Evaluating effort
November 2023 | SPECIAL REPORT: HEALTHCARE & LIFE SCIENCES SECTOR
Financier Worldwide Magazine
November 2023 Issue
Research-intensive industries commonly rely on licensing agreements to provide developmental and commercialisation capabilities to bring innovative ideas and products to market. These agreements often require the licensee to exert ‘best’, ‘commercially reasonable’ or some other defined level of effort to guide an idea through development and commercial launch.
Difficulties and disputes may arise when the product under development suffers in comparison to expectations, either failing in development or in meeting commercialisation targets. In these unfortunate circumstances, the out-licensing partner, and often investors, may question whether the level of effort expended by the licensee was a contributing factor.
How can parties determine if failures in performance were based on efforts or external market forces? This article provides a brief exploration into potential methods of evaluating the role of efforts in developing and commercialising new products.
Benchmarking
If contract terms used to describe the required level of effort are open to interpretation, identifying benchmarks may provide a reasonable first step in evaluating the licensee’s efforts. For example, how did the programme to develop the idea or product compare to the metrics outlined below.
Other programmes run by the licensee. Companies often have regular meetings to assess development programmes, sometimes including established milestone requirements or hurdle rates to justify continued development. Some efforts clauses specifically require that the in-licensed target be treated as if it were discovered in-house. A developer might find that internal programmes provide a structure in which to foster an in-licensed product. Or it might be that a developer prefers separating the in-licensed product to ensure that it commands particular attention. Deviations from how other programmes are evaluated and pursued may warrant a deeper investigation.
Similar programmes hosted by other companies. Sometimes there is enough information from competitors to provide insight into development and commercialisation efforts. Observable dimensions for comparison may include expenditures, timing, staffing, development milestones or other factors. Consider pharmaceutical development as an example – the development and commercialisation efforts of a licensee may be compared to other companies investigating similar therapies (similar molecules in other therapeutic areas or other molecules in the same therapeutic category).
Historical results. Success rates and timing realised by other development programmes might also provide useful context for evaluating effort. Continuing the pharmaceutical example, there are studies and data on the success rates and average timing for each phase of clinical trials, regulatory review and timing between marketing authorisation and commercial launch. How relevant those historical results may be for a particular product requires consideration, especially for situations where the targeted programme may offer something innovative from preceding examples.
Forecasts. It is not uncommon for a development programme to have a forecast for the timing and results of commercial launch. In fact, there may be an embarrassment of riches with respect to forecasts – some developed before the licence agreement, some developed in the effort to secure funding, some developed by the licensee, some developed by outside parties and perhaps others. Understanding the purpose and the timing of forecasts is often critical for evaluation. Development and commercialisation stages are inherently risky, and effort alone does not guarantee success. As time passes and effort (sufficient or not) is expended, more and more information becomes available, leading to updated foundations for forecasting. When forecasts change, the amount by which they change and the reason for the change may provide crucial information for evaluating effort. Similarly, a gap or sudden cessation in forecasts may also be telling.
The comparisons fostered by benchmarking efforts alone may be useful, but they are subject to limitations. After the licence agreement, the licensee is in the best (and sometimes only) position to learn additional information. Decisions that appear surprising based on old information may reflect realistic updates considering new learnings during the development or commercialisation stage.
Benchmarking is also stronger when parties had similar expectations when they entered into the licensing agreement. Diligence breakdowns or asymmetries may skew comparisons from the start.
Financial analysis
In addition to benchmarking, an evaluation of financial indicators may offer a method to assess the effort expended on an in-licensed development target. Examples of financial analysis that may inform inquiries into development efforts include those outlined below.
Evaluation of total investment. Not all programmes require comparable investments, but significant outliers in development and commercialisation spending may draw attention. In-licensing partners are often selected based on their experience or complementary development and commercialisation assets, factors that might suggest efficiencies in spend or timing for the in-licensed product.
Accounting cost centres. Sometimes in-licensed products have dedicated cost centres that accumulate related expenditures; other times, costs associated with the in-licensed product are assigned to and spread across existing codes constraining the ability to assess investment in the in-licensed opportunity. There may be implications to whether an in-licensed product has separable accounting cost centres. Integrating the in-licensed product may provide administrative efficiencies or may facilitate treating the in-licensed product comparably to internally-developed targets. But integrated accounting might require a more expansive production (or a more significant effort to allocate costs) of financial information if a licensing partner has and invokes audit rights.
Locus of activity. As important as how costs are accumulated and reported might be the issue of where or by whom they are incurred. If the in-licensing partner has established assets of relevance for the development and commercialisation effort, it may be reasonable to expect that activities related to the targeted development programme occur at those facilities and with contributions from the relevant personnel.
Pacing and periodicity of expenditures. In addition to the total investment in a development target, the timing of related expenditures may provide insight into effort. A blocky pattern of development expenditures need not necessarily draw scrutiny; development expenditures often show a step-wise pattern, with significant expenditures centred on particular milestones. Evaluating the reason for milestones might prove to be illuminating, particularly if there appear to be missing milestones from an expected development plan, if the milestones appear to be related to financial constraints or licensing party status inquiries, or if lead-time on spending differs from expectations. Commercialisation costs, for example, can often precede launch by months or years, so the timing of those expenditures may provide information on whether launch expectations were delayed or whether the licensee’s timing of investment was reasonable.
Using financial analysis to evaluate effort, however, is not without difficulty or peril. Development and commercialisation efforts often take years, during which time staff may leave or legacy accounting or financial systems are retired. Maintaining or recovering complete financial information may prove challenging. Even with complete financial records, there are two fundamental issues to address. First, does a lower than expected total investment indicate a lack of effort, or does it demonstrate an efficient use of resources? Second, what were the expected gains balancing the realised costs? The forecasts addressed in the benchmarking section might provide insight into how the licensee balanced expected costs and gains. This metric of expected profitability might be the key to understanding the licensee’s efforts, particularly if expending additional effort would lead to an unprofitable expected outcome.
Market developments
An important final consideration is that effort alone may not be sufficient to ensure success. The discussion above provides metrics and comparisons that may provide insight into dimensions over which the licensee could exercise some degree of control. The success of development and commercialisation procedures, however, also depends on what happened in the marketplace into which the development target was expected to launch. Exogenous factors might have affected the marketplace in a way that mitigates or obviates the effort invested in a development programme. Unexpected competitive entry might have affected consumer demand for the targeted product or introduced a new standard. Regulatory changes might affect the timing, pricing or marketability of the targeted product. Pandemics or natural disasters might disrupt development or the supply of materials. Even the passage of time might cool irrational exuberance or otherwise affect consumer demand. Ultimately the licensee’s success may be determined by the balance between the effort it could control, and the market forces it could not.
Peter J. Rankin is vice president of Charles River Associates. He can be contacted on +1 (202) 662 3935 or by email: prankin@crai.com.
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Peter J. Rankin
Charles River Associates