Intellectual Property Considerations in Pharmaceutical Industry Valuations

Journal Issue

Jun 2006

Column Name

Value & Cents

Citation

ABI Journal, Vol. XXV, No. 5, p. 46, June 2006

Topic Tags

Practice and Procedure

Journal HTML Content

Pharmaceutical industry facilities are typically
complex, special-purpose and functionally integrated. Accordingly,
these facilities are often appraised as a single income-producing
property for bankruptcy purposes. When the operating assets are valued

as a part of a single functional unit, the valuation often includes
the value increments associated with intellectual property. This is
the case (to varying degrees) regardless of which income-approach,
sales-comparison-approach or cost-approach methods are used. This
discussion explains the importance of intellectual property to
pharmaceutical industry property and/or business valuations. In
particular, this discussion focuses on the impact of current trends in
intellectual property licensing in the pharmaceutical industry.
Pharmaceutical industry facilities are often large, multi-purpose,
capital-intensive properties. These multipurpose properties often
include (1) administrative offices, (2) laboratories and research
facilities, (3) chemical processing and product manufacturing
operations, and (4) warehouse and distribution facilities. The
pharmaceutical plant structures can be large, fully integrated and
special-purpose. In addition to the structures, the pharmaceutical
plant tangible personal property can be complex, fully integrated and
special-purpose. Accordingly, the valuation of pharmaceutical
industry facilities for bankruptcy purposes often involves a
complicated analysis. Because these facilities are often complex,
integrated and special-purpose, appraisers often apply unit-based (or
unitary) valuation methods (instead of the more common summation-based
valuation methods) to appraise such properties. Some appraisers
believe that for bankruptcy purposes, unit valuation methods are both
effective and efficient. These appraisers believe that unit valuation

methods are effective because the appraisal can be completed with less

time and effort than an appraisal that is based on summation valuation

methods. These appraisers believe that unit valuation methods are
effective because the multipurpose facilities operate as a single,
fully-integrated operation. These appraisers believe that the
summation-based valuation of each structure or improvement would not
fully capture the synergistic effect of the overall pharmaceutical
property "unit." Pharmaceutical Industry Facility
Valuation Approaches Like all summation valuation methods, all
unit valuation methods are categorized into three generally accepted
property valuation approaches: (1) the sales comparison approach, (2)
the income approach and (3) the cost approach.However, both the
procedural application of and the data sources used in these three
approaches vary depending on whether the summation valuation concept or

the unit valuation concept are used. The value indications produced by
the selected approaches and methods may differ between unit valuations

and summation valuations because of the procedural and data source
differences. This is because, in the appraisal of the same
process/manufacturing property, the summation valuation concept and
the unit valuation concept do not always encompass (1) the same bundle

of operating assets and (2) the same bundle of value influences.
The Sales-Comparison Approach Pharmaceutical industry
facilities do not sell frequently. Accordingly, there is not a great
deal of comparable sales data available to perform a typical sales
comparison approach analysis. The problem of the limited comparable
sales data is exacerbated by the fact that most sales of
pharmaceutical properties involve the sale of a multi-property
going-concern business—and not the sale of a single real estate
property. Accordingly, in a unit valuation, appraisers sometimes use
the stock-and-debt method as a sales-comparison-approach method. Using

this method, the stock and debt securities of the subject
pharmaceutical debtor are valued as a surrogate for valuing the
operating assets of the subject pharmaceutical debtor. Because it
relies on stock market data related to the pharmaceutical industry
debtor, the value indication produced by the stock-and-debt method
represents the value of the subject business enterprise—not just

the subject operating assets. Therefore, the value indication produced

by the stock-and-debt method includes: <blockquote> 1. the entire
bundle of business-enterprise assets (both tangible assets and
intangible assets) that operate at the subject property, and 2.
all of the investment influences that affect the value of publicly
traded stock and bond securities. </blockquote>The Income
Approach Pharmaceutical facilities are typically owner-occupied.
Due to their special-purpose nature, such properties are rarely owned
by a lessor and rented to a lessee. Because such facilities are owner
occupied, there is a dearth of rental gross rent, net operating income

(NOI) and rental income empirical data. Therefore, it is difficult to
perform a typical income approach valuation analysis of such
properties. To address this problem, appraisers sometimes use the NOI

of the pharmaceutical business enterprise operating at the subject
facility (instead of a rental property NOI) as the income to be
capitalized in the income-approach analysis. Since comparable rental
properties are rarely sold in the marketplace, market-derived
direct-capitalization rates are typically not available. Therefore,
appraisers sometimes extract capitalization rates from stock market
data related to the pharmaceutical industry property owner. As
indicated above for the stock-and-debt method, the value indication
produced by this type of direct capitalization method includes:

<blockquote> 1. the entire bundle of business enterprise assets
(both tangible and intangible) that operate at the subject property
and 2. all of the economic influences that affect the value of
stock and bond instruments. </blockquote>The Cost
Approach As a special-purpose property, a pharmaceutical facility

is often well-suited to be appraised by the application of the cost
approach. The cost approach is particularly applicable to
special-purpose properties, including income-producing special-purpose

properties. With regard to pharmaceutical facilities, the cost
approach is not as affected by empirical data limitations as are the
sales-comparison and income approaches. In addition, the cost approach

requires the specific identification and quantification of two
valuation factors that often affect complex processing and manufacturing

plants: (1) functional obsolescence and (2) external obsolescence.
Intangible Assets Included in Pharmaceutical Facility
Valuations For all of the reasons discussed above, unit concept
valuations of pharmaceutical industry facilities often include the
value of the property owner's intangible assets. This is a
particularly significant valuation issue with regard to the
pharmaceutical industry because the value of intellectual property
represents a particularly large component of the overall business
enterprise value of the typical pharmaceutical company. To emphasize
the importance of intellectual property, the following discussion
summarizes the recent trends with regard to the pharmaceutical
industry commercialization of intellectual property. Types of
Intellectual Property The typical pharmaceutical company
intellectual property includes all four types of intellectual
property:<blockquote> 1. trademarks 2. patents 3.
copyrights 4. trade secrets </blockquote>Along with real
estate and tangible personal property, all four types of intellectual
property1 are used at the typical pharmaceutical
manufacturing facility. In particular, this discussion focuses on the

following issues with regard to the importance of intellectual
property to pharmaceutical company business/ property values:

<blockquote> • motivation of pharmaceutical industry
participants to license intellectual property, •
licensing of intellectual property as an alterative to other types
of industry strategic alliances, • economic advantages of
licensing intellectual property as a strategic alliance, 
• risks in pharmaceutical industry intellectual property, 
• trends in pharmaceutical industry intellectual property, and
 • data sources commonly used in the valuation of
pharmaceutical industry intellectual property.
</blockquote>Motivations to License Pharmaceutical Industry
Intellectual Property In order to effectively analyze the value
of pharmaceutical industry intellectual property (for bankruptcy or
any other purpose), the analyst should understand the various
motivations of the pharmaceutical company management to license
intellectual property. The common reasons for pharmaceutical companies
to enter into both inbound and outbound license agreements with regard

to the commercialization of intellectual property include:<blockquote>

1. The product portfolios of many major pharmaceutical companies
are mature and some of their most valuable patents are expected to
expire in the foreseeable future. 2. There is a lack of new
drugs in the current development pipeline of many major
pharmaceutical companies. 3. There is increasing investor and
government pressure on pharmaceutical companies to become more
efficient, particularly in the new-drug development process.

4. There is increasing investor and government pressure for
pharmaceutical companies to develop and distribute new drugs faster.

5. During the past decade, the initial public offering (IPO) and

private-equity markets have not provided sufficient funds for the
multitude of pharmaceutical/biotech start-up companies. 6.
The current average cost for the development of a new drug in the United

States is more than $1 billion. 7. The current average time
for the development of a new drug in the United States is 10-15
years. 8. Only one in 15 new drugs developed by the
pharmaceutical industry ultimately receives FDA approval for product

distribution in the United States. 9. Pharmaceutical industry
intellectual property licensing "partners" can exploit
each other's strategic strengths and minimize each other's strategic

weaknesses. </blockquote>For all of these reasons (and others),
there has been an increase in the inbound and the outbound licensing
of pharmaceutical industry product-related intellectual property.
Licensing Is Often Superior to Other Types of Strategic
Alliances There are a number of reasons why pharmaceutical
industry participants (both large and small) prefer
intellectual-property licensing to other forms of commercial
relationship (e.g., direct-debt investments, direct-equity
investments, joint-venture investments, etc.). Some of the more common

reasons include: <blockquote> 1. Cash infusions to finance new
product, new venture and new intellectual property development are
both expensive and risky. 2. Direct-investment cash infusions
have a negative financial statement impact on the investor entity
and a negative financial statement impact on the investment
recipient entity. 3. Direct-investment equity infusions
typically have no obvious exit strategy for the investor entity.

4. Special-purpose investment entities have significantly lost
their investor appeal after the collapse of Enron. 5.
Special-purpose investment entities now have to be disclosed in the
investor entity financial statements. 6. Co-development
agreements typically only work for drugs in the later stage of
development. 7. Other joint-venture intellectual property
development/commercialization agreements are complex, involve equity

allocation issues and have investor exit-strategy constraints.
</blockquote>Accordingly, both pharmaceutical industry investor
entities and investment recipient entities often prefer intellectual
property license agreements to other forms of new drug
development/commercialization arrangements. Economic Advances of
Licensing as a Type of Strategic Alliance There are also specific

economic advantages to the licensor and/or licensee that make
intellectual property licensees preferable to other forms of business
alliances. The following list summarizes some of these economic
advantages. <blockquote> 1. There may be no immediate cash-balance
or financial statement impact on the license agreement
"partners." 2. There may be no need to report the
intellectual property license agreement in any SEC documents.

3. There is often less financial and legal risk to both
license-agreement parties. 4. There is a defined exit
strategy (i.e., an expiration date) to the license agreement.

5. The license contract itself can be custom-tailored to the
needs of the individual "partners." 6. In
cross-border deals, intellectual property licensing is typically easier

to manage than other forms of business alliance. 7. The
license agreement-related royalty financing can provide upfront cash

to the intellectual property licensor: <blockquote> a.
either from the licensee entity or from a financial institution;

b. with a draw-down of the royalty financing loan scheduled to match
the new product R&D expenditures; c. with the
royalty financing loan proceeds paid off from future royalty
payments; or d. with the license agreement itself used as a
financing mechanism. </blockquote></blockquote>These economic
benefits have encouraged pharmaceutical industry new-product
developers to license their product-related intellectual property to
cash-rich (but new-product-poor) major pharmaceutical companies.

Risks in Intellectual Property License Agreements: Necessary
Contract Clauses and Indemnifications As with all
commercialization agreements, there are contractual and other legal
risks with regard to pharmaceutical-development intellectual property
license agreements. Some of these risks are summarized below:
<blockquote> 1. Not all countries respect the same intellectual
property legal rights as does the United States. The license
agreement should specify which national jurisdictional laws apply.
 2. There may be questions as to who helped create the new drug.
If a dispute arises, the agreement should specify a procedure for
resolving who has a claim on the license royalty payments. 
3. The question of who is responsible for what drug promotion and legal
defense expenditures should be specified in the license agreement.
 4. The license agreement should specify any and all royalty
payment offsets. 5. The license agreement should specify how

disputes are to be resolved. 6. The license agreement should
specify how to handle changes in the intellectual property,
commercial and income tax laws over the life of the license. 7.
The license agreement should specify all cross-licensing clauses.

8. The license agreement should specify all sub-licensing clauses.

9. The license agreement should specify all assignment clauses.

10. The license agreement should specify all minimum/maximum/up-front
royalty payments. 11. The license agreement should specify
the timing of all royalty payments. 12. The license
agreement should specify under what conditions there will be an
auditing or a full accounting of all royalty payments.

</blockquote>When these contractual issues are dealt with up
front in the license agreement, there is less risk of a downstream
dispute between the intellectual property development
"partners." Trends in Pharmaceutical Industry
Intellectual Property License Agreement Royalty Rates Table 1
summarizes recent pharmaceutical industry intellectual property
license royalty rate data. At the time of this writing, the year ended
December 2004 data is the most recently available published data.
The salient trends in the pharmaceutical industry license agreement
royalty rate data are: <blockquote> 1. The mean and median license

agreement royalty rates are fairly constant over time. 2.
There is a trend toward entering into early-stage license agreements.
 3. There is a trend toward specifying structured/milestone
royalty payments. 4. There is a trend toward having
guaranteed/up-front royalty payments. 5. There is a trend toward

the long-term contractual/commercialization involvement of the
license "partners." 6. There is a trend toward
specified risk sharing between the license "partners."

</blockquote>Pharmaceutical Industry Intellectual Property
Royalty Developments The pharmaceutical industry is well-suited
for product development-related intellectual property licenses. Such
intellectual property license agreements maximize the synergies
between older pharmaceutical companies that need new product and newer

pharmaceutical companies that need new capital for product-related
intellectual property development. Currently, more than half of the
20 best-selling drugs in the United States are either co-marketed or
licensed (according to the Strategic Decision Group (<a href="http://www.sdg.com">www.sdg.com</a>)). By 2007, it is estimated
that 40 percent of revenue from the top 20 pharmaceutical companies in

the world will be from the inbound licensing of product-related
intellectual property, according to the Strategic Decision Group.
Appendix 1 (p. 48) presents a list of royalty rate data sources that
analysts can refer to in the pharmaceutical intellectual property
valuation. Appendix 2 presents a list of periodical data.

Summary and Conclusion Intangible personal property (such
as intellectual property) is often an important component of the
pharmaceutical industry business or property valuation in many taxing
jurisdictions. Accordingly, analysts performing a valuation of a
pharmaceutical industry property/ business for bankruptcy purposes
should consider the value implications of the debtor company
intellectual property. <h3>Footnotes</h3> 1 This discussion refers to

all four types of intellectual property collectively as
"intellectual property."

Journal Authors

Robert F. Reilly

Journal Date

Thursday, June 1, 2006 - 12:00

Bankruptcy Rule

valuation

2006

none