NUCLEON

The date is December 1990 Nucleon is a small biotechnological company specialized in R&D, no manufacturing capabilities Potential products CRP (cell regulating protein) and 2 other products In order to get to the market the drug must be approved by FDA->successful clinical trials

DILLEMA

Vertically integrate downstream into (pilot) production or buy the production on the market

Biotechnology
Biotechnology a relatively new field Nucleon one of over 200 companies, most of them specialized in R&D. Companies racing to be first to clone a gene (proprietary position) CRP attractive niche

Burn wound treatment Kidney failure

Biotechnology

Strategies of BT companies -> most R&D, some integrated into manufacturing, some also into marketing

Legal framework
Competition was mostly in R&D establishing a strong proprietary position was crucial Risks of establishing a strong proprietary position

New legislation (difficult to predict court rulings) Time demanding to obtain a patent

Most companies could not wait until patent was granted (time lag)
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Drug development process

Drug development process was very complex (growing genetically altered bacteria was very much an art) Nucleon currently produced quantities well below those needed for clinical trials (scale up 10x) Due to complexity of process scaling up was unpredictable

Human clinical trials

To get FDA approval drug had to undergo three phases of clinical trials
Phase 1 trials assessed basic safety -adverse reaction (6-12 months) Phase 2 (determining appropriate dosages on a small sample->1-2 years) Phase 3 trials assessed products efficacy (multiple hospitals and large number of patients, 2-5 years)

Financial environment

Poor capital availability (buyers market) Venture capitalists expected returns of 30% Nucleon just about to receive another 6 mil $ from its venture capitalist With additional infusion (6 mil $) and cash on hand, Nucleon had about 6,5 mil $. Market analysts expected that situation on capital market would improve in 1992
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Manufacturing options for clinical trials

Three different options for Phase I and II

The new pilot plant Contract manufacturing Licensing product to another company

Two options for Phase III

V. I. into commercial manufacturing Licensing out manufacturing and marketing rights at Phase III

Phase I and II three options

Pilot production in the new pilot plant

Phase I and II

Contract manufacturing outside the firm

Licensing out in Phase I

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The new pilot plant

Pilot plant capacity (~600 m2) would meet Nucleons requirements for Phase I and II Investment outlay can be found in exhibit 3 The pilot facility could however not be used for Phase III (stricter requirements) It was beyond Nucleons financial capability to build such a plant at this time

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Contract manufacturing

Biggest advantage no major capital investment (if CRP failed contract could be easily terminated) Companies offering contract manufacturing had facilities and their personnel in place Contract manufacturing not inexpensive (see exhibit 4) Industry experts believed that excess capacity would accumulate in the future Much time needed to transfer process due to high complexity
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Licensing out-Phase I
Nucleon could license the product immediately (before human clinical trials) Get 3 mio $ cash on hand (immediately) and royalties equivalent to 5% of gross sales (upon FDA approval) Gross sales estimates (exhibit 5)

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Phase III two options

Vertical integration into manufacturing

Phase III

Licensing out in Phase III

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Vertical integration into commercial manufacturing

Before Phase III Nucleon could V.I into manufacturing 21 Mio $ required to perform scale up (provided by venture capitalist if intermediary results promising) If FDA approved the drug Nucleon received 5 mio $ upon FDA approval and royalties equal to 40 % of the partners gross sales

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Licensing out in Phase III

Under this option Nucleon could expect to receive 7 mio $ upon FDA approval of the drug and royalties equivalent to 10% of the partners gross sales

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Back to the case: Methodology

Use decision tree for determining possible scenarios Number of factors has to be considered:

Qualitative arguments (pros and cons of every alternative)

Organizational change Technology transfer costs and risks Long term strategic options Other

Quantitative arguments (Financial returnsNPV)

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Study question 1 (work in groups of 4)

Develop a proper decision tree

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Phase I&II

Phase III production

pilot

license production

contract

license

license

license
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Study question 2 (work in groups of 4)

Develop a table with pros. and cons. for

Phase I&II and Phase III

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Pros and cons (Phase I and II)

Pros Alternative Build pilot plant - Future options (other products) - Higher profits - Learning economies - Possibilities for economies of scope (Kidney failure treatment) -More control over process -high asset specificity - Organizational change - Large investment (capital availability) - Process uncertainty (scale up) - time consuming Cons

Contract manufacturing

- Requires no capital investments - Little risk (terminate contract) - Contracting companies have facilities and personnel in place - Focus on core competencies - Strategic flexibility -Obtain cash immediately - No further investments are necessary -Company can concentrate on R&D

- Big risk of confidential information disclosure - Still time consuming because of the complexity of process - V.I at Phase III questionable -Asset specificity - Lost ownership of CPR-1 - Much lower potential income - Mortgaging companys future in eyes of its employees
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License the product

Pros and Cons (Phase III)

Option Vertical integration of production Pros -Lower risk -Good possibilities of raising needed funds - Possibilities other products Large potential income no further investments - No organizational change - Could focus on R&D Cons - Large investment of $21 million -Organizational change -Could get lost in production

Licensing out

-Significantly lower income -Smaller risk -Lower possibilities of V.I in the long term
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Study question 3 (work in groups of 4)

Based on the NPV make recommendations

Assumptions: Discount factor 30 % Gross sales represent after tax cash flows Sales after 2002 grow constantly at 5% Depreciation tax shield CF and Phase III cost are approximately equal How do you feel about these assumptions?
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Calculating NPV: Estimate operating CF (exhibit) Discount factor (30 %) General approach (use different discount factors according to risk of each CF)

NPV calculation

First calculate pilot manufacturing + V.I. Based on NPV calculation make recommendations

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Example of NPV calculation pilot manufacturing + V.I.

Sales revenue 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Cash flow -3350 -1840 -23204 0 0 0 0 26480 39800 50000 52000 312000 NPV
Costs of pilot Present value protuction (1991) and testing -3350 -1415 -13730 0 Additional: 0 payment $ 5 mio 0 Additional: 0 costs of plant 4220 21 mio 4879 4715 3772 40% sales revenue 13392 12483
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Additonal: PV of future sales

53700 99500 125000 130000 780000

FCF analysis
Alternativa 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 NPV P/P -3350 -1840 -23240 0 0 0 0 26480 39800 50000 52000 312000 16478 P/L -3350 -1840 -2204 0 0 0 0 12370 9950 12500 13000 78000 3596 C/P -250 -1995 -23550 0 0 0 0 26480 39800 50000 52000 312000 19276 C/L -250 -1995 -2550 0 0 0 0 12370 9950 12500 13000 78000 6372 L/L 3000 0 0 0 0 0 0 2685 4975 6250 6500 39000 7275
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NPV of branches on the decision tree

Phase I&II Phase III production 16.487

pilot

license

3.596 19.276

contract

production

license
license license

6.372

7.275
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