Real Options in Biotechnology & Pharmaceutical Industries

Real option analysis is an attempt to quantify the value of flexibility. In drug R&D projects, there are several applications and possibilities. There are six different categories of real options based upon types of managerial flexibility. Specifically these are:

Option to abandon: When a drug discovery project fails to meet its expectations, the biotechnology company’s management team should consider to abandon it, in order to avoid losses. The company could recuperate a salvation value. The more reversible the investment, the higher will be the salvation value. This is a very valuable option for biotechnology companies since the preclinical and clinical developmental programs are segmented into different phases and the capital investment is planned according to the phase of development.

Option to grow: Growth options are strategic options and they are particularly relevant for projects that are not advantageous by themselves but may generate lucrative opportunities in the future. This type of option is most frequently found in R&D projects. In the biotechnology sector it takes more than 10-12 years for a drug to develop from the original discovery to the final product, having a low possibility of success. However, during the course of a project, the original investment may generate various other applications, which could be profitable. Furthermore, a biotechnology company could have the possibility to grow its activities to other countries or products. In addition, it is possible that one drug potentially could be used in different human diseases.

Option to defer: This option includes the possibilities where the time point of an investment is not determined but flexible allowing this time point to be optimized. Those options could also arise from alterations in the term structure of interest rates over time even if the future cash flow is deterministic. There are several cases in the biotechnology sector, where the best course of action is to defer investment until further preclinical or clinical data are available. This option is highly valuable for the biotechnology industry because of the high uncertainties and long investment horizons. On the other hand, waiting also involves the risk of losing the first mover advantage. Therefore, in a highly competitive environment, the option to defer might be worth less.

Option to expand or contract: This option includes the possibility to change the existing scale of the project according to the market movements. A company may commit more capital to a drug development project that it has licensed, in order to capture a greater share of the future cash flows. In addition a biotechnology company may build production facilities in excess of the expected demand. Testing a new market with a product and expanding if the test run proves successful is another example of this option type. On the other hand, the option to contract could be useful if additional preclinical and/or clinical data related to a specific drug are not promising.

Option to switch: This option comprises the possibility to react upon changed market conditions by changing the input and output factors. Furthermore, this option could refer to the cost of restarting activities.  Also, a company may reconsider its production location and switch to a cheaper place.

Option to stage investments:  Staging investment create the option to abandon the enterprise in midstream if new information is unfavorable. All the drug discovery and development projects require a staged investment. The biotechnology firm resolves in every subsequent stage further uncertainties. Based on new facts, the drug development project is revaluated and could be continued or abandoned after each stage. These staged investments are modeled as compound options.

There is a potential seventh category of options named “multiple interacting options”. It is known that most real-life projects involve a collection of different options, both upward-potential enhancing calls and downward-protection put options. Their combined option value may be different from the sum of separate option values. This could happen in case of interaction between the options.