Valuation Analysis in Pharmaceutical

Licensing and M&A Transactions

A Tutorial
By Tim Opler, Benj Garrett and Susan Langer
January 2014

 Discuss role of valuation and project assessment

Introduce valuation tools

Show how to use the tools in business development

Go over a variety of cases

AGENDA

Agenda

Table of Contents
1.
2.
3.
4.
5.
6.
7.
8.

Value Creation and Business Development

Valuation of Pharmaceutical Projects
Revenue Forecasting
Cost Estimation
Risk Estimation
The Discount Rate
Valuation Considerations in Licensing
Valuation Considerations in M&A

VALUE CREATION AND BUSINESS DEVELOPMENT

Revenues and Costs Over Time ($ millions)

350
300

250
200
150
100
50

0
-50

10

11

-100

Acquisition Cost

R&D

Launch Cost

Selling Cost

Other Cost

Revenue

12

13

VALUE IS CREATED BY INVESTMENT FOR FUTURE PROFIT

Typical Value Creating Profile

PROCESS

Value Creation Process

Assessing
the
projects
Finding
projects
that fit

Negotiating
deals for
the projects
in the face
of
competition

Delivering
on the
potential of
the projects

Realizing
the value

Assessment and negotiation calls for strong valuation and analysis

work. This is our focus today.
6

Evaluation Criteria

Financial Analysis
What is the time
horizon to peak
revenues for each
product?
What will sales and
marketing costs be?
What are the total
cash requirements?
What is the value of
each product
opportunity?

Ability to Execute /
Risks
How achievable are
the returns and how
significant are the
risks?
Do we have the
competencies to
succeed?
Can we control the
key success factors?

Fit with Future

Strategy

Perception of Wall
Street / Shareholders?

How does each

product fit with our
long-term vision?
Are there other
products in the
pipeline to realize our
goals?
What is the
opportunity cost of
pursuing these
initiatives?

Is Wall Street likely to

invest in a company
pursuing these
products?
How has Wall Street
responded to other
companies that have
adopted this
strategy?

HOW FINANCIAL ANALYSIS FITS INTO STRATEGY

Where Financial Analysis Fits into Business Development Strategy

Example: Licensing Process at Bristol-Myers Squibb

Identify
the
Opportunity

Initial
Technical
Evaluation

Detailed
Technical
Evaluation

Detailed
Commercial
Evaluation

Technical
Due
Diligence
Commercial
Due
Diligence

Final
Approval

Contract
Negotiations

Source: Talk by BMS: The Role of Licensing / Business Development in the Pharma Industry, 2004.

Product Profile / Pricing / Competition

Sales Forecast
P&L Assumption (COGS, S&M, R&D)

Deal Terms
Manufacturing / Tax Considerations
PTRS

Risk Adjusted NPVs & IRRs

BRISTOL-MYERS SQUIBB VALUATION PROCESS

Bristol-Myers Squibb Deal Valuation Process

Illustrative Table by Kazuo Edaza of BMS

Assets
Opportunity ID
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24

PTRS
92%
78%
20%
80%
74%
58%
30%
85%
27%
53%
81%
26%
59%
72%
62%
36%
40%
24%
26%
89%
55%
7%
24%
64%

ENPV
370
120
250
182
80
80
250
80
90
18
23
214
582
87
1,400
77
27
371
102
1,538
633
100
152
272

EIRR
535%
345%
318%
301%
230%
230%
210%
90%
83%
83%
76%
59%
58%
54%
48%
42%
41%
40%
40%
35%
34%
33%
31%
30%

Assets
Opportunity ID
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48

PTRS
6%
48%
25%
10%
82%
63%
40%
14%
21%
21%
43%
14%
35%
45%
35%
46%
19%
60%
42%
8%
31%
7%
18%
38%

ENPV
3
411
129
71
837
288
12
116
137
132
183
80
151
12
8
230
28
3
123
15
52
22
7
6

EIRR
29%
29%
27%
27%
26%
26%
26%
24%
24%
24%
24%
23%
22%
20%
19%
19%
19%
19%
19%
18%
18%
17%
15%
13%

PTRS = probability of technical and regulatory success

eNPV = expected NPV
eIRR = risk-adjusted internal rate of return
10

Source: Talk by Kazuo Ezawa, Bristol-Myers Squibb, Pharmaceutical Portfolio Management, DAAG, February 2004.

PROJECT RANKING

Bristol-Myers Squibb Ranking of Potential Licensing Deals

11

The approach that we will discuss today is very similar to that

used by Bristol-Myers Squibb.

In fact, almost every large pharmaceutical company uses the

same approach to deal valuation.

Consulting firms like BCG, Campbell Alliance, LEK, Mattson Jack

and McKinsey have standardized the industry in this way.

A key area of emphasis from us is to keep an eye on risk-adjusted

returns in transactions.

There are numerous fine points and ways in which firms differ in
approach.

We will discuss many of these but the key focus will be on the
hands on how to approach to valuation.

TODAYS DISCUSSION

Our Approach

ROI
(IRR)

Examples in Specialty Pharma

Small Project
Big Payoff

Big Project
Big Payoff
(The zone of shareholder bliss)

Small Project
Low Payoff

Allergan Botox
Biovail Wellbutrin XL
Cephalon - Provigil
ENDO lidoderm patch
Forest Lexapro
Gilead - Truvada
King Altace
Reliant - Lovaza
Salix Rifaximin
Viropharma - Vancomycin

Big Project
Low Payoff

Scale of
Project

The key to creating lasting value is to bet big and win.

12

VALUE IS CREATED BY INVESTMENT FOR FUTURE PROFIT

General View: Go Big and Go for IRR / ROI to Create Value

13

Big Pharma
A, B, C

Sometimes employ real options tools in project assessment.

The idea is to look at a drug development project as a
sequence of choices or options. The most important insight
is the option to abandon a project is valuable. A further
insight involves the value of the option to expand
indications.

Biotech A

Focuses largely on pie splitting the sharing of the rNPV of

a project. Other inputs like IRR are not looked at all. Have
historically used higher discount rates for risky projects but
without risk-adjustment.

TODAYS DISCUSSION

Some Key Differences Across Pharmaceutical Firms - Method

Big Pharma An organization called that carries out financial analysis of licensing and
M&A projects. They have prepared an internal manual on how to value
D
every aspect of a project which standardizes their approach. Tends to do
careful valuation work with reasonable discount rates. Always have at
least three scenarios. Organization tends to be intelligent but financially
conservative in looking at opportunities. Will occasionally look at real
options and offer option deals to biotechs.
Has created a management science group that engages in sophisticated
Big Pharma predictive modeling of pharma product performance. Their view is that
good forecasts are the most important and most difficult aspect of
E
pharma licensing. This group has been driving real options work but
hard for organization to grasp.
The focus is much more on simplicity, insight and medical soundness
Big Pharma than say Big Pharma E. Every projects gets summarized on two pages
(and not more ever) for either the head of commercial or the head of
F
R&D. Once there is a preliminary approval an AIF (autorissation
investiment financiere) is prepared (30 to 50 pages). This document
does not skimp on commercial analysis but uses basic rNPV models.
14

TODAYS DISCUSSION

Differences Across Firms - Process

VALUATION OF PHARMACEUTICAL PROJECTS

A: Profit = - $50 + $60

= $10

$10

Added Value
$50

16

Initial Investment

NET PRESENT VALUE

Q: Suppose we can invest $50 today & receive $60

later today. What is our increase in value?

This is the definition of NPV

60
Profit = -50 +
$4.55
1.10
$4.55
The idea of an expected rate of return or
discount rate reflect the time value of
money, otherwise known as the underlying
cost of capital in society.

17

$50

Added Value
Initial Investment

NET PRESENT VALUE

Q: Now suppose we can invest $50 today and receive

$60 in one year. What is our increase in value given
a 10% expected return?

Ct
NPV C
0 (1 r)t

For two
periods

With multiple periods

C1
C2
Ct
NPV C0

...

1
2
t
(1 r ) (1 r )
(1 r )
N

or

18

Ct
NPV
t
t 1 (1 r )

Where N=Number of years

t = year
C = cash flow
r = discount rate
Sigma = Summation Symbol

NET PRESENT VALUE

NPV = PV - required investment

Net Present Value Rule

If the net present value of a project is positive

then it creates value and should be carried out.
If resources are finite and there are more
positive NPV projects than time, money or
other constraints would allow then the group
of projects that maximize NPV should be
implemented.

19

Risk Adjusted NPV

Pharmaceutical cash flows are risky and the

risk can be characterized based upon stage of
development.
Risk-Adjusted NPV or rNPV is a risk weighted
NPV and should be used in assessing risky
project.

20

Revenues
Total Market
Prescriptions
Written
X
Penetration of
Product
=
Units Sold
X
Price
=
Revenue

Costs
COGS

+
Research and
Development
Expense

+
Selling Costs

Other Cash
Outflows

Net Cash
Flow

Capital
Expenditures
+
Change in
Working Capital
Cash Taxes

+
G&A / Other
Costs

+
Acquisition Costs

Risk Adjustment at Each Stage

21

rNPV

INPUTS TO RNPV MODEL

Elements of Risk Adjusted NPV Model

RNPV FORMULA

The rNPV Formula

R1Ct
rNPV
t
t 1 (1 r )

22

Where N=Number of years

t = year
t=1 (now)
C = cash flow
R1 = Probability of cash flow now
r = discount rate
Sigma = Summation Symbol

The risk-adjusted IRR is the discount rate that would give an rNPV equal to zero.
In other words, it is the expected rate of return on a project.
We refer to the rIRR as the risk-adjusted IRR.

23

IRR ANALYSIS

rIRR

Issue
Equity

vs.

Partner
Drug

Both of the choices shown at left involve

bringing cash today by causing current
equityholders to give up future cash flow
(either by sharing the cash flow through
issuance of more equity) or instead by giving
away product cash flows to a partner.
There is an embedded opportunity cost
which is computed in the rate of return
given up in future cash flows for cash today.
This is the internal rate of return or IRR.
When derived from a probabilized model we
refer to this as a rIRR (risk-adjusted IRR).

Cash Received by Licensor t

t 1

24

Cash Flow Given Up to Licensee t

(1 r )t

The internal rate of return is the discount rate that is

impounded in the equation comparing cash received
to cash flow given up.

APPLICATION OF IRR TO LOOK AT TRADE-OFFS

An Example Trade-Off

ACCOUN
TING

TREATM

ENT

Accounting Considerations EPS Impact

How will the expense be amortized?

Straight-line amortization
Negative EPS impact in later years due to smaller profit share
payments
Acquisition price set standard treatment
Amortize based on profit share payments
EPS accretive each year
What happens if we dont achieve projections? Write-down
Amortize in full each until asset is gone, then recognize full benefit
Most conservative approach
Not EPS accretive in the beginning years
Many pharma companies are highly focused on EPS management
Will prefer to use investment dollars over R&D dollars whenever
possible
Will prefer to push out spending into the future
25

EPS

Example of EPS Impact in a Transaction to Restructure an Alliance

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

$0.02

$0.03

$0.05

$0.06

$0.07

$0.08

$0.04

$0.04

$0.01

$0.01

$0.01

Assumptions
Discount Rate: 10%

Amortization: Based on projected profit share payments

Tax rate: ~35%

26

Revenue
Forecasting

27

Cost
Assumptions

Tax and
Working
Capital

Risk

ACCOUN
TING

TREATM

ENT

Building an rNPV Analysis of a Project

Cash Flow
Estimates

Discount Rate
Selection

rNPV
Computation

REVENUE FORECASTING

Estimating Product Revenue Trajectory

Analyst
Bottom Up
Looking at
Reports and
Market
Similar
Research
Analysis
Products
Reports
We believe the best approach is to have a good bottom up model and
check the thinking by looking at external reports and similar product
revenues.
29

THREE WIDELY USED METHODS FOR REVENUE FORECASTS

Approaches to Developing Market Sizes

Market / Valuation
Analysis

30

Full Service Analysis / Consulting / Support

VENDORS ARE OFTEN USED FOR MARKET ANALYSIS

Commonly Used Research Vendors

Total Population, Population in Target Markets

Incidence/Prevalence

Potential
Market Size

Use 10 year planning

horizon: 2012-2022.
Assume 2012 launch

% Diagnosed
Addressable
Market Size
% Treated for Disease

% Prescription of Drug

Price per Day of Drug

Actual Ave Days Used

It is very
common to
build several
scenarios
(good, poor,
expected)

Penetration, Pricing
Studies, Competitive
Analysis, Compliance
Analysis, Reimbursement
Analysis and Utilization
Patterns
Revenue Estimates over the
Planning Horizon

31

BUILDING A BOTTOMS UP REVENUE FORECAST

Going from Market Size to Revenue Estimates (Bottom Up)

2000

2025

U.S. Patients are Not Controlled with ACEs, ARBs and Beta Blockers

Trends in awareness, treatment, and control of high

blood pressure in adults ages 1874

800
700
600
500
400
300
200
100
0

National Health and Nutrition Examination Survey

Percent

Developed
Market
Economies

China

India

197680

198891

199194

19992000

Awareness

51

73

68

70

Treatment

31

55

54

59

Control

10

29

27

34

Other
Economies
Source: JNC 7

Source: Kearney et.al., Lancet, 2005, 365: 217-223

Many Patients Poorly Controlled with Existing Treatments

ALLHAT Study: Distribution of Patients by SBP Before
and After Treatment with HCTs, CCBs and ACEis
40
Baseline

36 Months

30

Thin Pipeline of New Treatments

The only major recent innovation in

anti-hypertensive therapy on the
horizon is the direct renin inhibitor
class (e.g., aliskiren/Tekturn) from
Novartis.

20

Direct Renin
Inhibitors

ACEs, ARBs

10
0
<100 100- 110- 120- 130- 140- 150- 160- 170- 180+
109 119 129 139 149 159 169 179

SBP (mm hg)

Source: Cushman, et al. J Clin Hypertens 2002, 4:393.

32

Diuretics, Beta
blockers,
Calcium Channel
Blockers
*Source: Sealey and Laragh,
American Journal of
Hypertension, May 2007

Renin inhibitors are not more

effective than ACEs and ARBs and
may be unsafe.*

EXAMPLE: NOVEL HYPERTENSION DRUG

Global Burden of Hypertension, Millions of Persons with Hypertension

Rationale for a Synergistic Effect with Current Treatments

There are four important ways in which the novel

drug can take share in the hypertension
market:
1. Better efficacy and/or safety than current
treatments
2. Synergistic with existing treatments (e.g.,
consider a triple ARB, HCT, novel combo)
3. Better outcomes in certain patient subgroups
4. Better marketing in the face of generics

The Novel drug is a vasodilator that operates

Opportunity for Segmentation / Differentiation by Patient Subgroups

Better outcomes
in patients on
Cox-2s and
NSAIDs

Better outcomes
in patients at risk
of nephropathy

Better outcomes
in nonresponders
to existing antihypertensives
Better outcomes
in salt sensitive
hypertensives

Novel Antihypertensive

Better outcomes
by genetic
biomarker

Better outcomes
in obese patients
Better outcomes
in cardiac
patients

33

Better outcomes
in patients with
inflammation

independently of the RAAS cascade and is likely

to be synergistic with RAAS inhibitors.
It is likely that a many uncontrolled
hypertensive persons would be controlled with
the novel drug given its mechanism.
Likely to be synergistic in salt-sensitive
hypertension
The drug appears more effective than
other meds in animals that are salt
sensitive.
Salt sensitive patients are some of the
poorest responders to existing
medications.
Likely to be synergistic in obese patients
The drug appears to be effective in the
presence of obesity.
Obese patients are some of the poorest
responders to existing medications.

DIFFERENTIATION OPPORTUNITY

Taking Share by Differentiation

Key Assumptions
Daily Cost of Therapy
ROW as % of US Market

$4
80.0%

2010

2012

2014

2015

2016

2018

2019

2023

2028

2031

Begin Year Patient No.

Growth in Patients

80,000,000

84,872,000
3%

90,040,705
3%

92,741,926
3%

95,524,184 101,341,607 104,381,855 117,482,697 136,194,645 148,823,566

3%
3%
3%
3%
3%
3%

Diagnosis Rate
Treatment Rate
# of Patients Treated
Compliance Rate

50.0%
70.0%
28,000,000
50.0%

50.0%
70.0%
29,705,200
50.0%

50.0%
70.0%
31,514,247
50.0%

50.0%
70.0%
32,459,674
50.0%

50.0%
70.0%
33,433,464
50.0%

50.0%
70.0%
35,469,562
50.0%

50.0%
70.0%
36,533,649
50.0%

50.0%
70.0%
41,118,944
50.0%

50.0%
70.0%
47,668,126
50.0%

50.0%
70.0%
52,088,248
50.0%

0.0%

0.0%

0.0%

0.0%

0.0%

6.0%

8.0%

12.0%

12.0%

12.0%

0
250
4.00 $
1,000
$0.0
0.0

0
250
4.20 $
1,050
$0.0
0.0

0
250
4.41 $
1,103
$0.0 $
0.0

Hypertension - US

Penetration Rate
Patients on drug
Average Days of Therapy
Cost Per Day
Cost per Day * Days of Therapy
Total Revenues
Probabil. Adj Revenues

0
250
0
0
$0.0
0.0

5.0%

0
250
0$
0
$0.0
0.0

2,128,174
250
4.86 $
1,216
2,586.81 $
129.3

2,922,692
250
5.11 $
1,276
3,730.18 $
186.5

4,934,273
5,720,175
6,250,590
250
250
250
6.21 $
7.92 $
8.73
1,551
1,980
2,183
7,654.68 $ 11,325.56 $ 13,644.25
382.7
566.3
682.2

Hypertension - ROW
Begin Year Patient No.
Growth in Patients

64,000,000

67,897,600
3%

72,032,564
3%

74,193,541
3%

76,419,347
3%

81,073,285
3%

83,505,484
3%

93,986,158 108,955,716 119,058,853

3%
3%
3%

Diagnosis Rate
Treatment Rate
# of Patients Treated
Compliance Rate

50.0%
70.0%
22,400,000
50.0%

50.0%
70.0%
23,764,160
50.0%

50.0%
70.0%
25,211,397
50.0%

50.0%
70.0%
25,967,739
50.0%

50.0%
70.0%
26,746,771
50.0%

50.0%
70.0%
28,375,650
50.0%

50.0%
70.0%
29,226,919
50.0%

50.0%
70.0%
32,895,155
50.0%

50.0%
70.0%
38,134,501
50.0%

50.0%
70.0%
41,670,598
50.0%

0.0%

0.0%

0.0%

0.0%

0.0%

6.0%

8.0%

12.0%

12.0%

12.0%

0
250
0$
0
$0.0 $
0.0 $

0
250
4.00 $
1,000
- $
- $

0
250
4.20 $
1,050
- $
- $

0
250
4.41 $
1,103
- $
- $

1,702,539
250
4.86 $
1,216
2,069.45 $
103.47 $

2,338,154
250
5.11 $
1,276
2,984.14 $
149.21 $

3,947,419
250
6.21 $
1,551
6,123.74 $
306.19 $

- $

- $

- $

- $

4,656 $

6,714 $

13,778 $

Penetration Rate
Patients on drug
Average Days of Therapy
Cost Per Day
Cost per Day * Days of Therapy
Total Revenues
Probabil. Adj Revenues
Total Worldwide Revenue

34

0
250
0
0
$0.0
0.0

5.0%
$

- $

4,576,140
5,000,472
250
250
7.92 $
8.73
1,980
2,183
9,060.44 $ 10,915.40
453.02 $
545.77
20,386 $

24,560

LARGE REVENUE FOR NOVEL HYPERTENSION DRUG

Revenue Forecast for Novel Hypertension Drug

 Prevalence:
Total number of potential
customers at any one point in
time
Best for products purchased
by same customer on a
recurring basis (chronic Rx)
Incidence:
Number of new potential
customers each year
Best for products treating
onetime acute event (heart
attack)

35

ACCOUN
TING

Estimate Incidence and

Prevalence

TREATM

ENT

Defining the Market

Identify Segments

Change Over Time

All potential customers are not

alike
Segmentation helps refine
penetration and share
forecasts
It also allows you to refine
estimates and focus efforts by
identifying early adopters
Example in RA
Severely affected patients
(25% of the market)
Moderately affected
Mildly affected

Customer base and

segmentation are influenced
by factors that change over
time
Growth driver analysis provides
insight into changing and/or
emerging markets

Penetration is usually the main driver of revenue forecasts. There are a few
different means to estimate the peak penetration that a new product can be
expected to achieve:
1. Historical penetration of comparable products
2. Objective comparisons versus currently available treatments (efficacy, safety,
convenience)
3. Physician interviews to gauge acceptance and potential use versus competing
treatments (preference share analysis)
4. Analysis of likely reimbursement and factors related to achieving reimbursement
from key payor groups
5. Mapping of commercial effort into physician prescribing behavior (companies
often use IMS analysis)
6. Almost all bottoms up approaches to penetration analysis tend to overestimate
penetration in practice. Preference analysis tends to do a poor job of predicting
actual prescribing behavior in the face of detailing and sampling
7. Comparison versus pipeline products and relative timing to market

36

Can then build low, expected and high penetration scenarios

(important to understand limitation of forecasts in practice)

IMPORTANCE OF MARKET PENETRATION SCENARIOS

Building Penetration Scenarios

Primary Market Research

(Structured Interviews)

Historical Analysis of Impact of

Order of Entry
Expected Product Market Share By Order of Entry

P&T
Committees

Physicians by
Segment

Payor
Research

Estimates of usage and

dependence on pricing

By Physician
Segment

By Disease State
(e.g., first line,
second line)

Build demand curve, make pricing

estimates
37

Total
Products
on Market

1st

100

58

42

43

31

26

35

26

21

18

30

22

18

16

26

19

16

14

2nd

3rd

4th

5th

6th

13

12

Research Sources:
G. Kalyanaram,The order of entry effect in prescription (Rx) and over-thecounter (OTC) pharmaceutical drugs, International Journal of
Pharmaceutical and Healthcare Marketing, 2008, pp. 35-46.
Hans Bauer and Marc Fischer, Product life cycle patterns for
pharmaceuticals and their impact on R&D profitability of late mover
products, International Business Review, 2000, 703-725.

IT IS POSSIBLE TO TAKE AN EVIDENCE-BASED APPROACH

Research Methods for Market and Penetration Analysis

t
uc
od
Pr
w
Ne
ed
a t al
tim rci
Es me
m
Co s
ve

Li

T3
T3
T2
NF
T3
NF
T2
T2
T3
T3
NF
T3
T3
NF
T2
T3
T2
T2

ia

id
iz

T2
T2
T2
NF
T3
NF
T2
T3
T3
T3
NF
T3
T3
NF
T2
T3
T2
T3

d
an
Av

lip
G

T2
T2
T2
F
T2
NF
T2
T3
T2
T2
T2
T2
T2
T2
T3
T2
T2
T3

in
rm

fo
et

T3
T3
T3
T3
T3
NF
T3
T3
T3
T3
T3
T3
T3
T3
T3
T3
T3
T3

24,900,000
12,020,000
10,960,000
9,000,000
8,990,000
7,290,000
3,340,000
2,730,000
2,520,000
2,290,000
69,000,000
49,000,000
49,000,000
6,000,000
5,000,000
3,300,000
8,900,000
1,200,000
275,440,000

ia

National
National
National
Internal PBM
National
Regional
Internal PBM
Regional
Regional
National
PBM
PBM
PBM
PBM
PBM
PBM
PBM
PBM
PBM

v
nu
Ja

Target Payers*

WellPoint/Anthem
Aetna/US Healthcare
United Healthcare
Prime Therapeutics
Cigna
Kaiser
RxSol / PacifiCare
Coventry
HealthNet
Humana
Caremark
ExpressScripts
Medco
PharmaCare
MemberHealth Rx
Anthem
NMHCRx
Coventry

pe
Ty

38

an
Pl

Leads to suggested sales force sizing

and territory coverage with a managed
care strategy in light of a launch
budget. This facilitates building a
penetration forecast that is market
based. Typically such forecasts are
much lower than those derived from
physician preference share analysis.

T3
T3
T2
NF
T2
F
T2
T2
T2
T3
NF
T3
T3
NF
T2
T3
T2
T2

COMMERCIAL ANALYSIS AND PENETRATION

Penetration Analysis Should Understand Prescriber Concentration, Sales

Force Design, Prescribing Behavior and Reimbursement Positioning

Historical Ramp Speed Analysis

Bauer and Fischer (2000) show that Early Movers Ramp Slowly

Source: H.H. Bauer, M. Fischer, International Business Review 9, 2000, pp 703725

39

COST ESTIMATION

ACCOUN
TING

TREATM

ENT

Estimating Costs

Research Costs / Clinical Development Costs

Identify remaining steps to IND (Toxicology, PK, etc.)
Estimate cost of remaining steps
Evaluate anticipated time and numbers of patients per phase
Examine patient enrollment issues, treatment length and cost, ease of
establishing endpoints, long-term safety, regulatory complexity, etc.

COGS
Look at COGS estimates on comparable products
Use expected dosing and treatment length to generate unit sales. Estimate COGS
at that sales volume
Important to be aware of fixed / variable elements of COGS
Review status and current data on scale-up issues

Sales and Marketing Costs

Examine concentration of customer base: hospital or office based physicians, etc.
Use IMS sales force sizing / penetration studies.
Evaluate potential market issues: requirements for physician training and
education, patient education, direction to consumer marketing, etc.

41

Estimating Costs
Pre-Clinical Costs

Clinical Development Costs

From lead to IND: $5 to

$15mm

Number of Patients in Trials

From target to lead: $5mm to

$50mm

Complexity and Length of

Protocol

Pre-Clinical Cost Drivers

Time in Trial

Difficult of chemically reaching target

Existence of pool of potential targets
Existence of predictive animal models

Demand for Patients / U.S. vs.

ROW

Cost and complexity of pharmacology work

Need for extensive animal toxicity work

Drug supply costs

Need for formulation / scale-up work

A good rough benchmark is to assume $25,000

per patient and count the number of patients.
42

 Raw materials
Inventories
Small molecular
versus biologic

43

ACCOUN
TING

Input Costs

TREATM

ENT

COGS Factors

and production
costs
Batch size
Production process
(complexity, steps)
Storage and
inventories
Delivery to
customers

Estimating COGS can

be based on a number
of factors
Similarity to other
drug profiles
Complexity
Economies of scale

ACCOUN
TING

TREATM

ENT

Sales Force Costs: Example of Costing Grid

Number of
Personnel

Fully Loaded
Cost

Total Annual
Costs

Senior
Management

$380,000

$760,000

Regional
Managers

$260,000

$1,300,000

MSLs

$250,00

$4,000,000

Sales Reps

120

$180,000

$21,600,000

Support Staff

12

$80,000

$960,000

Total

$28.6 million

Level

44

ACCOUN
TING

TREATM

ENT

SG&A Typically is Typically Much Higher than Direct Sales Force Cost

Company
Pfizer
GlaxoSmithKline
Sanofi-Aventis
Novartis
AstraZeneca
Merck
Wyeth
Bristol-Myers Squibb
Eli Lilly
Schering-Plough
King Pharmaceuticals
Sepracor
Reliant Pharmaceuticals
Sciele

Revenues
2006 ($mil)
$ 48,371
$ 45,500
$ 38,934
$ 36,749
$ 26,475
$ 22,636
$ 20,351
$ 17,914
$ 15,691
$ 10,594
$
1,998
$
1,196
$
800
$
293

SG&A
Expense
($mil)
$ 15,589
$ 14,268
$ 10,641
$ 13,157
$ 9,464
$ 8,165
$ 6,501
$ 6,270
$ 4,890
$ 4,718
$
714
$
764
$
550
$
145

SG&A
Margin
32%
31%
27%
36%
36%
36%
32%
35%
31%
45%
36%
64%
69%
49%

Salesforce
Cost ($mil) Revenue / Rep
$ 4,140
$ 1,389,971
$ 4,375
$ 1,229,730
$ 3,342
$ 1,364,191
$ 1,940
$ 2,370,903
$ 1,950
$ 1,765,000
$ 1,900
$ 1,741,231
$ 1,575
$ 1,695,917
$ 1,348
$ 1,628,545
$ 2,175
$ 950,970
$ 1,618
$ 827,656
$
193
$ 1,816,364
$
333
$ 629,474
$
126
$ 1,111,111
$
114
$ 450,769

U.S. Reps
8,800
9,000
6,500
5,200
6,000
8,000
5,000
3,300
7,000
4,500
1,100
1,900
720
650

Worldwide
Reps
34,800
37,000
28,540
15,500
15,000
13,000
12,000
11,000
16,500
12,800
1,100
1,900
720
650

Source: Cowen Pharma, Jan 2007 and Torreya Partners Analysis

It is important to estimate variable cost components of a new drug introduction

beyond direct sales force costs.

45

ACCOUN
TING

TREATM

ENT

Illustration of a Launch Budget for a Primary Care Product

New Drug Launch Costs
Marketing
Travel
Advertorial Media
Patient Starter Kit
Launch Sales Aid
Launch Campaign Art
Small Science Flash Card
Patient Ed Booklet & Holder
Direct to Patient Concepts
Printing Sales Aids
Testing
Media to PCPs and GI docs
Launch Journal Advertising
Launch Media
Launch Convention Panels
MDAlert
PharmAlert
Pharmacy Sell Sheet
Managed Care Sales Aid
Formulary Stickers
Shelf Talker
Web site
Direct Mail
Product Website Development
Premium Item Give-Aw ays
Launch Meeting (does not include hotel and flight arrangements)
Marketing Plan -Consulting
Sales Training Modules
Promo Items
Rebate
Trade Show Booths
RCW Account service fee
Drug Med Ed
Sample packaging
Marketing Total

46

2011
1,000,000
6,000,000
30,000
86,500
100,000
43,000
98,750
58,000
250,000
12,000
1,500,000
2,000,000
40,000
37,000
32,000
27,000
37,000
15,000
20,000
250,000
205,000
60,000
107,000
1,000,000
120,000
20,000
150,000
630,500
3,000,000
568,000
17,496,750

Regulatory & Prod Developm ent

Surveillance system
800 number
Orange book costs
PDUFA establishment
Total
Personnel
Representatives (1500) including salary, benefits & fleet
Recruiting, Travel and Misc Personnel Expenses
Managed care organization (100)
Sales Management, MSLs, Outcomes Grp (80)
Total
Sam ples
Manufacturing, Packaging

250,000
20,000
100,000
50,000
420,000

262,500,000
75,000,000
15,000,000
20,000,000
372,500,000

50,000,000

Sales
Sales Incentive (trip/other)
Training
Inventory sample cost
Total
Shipping costs

3,000,000
1,500,000
1,000,000
5500000
1,000,000

Total
$ 446,916,750

RISK ESTIMATION

Phase 1:
Done Q3 2008

Phase 1b:
Done Q2 2009

Phase 2:
Done 2010

Phase 3:
Done 2012

Opportunity to show
range of doses

Opportunity to find
clear efficacy and start
to see safety profile.
Hopefully, primate tox
is complete and we
have a backup
compound in Phase 1.

Critical to get the dose

right, establish a safety
profile and begin to
write the label. Animal
carcinogenicity done.

Write the label, confirm

the safety profile and
dose. Consider head to
head trials vs. standard
of care, noting points of
differentiation. Get QT
study done.

Phase 3: Large
safety confirmation
trial / write label

48 48

Drug Safe and

Superior to existing
meds
Drug Safe, not
Superior but adds
to existing meds

Phase 3: Not Safe

Terminate /
Consider Other
Indications

Phase 1b: Not Safe

Terminate /
Consider Other
Indications

Terminate /
Consider Other
Indications

Terminate
Development

Terminate
Development

Terminate
Development

Phase 1b: Initial

Proof of Concept

Phase 1: Not safe

If we can beat on efficacy

and match safety we
have a giant drug.

Drug approvable
but inferior to
existing meds

Phase 2: Dose and

Safety Confirmed

AR9281 Phase 1a
Safety Trial

Drug Approval /
Label: 2013

KEY CLINICAL EVENTS AND POTENTIAL OUTCOMES

Important to Diagram Key Development Steps and Risks

100%

80%

100%

60%

80%

Cumulative probability
of success (percent)
40%

52%

20%

26%
18%

15%

0%
Pre-Clinical

Successful
IND
Submission

Phase I/IIa
Successful

Phase IIb
Successful

Stage of Development
49

Phase III
Successful

NDA
Successful

MOST DRUG CANDIDATES FAIL TO BE APPROVED

Using Industry Average Failure Rates to Handicap Risk (PTRS)

Probability of FDA Approval

Probability of FDA Approval for Products Entering (%)
STUDY

Lehman Brothers (1997)

Myers / Howe (1997)(1)
DiMasi / Manocchia (1997)
(1)

Kaitin (1995)
DiMasi / Hansen / Grabowski / Lasagna (1997, 1995)
Struck (1994 biotech)
Struck (1994 conventional NCE)
DiMasi / Seibring / Lasagna (1994)
Wenzel (1993)
Grabowski (1991)
Tucker / Blozan / Coppinger (1988)
Sheck / Cox / Davis et al. (1984)
Hansen (1979)
Recombinant Capital (o.D.)
Bienz-Tadmor / DiCerbo / Lasagna (1992)
Grosse / DiMasi / Nelson (1996)
Average
Average (excl. high and low)

Preclinical

Phase I

Phase II

Phase III

FDA

4
22

38
11

19

10
24

20
23
69
25

63
64

62
64
92
66

63
64
?

60

90
75
90
75

100
100
83

29
21

30
32

30
31
79
33

30
31
?

50
30

19
18

25
23

38
34

66
64

87
87

23
?
17
19

Notes

(2)

(3)
(4)

Source: "Real Option Valuation in R&D Decision-Making in Pharmaceuticals" by Dr. Gunnar Pritsch, Associate Principal, McKinsey & Co.
(1) No empirical study, but conclusion estimates.
(2) Gastrointestinal: 79%; anti-infective: 84%; cardio: 90%; oncology: 92%; antiviral: 93%; endocrine: 94%; neuropharmacologic + radiologic: 100%.
(3) Peptide hormone analogous: 24%; antiviral 29%; antineoplastics: 33%; cardiovascular: 34%.
(4) Data 1980-89; number reflects average expected success for all recombiment protein and monoclonal antibody drugs; all recombinants: 19-43%;
new recombinants: 15-39%; therapeutic MAbs: 4-29%.

50

WIDE RANGE OF SUCCESS RATE ESTIMATES

Studies of Drug Approval Risk

Avance published a study in November 2009 of over 200 companies listed on

public stock exchanges, tracking their clinical drug candidates from 2003-2009.

Cost ($ million)

Success Rate /
Transition
Probability (%)

Duration
(Months)

Phase I

71%

12

Phase II

12

44%

26

Phase III

68

69%

34

NDA

NA

18

Total

88

21%

90

Stage

In biotech the success rate was even lower, averaging 9% for NCEs and 15% for
biologicals.

51

OVERALL SUCCESS RATE OF DRUG APPROVAL: 21%

Success Rates from a Recent Study

Another Updated Study: DiMasi March 2010

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, Trends in Risks Associated With New Drug
Development: Success Rates for Investigational Drugs, Clinical Pharmacology and Therapeutics, March
2010, pp. 272-277.

52

Success Rates Depend on Therapeutic Indication

Source: DiMasi, J.A., 2001, Risks in New Drug Development: Approval Success Rates for
Investigational Drugs, Clin Pharmacol Ther, vol. 69, p. 297-307.

53

Transition Probabilities by Therapeutic Class

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, Trends in Risks Associated With New Drug
Development: Success Rates for Investigational Drugs, Clinical Pharmacology and Therapeutics, March
2010, pp. 272-277.

54

Small versus Large Molecule

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, Trends in Risks Associated With New Drug
Development: Success Rates for Investigational Drugs, Clinical Pharmacology and Therapeutics, March
2010, pp. 272-277.

55

THE DISCOUNT RATE

ACCOUN
TING

Nominal / Real

TREATM

ENT

Discount Rates Used in Industry

Discount Rate

Company
Actelion

57

Source
Nominal

13.2%

HY Report 2009

Large Pharma A

Real

10%

2010 Interview

Spec Pharma A

Nominal

12%

2010 Interview

Large Biotech A

Nominal

10%

2009 Interview

Spec Pharma B

Nominal

14%

2009 Interview

Large Pharma B

Nominal

12%

2009 Interview

AstraZeneca

Nominal

11%

Annual Rpt 2008

Range

10 to 14%

ACCOUN
TING

TREATM

ENT

Nominal Versus Real Discount Rates

Nominal rates include the effects of inflation.

Real rates have been adjusted for inflation.
It is important to match cash flows in the forecast to the type
of rate used:
Nominal cash flows with nominal rates and real cash flows with real
rates.
Its an important distinction because many pharma revenue forecasts
are real whether stated or not. Price increases that are modeled in are
above and beyond normal inflation.

58

Discount Rate Should Reflect the Cost of Capital

What is the Cost of Capital?
The cost of capital is a measure of the opportunity cost of capital in an economy.

A companys cost of capital should equal the marginal return available to

investors in the next best investment opportunity of similar risk available in the
capital markets
The cost of capital should reflect:

The return available to investors in the economy on risk-free instruments

The return that investors require for taking systematic risk over and above
the risk-free rate

Systematic risk is that which cannot be diversified away.

Traditionally measured as the weighted average of the cost of equity and

debt. Known as the Weighted Average Cost of Capital (WACC).

The Cost of Capital is the opportunity cost of money in a competitive market

economy and is a guide to the right discount rate.
59

Weighted Average
Cost of Capital (WACC)

Cost of Equity

Cost of Debt

Risk-Free
Rate

Credit
Spread

Country/
Political
Risk
Premium

Tax Shield

Risk-Free
Rate

Equity
Market
Risk
Premium

Equity
Beta

Business
Risk

Country/
Political
Risk
Premium

Financial
Risk

WACC is a weighted average of cost of equity and debt, where the weights for cost of debt
and cost of equity are determined by market values of equity and debt. Because a number of
inputs to WACC are of statistical nature, WACC is a range rather than a point estimate.
60

THE TRADITIONAL APPROACH TO WACC

Estimating The Cost of Capital using WACC Approach

Because equity is a long-term investment,

a risk-free rate representing a long-term
horizon is most appropriate.
Consequently, we utilize the 30-year U.S.
Treasury as the risk-free rate in the CAPM.

EQUITY MARKET RISK PREMIUM

The equity market risk premium is the

excess return expected for the equity
market relative to the long-term bond
market. The figure that is used normally
ranges between 4 and 8%.

EQUITY BETA(1)

The beta is a risk measure which

represents the non-diversifiable risk
associated with an equity investment
measured relative to the overall equity
market. It is a function of asset risk and
financial risk.
POLITICAL RISK PREMIUM

The political risk premium represents the

incremental return investors require for
use of their funds in international
investments and represents nonsystematic risks such as expropriation.

(1) When calculating the asset beta for high-levered, non-investment grade companies, it is important to utilize a debt beta in the calculation.

61

TRADITIONAL APPROACH TO WACC (CONTD)

RISK-FREE RATE

Discount Rates in Practice

62

CAPM near useless

(betas on risky pharma
companies often very
low)

Industry betas are

better if you must use
beta

We prefer to pick a
fixed rate that reflects
the leveraged
opportunity cost of
equity

Another approach is to
look at industry wide
implied cost of equity
from actual market
prices.

VALUATION CONSIDERATIONS IN LICENSING

Illustrative

Value to
Original
Developer

Total Program Value

NPV= $30
License

Milestones
Royalties

NPV= $80
R&D

Sales

COGs
R&D

NPV= $50
Sales

S&M
License

Value to
Partner

COGs
Milestones

S&M
R&D

64

Royalties

PARTNERSHIP AND NPV

Partnering a Program Splits the NPV Between the Original Developer and the Partner

Negotiating and Valuing Licensing Deals

NPV Split

What percent of the rNPV goes to the licensor and licensee?

Generally the licensor can get more than 50% of the value
Generally the split is more favorable to the licensor on earlier deals
Generally the split is more favorable to the licensor when the licensee
is small or in financial difficulty

rIRR to the Licensee

A key benchmark is what return on investment goes to the licensee
(risk-adjusted internal rate of return)
A smart licensee avoids putting his capital to work in order to boost
the rIRR
A smart licensor tries to get the lowest rIRR deal possible
Surprisingly, many counterparties in pharma negotiations pay less
attention to this metric than they should.

65

66

PARTNERSHIP DASHBOARD

Partnership Economics in a Recent Torreya Advised Transaction

1. Pick deals with large scale and high rIRRs

2. Know your rIRR limit generally in the 20 to 30% range.
3. Focus on putting largest payments after key risk points
have been passed
4. Focus discussion on precedent transactions (example at
right)
5. Focus discussion on key issues (e.g., reimbursement,
compliance, other related product revenues)
6. Focus discussion on fit and good job that can be done
7. Include equity as consideration if licensor is cash-strapped
(often is misvalued)
8. Understand liquidation preferences of licensor / seller
67

BARGAINING TACTICS WHEN IN-LICENSING

Bargaining Tactics when In-Licensing

1. Ask licensor to show what they can do for you. Get financial forecasts if
possible. Ask for a capabilities presentation.
2. Figure out the licensors financial modeling approach and assumptions
as best as possible.
3. Figure out the licensors hurdle rate on rIRR.
4. Solve for the licensors model and the rIRR as terms change.
5. Focus less on deal comparables.
6. Try to get payments made early in the collaboration.
7. Avoid including equity as consideration.

68

BARGAINING TACTICS WHEN OUT-LICENSING

Bargaining Tactics when Out-Licensing

Assume $20 million upfront, $160 million in milestones and a 22% royalty.
Cash Flows to BigPharma from Partnership Transaction - US
Items
Forecast Revenue
Cost of Goods Sold
Royalty payment to Biotech
BigPharma development expense
SG&A and launch cost
Milestone payments to Biotech
BigPharma Pre-tax cash flows
After-Tax Cash Flow
Probability of Success in Year
Probability of Payment if Deal in 2008
Probability Adjusted Cash Flow

EPS Impact with success

2008
0
0
0
5
0
20
(25)
(25)
10%
100%
(25)
$
(0.00)

BigPharma Tax Rate

22%

BigPharma Rate of Return on

Partnership

36%

Value created at BigPharma by deal:

2009
0
0
0
10
0
0
(10)
(10)
20%
50%
(5)
$
(0.00)

2010
0
0
0
20
0
40
(60)
(60)
40%
25%
(15)
$
(0.01)

2011
0
0
0
20
0
0
(20)
(20)
40%
25%
(5)
$
(0.00)

$6,104 million for an investment of

2012
0
0
0
50
(30)
60
(140)
(140)
70%
20%
(28)
$
(0.02)

2013
0
0
0
50
(30)
60
(140)
(140)
70%
20%
(28)
$
(0.02)

2014
0
0
0
10
0
0
(10)
(10)
85%
15%
(2)
$
(0.00)

2015
624
62
137
0
(156)
200
68
53
100%
10%
5

2016
1,686
169
371
0
(422)
0
725
565
100%
10%
57

2017
2,918
292
642
0
(642)
0
1,342
1,047
100%
10%
105

2018
4,339
434
954
0
(954)
0
1,996
1,557
100%
10%
156

0.01 $

0.08 $

0.15 $

0.22 $

(78) million in expected terms.

The deal on the table here is for a Phase 1b cardiometabolic drug. The
proposal made of 20mm upfront gives the licensor (big pharma company) a
generous return of 36%. However, the project is highly risky. The licensee
should keep bargaining to try to get the pharmas return down to a sub 25%
area. This will require getting the upfront to be higher.

69

2019
5,972
597
1,314
0
(1,314)
0
2,747
2,143
100%
10%
214

0.31 $

2024
8,836
884
1,944
0
(1,944)
0
4,064
3,170
100%
10%
317

0.45 $

2029
12,450
1,245
2,739
0
(2,739)
0
5,727
4,467
100%
10%
447

0.64

ONE SHOULD ALWAYS TRY TO GUESS THE OTHER SIDES VALUE

Solving for the Other Sides Model

THE M&A SETTING

M&A and Licensing Valuation Analysis are Conceptually Similar

Same exercise but now we are valuing a company rather than a drug.
Sum the rNPVs of the projects of the target company with adjustment
for overhead costs or model the company as a whole (will shown an
example for Eli Lilly).
This gives the target company intrinsic valuation.
Try not to overpay. Valuation is treacherous, particularly with terminal
value assumptions.
Problem is that most M&A deals involving later stage and marketed
assets are NPV negative.
Two ways to think about this:

1. Look at the IRR on your own company what is your cost of cash?
2. Look at missing elements particularly the targets pipeline.
71

OUR
UNDE
RSTAN
DING
OF

LILLYS
VALUA

TION
APPRO
ACH

M&A Analysis Approach at One Pharma

72

The Pharma has a well developed approach

Step 1. Identify cash flows from identifiable products
Step 2. Discount the cash flows at a rate in the low teens to get the DCF value
Step 3. Compute the target purchase price as the equity value plus a premium of
30 to 50% (typically 40%) plus debt less cash
Step 4. Compare the DCF to purchase price of the target
The difference between enterprise value and DCF is known as pipeline or
science value
If pipeline value is negative then the valuation test suggests acquire
If pipeline value is greater than 50% then the valuation test suggests avoid
If pipeline value is between 0 and 50% then study further and make a
business judgment
This approach leaves significant room for quantitative and qualitative judgment. It is
intelligent and designed to avoid situations where the pharma overpays for targets.

Consequences of a Hypothetical 2004 Acquisition of a Specialty Pharma

Operating Income (ex-Synergies)
Operating Income (ex-syergies)

Revenues
$3,966
$3,549
$3,163

Revenues

$3,072
$2,777

$2,725
$2,373

$2,199

$526

2005

$699

$772

$803

2006

2007

2008

Warner Chilcott

$996

$726
$625

$351

$377

2007

2008

$270

$216

2006

28.4% 41.1% 30.7%

30.6% 38.9% 32.5%

Allergan

Pro Forma

Source: Wall Street projections

$1,000
$856

$841

2005
Operating Margin

Allergan

$1,377
$1,207

30.8% 45.4% 33.9%

Warner Chilcott

31.6% 46.9% 34.5%

Pro Forma

Source: Wall Street projections

EPS

2003-2008 CAGR
19.9% accretive

18.8% accretive

14.1% accretive

$5.54
$4.62

$4.42
$3.28

$3.55

2005

$5.48

$3.87

2006
Allergan

2007
Pro Forma

Source: Wall Street projections

2008

2005-2008 CAGR

8.4% accretive

21.4% 22.4%

20.5%

$6.51
17.0%
15.2%
12.9%

17.9%

18.7%

13.3%

Revenue

Operating Income (ex-synergies)

Allergan

Warner Chilcott

Pro Forma

EPS

Factors to Consider in NPV Models of Pharmaceutical Companies

Model each drug in an additive manner.

Revenues and cost curves for each drug.
Use reasonable estimates to the curves for the models.

Take drugs out at least 10 to 15 years past patent expiration dates

Analyst reports generally stop too soon
Pay careful attention to patent issues and associated cliffs
Use analyst reports to get the estimates started
Carefully think about the role of R&D in the model.
If you keep R&D in then you need a terminal value
If you leave it out or scale it down then no terminal value required

Be aware of how your own company looks through the same lens
For the purpose of a stock for stock merger its important to look at each party with the
same analytical approach
If you ignore their pipeline, you should ignore yours etc.

74

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