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:

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.

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:

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.

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:

1. trademarks
2. patents
3. copyrights
4. trade secrets

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:

• 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.

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:

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.

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:

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.

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.

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:

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.

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:

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.

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:

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."

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 (www.sdg.com)). 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.

Footnotes

1 This discussion refers to all four types of intellectual property collectively as "intellectual property."