relative to the long-term bond market. The figure that is used normally ranges between 4 and 8%.

The political risk premium represents the incremental return investors require for use of their funds in international investments and represents non-systematic risks such as expropriation.

TR

AD

ITION

AL A

PP

RO

AC

H TO

WA

CC

(CO

NTD)

RISK-FREE RATE EQUITY BETA(1)

EQUITY MARKET RISK PREMIUM POLITICAL RISK PREMIUM

(1) When calculating the asset beta for high-levered, non-investment grade companies, it is important to utilize a debt beta in the calculation.

62 I

Discount Rates in Practice

CAPM near useless (betas on risky pharma companies often very

low)

Industry betas are better if you must use

beta

We prefer to pick a fixed rate that reflects

the leveraged opportunity cost of

equity

Another approach is to look at industry wide implied cost of equity

from actual market prices.

VALUATION CONSIDERATIONS IN LICENSING

64 I

PA

RTN

ERSH

IP AN

D NP

V

Partnering a Program Splits the NPV Between the Original Developer and the Partner

Illustrative

Total Program Value

Value to Original

Developer

Value to Partner

R&D

License

R&D

R&D

Sales

S&M

COGs

NPV= $80

NPV= $30

NPV= $50

License

Sales

Milestones

Milestones

Royalties

Royalties

S&M

COGs

65 I

Negotiating and Valuing Licensing Deals

What percent of the rNPV goes to the licensor and licensee?

Generally the licensor can get more than 50% of the value

Generally the split is more favorable to the licensor on earlier deals

Generally the split is more favorable to the licensor when the licensee is small or in financial difficulty

NPV Split

A key benchmark is what return on investment goes to the licensee (risk-adjusted internal rate of return)

A smart licensee avoids putting his capital to work in order to boost the rIRR

A smart licensor tries to get the lowest rIRR deal possible

Surprisingly, many counterparties in pharma negotiations pay less attention to this metric than they should.

rIRR to the Licensee

66 I

PA

RTN

ERSH

IP DA

SHB

OA

RD

Partnership Economics in a Recent Torreya Advised Transaction

67 I

BA

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AIN

ING

TA

CTIC

S WH

EN IN

-LIC

ENSIN

G

1. Pick deals with large scale and high rIRRs

2. Know your rIRR limit generally in the 20 to 30% range.

3. Focus on putting largest payments after key risk points have been passed

4. Focus discussion on precedent transactions (example at right)

5. Focus discussion on key issues (e.g., reimbursement, compliance, other related product revenues)

6. Focus discussion on fit and good job that can be done

7. Include equity as consideration if licensor is cash-strapped (often is misvalued)

8. Understand liquidation preferences of licensor / seller

Bargaining Tactics when In-Licensing

68 I

BA

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AIN

ING

TA

CTIC

S WH

EN O

UT-L

ICEN

SING

1. Ask licensor to show what they can do for you. Get financial forecasts if possible. Ask for a capabilities presentation.

2. Figure out the licensors financial modeling approach and assumptions as best as possible.

3. Figure out the licensors hurdle rate on rIRR.

4. Solve for the licensors model and the rIRR as terms change.

5. Focus less on deal comparables.

6. Try to get payments made early in the collaboration.

7. Avoid including equity as consideration.

Bargaining Tactics when Out-Licensing

69 I

ON

E SH

OU

LD ALW

AYS T

RY TO

GU

ESS THE O

THER S

IDES V

ALU

E Solving for the Other Sides Model

The deal on the table here is for a Phase 1b cardiometabolic drug. The proposal made of 20mm upfront gives the licensor (big pharma company) a generous return of 36%. However, the project is highly risky. The licensee should keep bargaining to try to get the pharmas return down to a sub 25% area. This will require getting the upfront to be higher.

Assume $20 million upfront, $160 million in milestones and a 22% royalty.

Cash Flows to BigPharma from Partnership Transaction - US

Items 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2024 2029

Forecast Revenue 0 0 0 0 0 0 0 624 1,686 2,918 4,339 5,972 8,836 12,450

Cost of Goods Sold 0 0 0 0 0 0 0 62 169 292 434 597 884 1,245

Royalty payment to Biotech 0 0 0 0 0 0 0 137 371 642 954 1,314 1,944 2,739

BigPharma development expense 5 10 20 20 50 50 10 0 0 0 0 0 0 0

SG&A and launch cost 0 0 0 0 (30) (30) 0 (156) (422) (642) (954) (1,314) (1,944) (2,739)

Milestone payments to Biotech 20 0 40 0 60 60 0 200 0 0 0 0 0 0

BigPharma Pre-tax cash flows (25) (10) (60) (20) (140) (140) (10) 68 725 1,342 1,996 2,747 4,064 5,727

After-Tax Cash Flow (25) (10) (60) (20) (140) (140) (10) 53 565 1,047 1,557 2,143 3,170 4,467

Probability of Success in Year 10% 20% 40% 40% 70% 70% 85% 100% 100% 100% 100% 100% 100% 100%

Probability of Payment if Deal in 2008 100% 50% 25% 25% 20% 20% 15% 10% 10% 10% 10% 10% 10% 10%

Probability Adjusted Cash Flow (25) (5) (15) (5) (28) (28) (2) 5 57 105 156 214 317 447

EPS Impact with success

$

(0.00)

$

(0.00)

$

(0.01)

$

(0.00)

$

(0.02)

$

(0.02)

$

(0.00) $ 0.01 $ 0.08 $ 0.15 $ 0.22 $ 0.31 $ 0.45 $ 0.64

BigPharma Tax Rate 22%

BigPharma Rate of Return on

Partnership 36%

Value created at BigPharma by deal: $6,104 million for an investment of $ (78) million in expected terms.

THE M&A SETTING

71 I

M&A and Licensing Valuation Analysis are Conceptually Similar

Same exercise but now we are valuing a company rather than a drug. Sum the rNPVs of the projects of the target company with adjustment for overhead costs or model the company as a whole (will shown an example for Eli Lilly). This gives the target company intrinsic valuation. Try not to overpay. Valuation is treacherous, particularly with terminal value assumptions. Problem is that most M&A deals involving later stage and marketed assets are NPV negative. Two ways to think about this: 1. Look at the IRR on your own company what is your cost of cash? 2. Look at missing elements particularly the targets pipeline.

72 I

OU

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ND

E

RSTA

N

DIN

G

OF

LILLYS

VA

LUA

TION

A

PP

RO

AC

H

The Pharma has a well developed approach

Step 1. Identify cash flows from identifiable products

Step 2. Discount the cash flows at a rate in the low teens to get the DCF value

Step 3. Compute the target purchase price as the equity value plus a premium of 30 to 50% (typically 40%) plus debt less cash

Step 4. Compare the DCF to purchase price of the target

The difference between enterprise value and DCF is known as pipeline or science value

If pipeline value is negative then the valuation test suggests acquire

If pipeline value is greater than 50% then the valuation test suggests avoid

If pipeline value is between 0 and 50% then study further and make a business judgment

This approach leaves significant room for quantitative and qualitative judgment. It is intelligent and designed to avoid situations where the pharma overpays for targets.

M&A Analysis Approach at One Pharma

$1,377

$625$726

$856

$1,000

$216$270

$351 $377

$841

$996

$1,207

Op

era

tin

g I

nco

me

(e

x-s

ye

rgie

s)

Allergan Warner Chilcott Pro Forma

2005 2006 2007 2008

Revenues Operating Income (ex-Synergies)

EPS

$3,163

$2,777

$2,373$2,199

$803$772$699$526

$3,966

$3,549

$3,072

$2,725

Revenues

Allergan Warner Chilcott Pro Forma

2005 2006 2007 2008

$6.51

$5.48

$4.62

$3.87$3.28

$5.54

$4.42

$3.55

Allergan Pro Forma

2005 2006 2007 2008

Source: Wall Street projections

Source: Wall Street projections Source: Wall Street projections

8.4% accretive

14.1% accretive

19.9% accretive 18.8% accretive

Operating Margin 28.4% 41.1% 30.7% 38.9% 32.5% 30.8% 30.6% 45.4% 33.9% 46.9% 31.6% 34.5%

20.5%21.4% 22.4%

18.7%17.0%

12.9%

15.2%

17.9%

13.3%

20

05

-20

08

CA

GR

Allergan Warner Chilcott Pro Forma

Revenue Operating Income (ex-synergies) EPS

2003-2008 CAGR

Consequences of a Hypothetical 2004 Acquisition of a Specialty Pharma

74 I

Factors to Consider in NPV Models of Pharmaceutical Companies

Revenues and cost curves for each drug.

Use reasonable estimates to the curves for the models.

Model each drug in an additive manner.

Analyst reports generally stop too soon

Pay careful attention to patent issues and associated cliffs

Use analyst reports to get the estimates started

Take drugs out at least 10 to 15 years past patent expiration dates

If you keep R&D in then you need a terminal value

If you leave it out or scale it down then no terminal value required

Carefully think about the role of R&D in the model.

For the purpose of a stock for stock merger its important to look at each party with the same analytical approach

If you ignore their pipeline, you should ignore yours etc.

Be aware of how your own company looks through the same lens

DISCLAIMER These materials have been provided to you by Torreya Partners LLC or Torreya Partners (Europe) LLP together with their respective affiliates and the members, directors, officers, employees, advisers or agents of each of them (together Torreya Partners) and may not be used or relied upon for any purpose other than as specifically contemplated by a written agreement with Torreya Partners. t The information used in preparing these materials was obtained from public sources and is intended only for educational and illustrative purposes. The material herein was prepared by the authors and may not represent the opinions or methods employed by Torreya Partners. Torreya Partners assumes no responsibility for independent verification of the validity of the content herein nor can it indicate that the content is complete and accurate in all material respects. No representation, warranty or undertaking, express or implied, is made and no responsibility is accepted by Torreya Partners as to or in relation to the accuracy or completeness or otherwise of these materials or as to the reasonableness of any other information made available in connection with these materials (whether in writing or orally) to any interested party (or its advisers). Torreya Partners will not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement contained in these materials or any such other information. None of these materials, the information contained in them or any other information supplied in connection with these materials will form the basis of any contract. To the extent such information includes estimates and forecasts of future financial performance (including estimates of potential cost savings and synergies) prepared by or reviewed and discussed with the managements of your company and/or other potential transaction participants or obtained from public sources, we have assumed that such estimates and forecasts have been reasonably prepared on bases reflecting the best currently available estimates and judgments of such managements (or, with respect to estimates and forecast obtained from public sources, represent reasonable estimates). These materials were designed for us by specific persons familiar with the business and the affairs of your company and Torreya Partners assumes no obligation to update or otherwise review these materials. These materials have been prepared by Torreya Partners and its affiliates and accordingly information reflected or incorporated into these materials may be shared with employees of Torreya Partners and its affiliates and agents regardless of location. This presentation speaks only as of the date it is given, and the views expressed are subject to change based upon a number of factors, including market conditions and the Companys business and prospects. Nothing contained herein should be construed as tax, legal or accounting advice. You (and each of your employees, representatives or other agents) may disclose to any and all persons, without limitation of any kind the tax treatment and structure of the transactions contemplated by these materials and all materials of any kind (including opinions or other tax analyses) that are provided to you relating to such tax treatment and structure. For this purpose, the tax treatment of a transaction is the purported or claimed US federal income tax treatment of the transaction and tax structure of a transaction is any fact that may be relevant to understand the purported or claimed US federal income tax treatment of the transaction. Torreya Partners (Europe) LLP, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority, is not acting for you in connection with any potential transaction(s) described in these materials and thus will not be responsible for providing you the protections afforded to clients of Torreya Partners (Europe) LLP or for advising you in connection with any potential transaction(s) as described in these materials except and unless subject to a subsequent specific written agreement relating to such potential transaction(s) between you and Torreya Partners (Europe) LLP.

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