It is often common to see start-ups and small biotechnology companies sell their technologies to bigger companies. The bigger companies purchase these technologies with hopes of making huge profits while the biotech companies sell in other to get finances to proceed with other business ventures or to stay in business. In order for both parties to benefit, major decisions have to be made on the method of valuation. The method used has to be objective and valid. This case study is about LAB and its decision to license off Davanrik to Merck.
This analysis is about how Merck has been able to generate substantial returns given the costly and lengthy time to develop drugs and the potential outcome for Davanrik should LAB licenses off to Merck, Also, the analysis will determine if Merck should license the drug and for how much, and to determine how much LAB would receive given a 5% royalty fee on any cash flow. Lastly, the paper will analyze the change in launching Davanrik for weight loss if the cost was $225 million instead of $100 million.
Merck is a giant pharmaceutical company that concentrates on research and development of new drugs. It performs several research and develops medical products for humans and animals. Merck owns lots of blockbuster medical supplies and drugs. In 1999, it earned $5.9 billion in sales, an increase of about 20% from 1998 (Ruback, 2003). Merck makes huge profits from its patented drugs like Vasotec, Prinivil and Pepcid. Merck is able to achieve substantial returns to capital even with large cost and lengthy time to develop drugs through the sale of patented drugs like Pepcid. Merck has exclusive right to sell the drugs until the patent expires. The sales made during this time are able to cover the large cost. While Merck might not make as much profit from its drugs after its patents expire, Merck also sells drugs with expired patent made by other companies. The production and selling of drugs with expired patent by other companies does not cost Merck as much and would take less time compared to the production of new drugs. Merck has also been able to achieve substantial returns by staying on the leading edge of drug development technology. The launch of many new products enables them to constantly refresh the company’s portfolio and maintain high revenue over a lengthy period of time. Production of drugs might take long and cost more but it is a good investment. These new products are developed primarily through internal research and initiative with biotechnological companies such as LAB.
Decision Tree

The potential outcome can be measured in terms of risk and reward. Based on the calculation and decision tree analyzes, the project is a potential high risk for Merck. The expected cash flow for success in depression only is $680 million compared to $1.28 billion expected cash flow for both weight loss and depression. However, the expected cash flow for failure of both weight loss and depression is -$570 million compared to -$270 for depression only. Also, the expected cash flows for success and failure of weight loss only are $25 million and -$220 million respectively, which makes it not a viable option. The expected cash flows for weight loss were calculated based on $100 million to launch, however, the expected cash flow values will be -$100 if $225 million is use to launch. Although phase 2 indicates that the drug could be viable for depression and weight loss, Merck may reduce risk by sticking to depression because as per the decision tree in phase 3. Going ahead with depression only will be beneficial to Merck given that failure did not occur in the earlier phases. There is more probability for success as the drug moves to a higher phase for FDA approval following the depression branch of the tree, it is indicative that Davanrik has 85% chance of success. As per this branch, the cash flow is as much as $680million. Merck seem to be obtaining rewards for taking high risk.
According to the decision tree, the expenditure made in phase 1 has the most impact on the total expected value. Given that there is no information about competitors, it is difficult to determine how much Merck may use. To be on the safe side, Merck could bargain for a lower licensing fee at the initial face and promise to increase the price in phase 3 or as long as the licensing bid is less than or equal to $13.98 million, which is the net present value based on 5% royalty fee of the Davanrik drug. Although the option of paying higher in phase 3 does not make much difference, it is till of advantage because probability of the drug failing at this phase is much less. Considering the financial position of LAB, it will need more cash in phase 1 and might accept lower payments in phase 3 because its stock price fell by 30%. Whatever the case, LAB may make some profits as it will receive royalties on any cash flow from Merck for as many as 10 years. Merck should make a good bid for the Davanrik drug, because based on Merck’s business model, it makes most profit from their patented drugs. Davanrik as a new product in the market, may help Merck stay in competition as well as maintain its profit margins. There is a high risk involved but pharmaceutical companies only thrive because they can bear the risk. Merck has the financial capability to take the risk and this makes it an interesting offer, Merck should be aggressive and bid wisely.

References
Ruback, R. S. (2003, March 25). Retrieved from Harvard Business School: https://cb.hbsp.harvard.edu/cbmp/access/38693838