How does a DCF Analysis help formulate a royalty rate?

Introduction

A discounted cash flow (DCF) analysis is a valuation methodology to value intellectual property as a lump sum amount. But how does it help formulate the package of financial terms (up front payments, milestone payments, and royalties) payable under a license?


What is a DCF Analysis?

A discounted cash flow analysis:

  1. forecasts the revenue that will be earned from the commercialisation of intellectual property, for the unexpired duration of a patent
  2. forecasts the expenses that will be incurred in the commercialisation of the intellectual property, for the unexpired duration of the patent
  3. factors in the changing value of money over time by applying a discount factor
  4. assesses the likelihood of the intellectual property being fully developed and resulting in a product reaching the marketplace, by factoring in the probability of success,

and arrives at a lump sum amount.

Its sounds straightforward. But a spreadsheet analysis to arrive at that lump sum is a complex and skilled exercise.

It is not intended in this edition of IP Bits to go through each step of a DCF analysis, but only to make a few brief remarks before focusing on the real question that this edition is concerned with: how that lump sum will help in formulating license financial terms.

Necessarily, assumptions (for example, price, market size, market share, competitors, expenses, etc). have to be made in forecasting revenue and expenses, and the probability of success and failure. The robustness of those assumptions will influence the robustness of the result of the analysis. The skill in undertaking the analysis is not in using spreadsheets, but in identifying and collecting data to ensure that the assumptions that need to be made are as robust as possible.

The more robust the identification and collection of data, the more robust the resulting assumptions, and in turn the more robust and reliable the result of the analysis. Conversely, the less robust the assumptions, the less reliable the results of the analysis.

The changing value of money over time is factored into the analysis by applying a discount rate.

The probability of success or failure can be factored in using a number of techniques. One is to apply a higher discount rate. For pharmaceutical licensing, the practice is to factor the probability of success or failure by analysing the published statistics of drugs for particular indications successfully emerging from Phase 1 trials, Phase 2 trials, Phase 3 trials, and a new drug application being successful.

A DCF analysis is not a short exercise. The spreadsheet that records the analysis may have thousands of rows.

Having now arrived at a lump sum amount, how can that be used formulate the quite different financial terms of a license: up front payments, milestone payments, and royalties?


Using the result of the DCF analysis to formulate license financial terms

The result of a DCF analysis is to arrive at the net income that intellectual property will generate over its remaining life.

Having arrived at that net income amount, the question now becomes how to apportion that net income as between

  1. a licensor, in the form of up front payments, milestone payments, and royalties, and
  2. a licensee, as to the remainder of that income.

This will be influenced by the stage of the development of the intellectual property.

If the intellectual property is at an early stage of development, the licensor’s share of that income will be modest, reflecting the comparatively modest risk that the licensor has taken. Correspondingly, the licensee’s share of that income will be greater, reflecting that the licensee will comparatively take the greater risk in developing the intellectual property to the stage where a product is launched in the market place. A licensor’s share of the future income might be a modest 15% to 30%, depending upon many factors.

Conversely, if the intellectual property is at an advanced stage of development, the licensor’s share of that income will deserve to be greater, reflecting the comparatively greater risk that the licensor has taken. Correspondingly, the licensee’s share of that income will be lower, reflecting that the licensee will comparatively take the lower risk. A licensor’s share of the future income might now be a more substantial amount, of 30% to 50% or more, again, depending upon many factors.

But we still now only have a lump sum amount that represents the licensor’s share of the future income. How does that transform into up front payments, milestone payments, and royalties?

The answer is that it transforms into any amounts of up front payments, milestone payments, and royalties which in aggregate add up to the lump sum amount that represents the licensor’s share of the future income. 

That can be done in a myriad of ways. Consider the graph below which illustrates three different ways that a licensor can receive $100 million, which is its share of the future income on this example.



Deal 1 is front end loaded with the highest up front payment of $15 million, while Deal 3 has the lowest up front payment of $5 million. 

Milestone payments are largest in Deal 2.

Deal 3 is back end loaded with royalties of $85 million, while Deal 1 has $60 million in royalties, and Deal 2 has $50 million in royalties.

But all three deals represent the same total amount (in present money’s worth) for the licensor’s share of the future income. All three deals are identical in present value of $100 million. It is just that in each deal how that $100 million is represented differs. 

Deal 1 is loaded with up front payments. Deal 2 is loaded with milestone payments, and Deal 3 is loaded with royalties. But all three deals are of identical present value.

What the table shows is that if a licensor receives less of one type of remuneration (eg, up front payment in Deal 3) then it must be compensated by receiving more of another type of remuneration (that is, royalties in Deal 3).


Where is the royalty rate?

The DCF spreadsheet calculates the aggregate remuneration (up front payment, milestone payments, royalties) that a licensor should receive, on our example above - $100 million.

Now, the analysis will "try out" different combinations of each component (up front payment, milestone payments, royalties) of that remuneration, but always remaining within the parameter of the aggregate of all components of remuneration calculated by the DCF analysis.

Increasing the royalty rate (such as in Deal 3) will reduce the up front payments and milestone payments in the spreadsheet. Correspondingly, decreasing the royalty rate will increase the up front payments and milestone payments.

The result of the DCF analysis will be to arrive at:

  1. a royalty rate range 
  2. a range for an up front payment, and
  3. a range for milestone payments.

These ranges will now assist the negotiation of the financial terms of the license. 

If the royalty rate negotiation is producing a rate in the higher range, then the up front payment and milestone payments, while sought to be maximised of course, may have to be in the lower end of the possible range. 

Correspondingly, if a high up front payment is being negotiated, then while still seeking the highest possible royalty, the final royalty rate may have to be in the lower end of the range.

A DCF analysis therefore helps:

  1. quantify the aggregate remuneration (up front payment, milestone payments, and royalties) that a licensor should receive - the higher the aggregate remuneration, the higher each component (up front payment, milestone payments, and royalties) should be 
  2. "try out" different royalty rates and different amounts of other components of the licensor's remuneration to assess the possible range of royalty rates and other financial terms for a specific license
  3. protect a licensor from the risk of under-aspiring and seeking financial terms that are too modest, and which do not secure the financial terms the licensor deserves
  4. protect a licensor from over-aspiring and seeking too much, and by doing so risking the potential licensee deciding to walk away and to not proceed.