Evaluating a Drug Licensing Opportunity

Statement of the problem- Merck must determine whether or not to bid to license Davanrik

My recommendation is that Merck must definitely make a competitive bid for Davanrik.
The total expected value from the deal based numbers given in the Merck article is a healthy $14million so keeping a 20% incentive, Merck should bid no more than $11million for Davanrik as the initial licensing fee.

Looking at the background of Merck, it is clear that it is a successful company with good cash flow and investable assets. Not only can Merck afford to take risk but also given the fact that several of its key patents are expiring in 2002, Merck must replenish its patented product portfolio otherwise Merck risks loosing its profit margins in future. Since the pharmaceutical business is based on high-risk high-reward model, Merck should be aggressive in getting new products on the market. Although Merck could be developing its own new products, Davanrik presents an interesting opportunity since the parent company LAB pharmaceuticals is eager to license the drug in light of its recent FDA rejection. Looking for a much needed cash influx, LAB might be willing to strike a bargain.

To evaluate the risks/rewards of the deal we construct a decision tree for Merck. The structure of tree presents a clearer picture of the possible risks and rewards during the comprehensive FDA approval process. Looking at this decision tree in phase 3, perhaps Merck can reduce its risk by pursuing only ‘depression’ even if phase 2 indicates that Davanrik could be efficacious in both ‘depression’ and ‘weight loss’ because the total expected return is $32million (34.7-2.4) against $14.4million (26.9+1.7-0.5-12-1.7) in the ‘depression only’ and ‘dual launch’ respectively. Also the staggered payment scheme is beneficial to Merck in reducing risk because as Davanrik moves to a higher phase of the FDA approval process, the probability of success increases since we already know for certain that the previous stage’s failure didn’t happen. For instance in the “Pursue Depression” arm of the decision tree we already know that Davanrik has an 85% chance of success! Looking at this branch separately we see that the cash flow and expected value for success are a staggering $750million and $638million respective. In this branch Merck is being rewarded for the high risk it took in the first two phases.

Not having data on competitors bidding on Davanrik presents some difficulty in judging whether Merck should use the full $11million because it is clear from the decision tree that the initial expenditure during phase 1 impacts the total expected value the most. If we had more data on competitors we could possible advise Merck to go with a lower phase 1 licensing fee. For example if Merck could strike a fair deal with LAB and reduce phase 1 licensing fee by 2 million (keeping all other payments the same) then the total expected value increases by $2million to $16 million. Alternatively Merck could increase its expected value by offering to pay LAB more in the phase 3 payments in lieu of reduced phase 1 payment. For example if Merck stuck a deal where it pays LAB only $1million in phase 1 but doubled all the payments in phase 3, it would still increase net expected value for Merck to $14.7million. This works because the total failure probability in phase 3 is only 3.45%.

From LAB’s perspective, the company is hesitant to use its shares to raise money since its stock price has recently fallen by 30%. Therefore LAB will have a preference to have a bigger cash payout in phase 1 and might be willing to accept lower payments in later stages. In any case LAB stands to benefit tremendously if the drug is approved since it will have at least 10 years of royalty payments from Merck with its established capabilities. Considering the above factors Merck should bid $11million as phase 1 payment and reduce phase 2 payment to $1million and phase 3 payments to 5,3 and 15 million dollars respectively for depression, weight loss and dual. This would still leave Merck with a tidy $11.2million expected value and increase its chances of securing the Davanrik deal.