On NPV, DCF and IRR(elevance)?
Confronted with the business imperative and opportunity to in-license or acquire a late-stage clinical product candidate, biopharmaceutical leadership teams immediately turn to financial analysis tools to evaluate the asset.
No doubt NPV, DCF and other financial analyses have a role in defining the bounds of rationality for a purchase or sale price. But this type of financial analysis fails to account for different buyers’ ability to withstand a failure, as well as how badly they need the asset.
Consider this: You and I go to our corner convenience store every Friday morning and purchase $100 worth of lottery tickets. The projected DCF of our purchases is exactly the same; equally so with the NPV.
But I make $30,000 per year. You are a private equity maven who makes $50 million per year. We all know intuitively that what I am doing is irrational and value destructive, while in your case there is no issue with your behavior. In fact, it is arguably irrational for you not to buy those tickets.
What this suggests to me is that NPV/DCF analysis, in and of itself, is an insufficient basis for making the decision whether or not to make a purchase — at least in situations characterized by high risk, discordant relative downsides to the buyers and a bimodal outcome.
That fairly well describes what a biotech CEO is facing when contemplating a large acquisition or in-license of late-stage clinical assets. Like a lottery ticket, the outcome of the purchase is fundamentally bimodal: you win or you lose (and, for simplicity, let’s assume you either lose it all or win big).
Hence, the NPV/DCF-based value, incorporating as it does a probability of success (POS), is the one value the asset will never be worth. Indeed, POS is essentially irrelevant (IRR) to the valuation of a late-stage product candidate.
A far better approach is to rely on the courage of your best scientists’ or clinicians’ convictions, and ask them: do you think this puppy will make it, yes or no? If “It’s 50/50” is the best they can do, forget the asset. Unless your key people are ready to stake their reputations on the line — fully recognizing that drug discovery and development is a brutally tough game defined by more failure than success — anything you are likely to pay for it is too much.
Once the scientists/clinicians have aligned behind an asset, three analyses are relevant to determining what you should be willing to pay.
- Relative Upside (RU): If we are right that the asset will succeed (100% POS), what will it be worth and how important or material a difference will that make to our future?
- Relative Downside (RD): If we are wrong about the asset (0% POS) and have to write off the purchase price, how important or material a difference will that make to our future?
- What If We Don’t (WIWD): If we don’t make this move or one like it now or soon, will we be in trouble? If yes, and if we pass on this one, how many more, if any, are there out there?
Two paradigm cases
A few years back, Gilead Sciences Inc. paid about $ 11 billion to acquire Pharmasset Inc. for its late-stage HCV product candidate. Last year Celgene Corp. paid about $7 billion to acquire Receptos Inc. for a late-stage multiple sclerosis (MS) and inflammatory bowel disease (IBD) product candidate. In neither case can the purchase be explained solely in terms of an NPV/DCF analysis.
For Gilead, the RU was obvious: a product that sells in excess of $10 billion a year. The RD was quite large at the time of the purchase; with not quite $30 billion in market cap and about $5.5 billion in cash, an $11 billion purchase was a huge gulp for Gilead and would have been fairly disastrous if it had been wrong.
Nevertheless, the WIWD overwhelmed the RD: Absent securing its predominant position in the antiviral space, Gilead’s future growth would be placed seriously in doubt. And Gilead judged that the Pharmasset asset was essentially the only thing out there that would allow it to retain its position.
In the case of Celgene, the RU was judged to be peak sales in the $4-4.5 billion range. The RD was relatively small. With a market cap above $75 billion and a huge cash flow, Celgene could afford to be wrong about and write off the purchase price without materially damaging the company.
Finally, what I think was really compelling for Celgene was the WIWD. Facing the likelihood of flattening sales of cancer drug Revlimid lenalidomide later this decade, and with the full impact of its large portfolio of investments in early stage discovery not likely to occur before the early to mid-2020s, Celgene was confronting a challenging top-line growth profile in the 2018-23 period. The Receptos asset, if successful, could fill that trough in a way in which very few, if any, other available late-stage assets could. And, arguably, there were not any others available.
Moral of the story
In Book I of his Nichomachean Ethics, Aristotle distinguishes between the goals of different types of human inquiry. In math and logic, we seek universal truths; our goal is “sophia,” or theoretical wisdom (personified by Plato). In matters of human action, we seek knowledge of the particular; our goal is “phronesis,” or practical wisdom (personified by Pericles). Aristotle cautions us that “It is the mark of an educated mind to expect that amount of exactness in each kind which the nature of the particular subject admits.” [ Book I. iii. 4]
For a certain cast of humanity, there exists a deeply seated compulsion to try to render the fundamentally subjective as objective as mathematics and logic, to escape the need and responsibility for human judgment. Financial analysis seems to promise to address this need. However, we are tricked into confusing the extraordinary precision of financial analysis with accuracy.
In his Philosophical Investigations, Wittgenstein, echoing Aristotle, cautions against this desire to escape the “messiness” of human life. Writing of the desire to reduce ordinary discourse to logic, a desire very analogous to seeking to reduce business decisions to financial analysis alone, he writes, “the more precisely we examine ordinary language, the sharper becomes the conflict between it and our requirement. (For the crystalline purity of logic was, of course, not a result of investigation; it was a requirement.) The conflict becomes intolerable; the requirement is now in danger of becoming empty. –We have got on to the slippery ice where there is no friction and so in a certain sense the conditions are ideal, but also, just because of that, we are unable to walk. We want to walk: so we need friction. Back to the rough ground!” [Section 107]
The biotechnology industry began with renegade academic scientists, entrepreneurs and a handful of venture capitalists who invested based on their belief in people. What banded these pioneers together was a sense that biotechnology was not merely a business or a job, it was a mission and vocation.
Forty years on, biotechnology has transmogrified into something much more respectable. An Ivy League or Stanford M.D./Ph.D., plus an M.B.A. from Harvard, Wharton or Stanford, are rapidly becoming the price of entry into the field.
With this, the analytic tools of the trade, paradigmatically NPV and DCF analyses, have assumed a paramount place in business decision making.
But what has equally occurred, at a deeper, more personal and individual level, is the replacement of the goal of fulfilling one’s vocation with the primacy of building and preserving one’s career.
As David Brooks put it in the New York Times, “Let’s start with a refresher on the difference between a vocation and a career. A career is something you choose; a vocation is something you are called to. A career is a job you do as long as the benefits outweigh the costs; a vocation involves falling in love with something, having a conviction about it and making it part of your personal identity. A vocation involves promises to some ideal, it reveals itself in a sense of enjoyment as you undertake its tasks and it can’t be easily quit when setbacks and humiliations occur. As others have noted, it involves a double negative — you can’t not do this thing. [August 24, 2016]
To build a career, it is of paramount importance not to make, or be seen to have made, a mistake. Fulfilling one’s vocation, on the other hand, requires putting one’s self at risk of being publicly wrong and taking responsibility for your error. It is in those moments of critical decision making that the soul is revealed.
At least for now, building a great biotechnology company will remain not just a matter of correctly applying business analytics; it will require leadership marked by a sense of mission and vocation, character, judgment and guts.