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Accounting for R&D when valuing life sciences companies

After considering the various inputs of the Risk Adjusted NPV (rNPV) model - which is used to value life sciences companies and was discussed in Part 3 of series - it is worth considering one of the key inputs of the model, Research and Development (“R&D”).

R&D Period

As displayed in the below table (1), the total time to develop a drug is generally 12 years. Given that a patent is filed at the beginning of the development process to protect the drug and the patent period is normally 20 years, this means that subsequent to the 12-year R&D period only 8 years will remain for a drug to have market exclusivity.

Cost of R&D

The out-of-pocket R&D costs needed to develop a drug average $1 billion. The breakdown of these R&D costs according to each specific trial stage is described in the following table (2):

Pre-clinical costs are highly variable costs which can skyrocket as they greatly depend on how fast promising compounds can be found and how well they respond to initial testing. During phase III trials, the development of the drug follows a more rigorous model with rather standardised procedures and the phase also incurs significant costs as it requires the largest sample group.

Probability of R&D Success

The overall probability of clinical success (i.e., the likelihood that a drug that enters clinical testing will eventually be approved) is estimated to be 18%. However, if we look at studies from the past decade this success rate is substantially lower at 13%.

To sum up, R&D is one of the most important factors to consider when valuing a life sciences company or drug. Total R&D out-of-pocket costs incurred to develop a successful drug average $1bn. However, there is only an 18% chance that a drug will successfully pass all the testing phases and receive FDA approval. Another challenge is that the R&D process usually takes a long 12 years, which only leaves a further 8 years for the treatment to enjoy market exclusivity (assuming a patent period of 20 years).

If you want to discuss valuing life sciences companies contact me at Anthony.Vago@Friday.Capital

[1] EFPIA – Phases of the research and development process (2020)

[2] Olivier J.Wouters, Martin McKee, Jeroen Luyten - Estimated Research and Development Investment Needed to Bring a New Medicine to Market, 2009-2018 (2020); Joseph A. DiMasi, Henry G. Grabowski, Ronald W. Hansen - Innovation in the pharmaceutical industry: New estimates of R&D costs (2016); Jorge Mestre-Ferrandiz, Jon Sussex and Adrian Towse – The R&D Cost of a New Medicine (2012)