Why royalty monetisation transactions are big news for life sciences innovators
For universities, research-based charities and smaller biotechs, selling the rights to drug revenues is an attractive and increasingly common way of generating upfront cash from long-term IP income streams
Selling a share of the royalties in pharmaceuticals products is on the rise as a means for healthcare innovators to generate cash from their inventions. In the past 25 years, royalty monetisation transactions have evolved from their humble beginnings as a simple sale of royalty streams in return for an up-front payment to increasingly complex and sophisticated transactions with virtually countless variations.
While the structures vary considerably, the underlying principle is the same: by properly modelling future anticipated revenue streams generated through the commercialisation of intellectual property, the ongoing economic value and risks associated therewith can be efficiently transferred from the technology innovator to the technology investor in a true win-win manner.
Anatomy of royalty monetisation
In its simplest form, royalty monetisation involves the sale of royalties and/or milestone payments that a party (usually a licensor) is entitled to receive under a contract (usually a licence or collaboration agreement).
In a typical case, the IP owner (whether this is patents, know-how or materials such as a cell-line) grants a licence to a third party to use that intellectual property to commercialise products. In return, the licensee pays the IP owner an ongoing royalty (paid on a quarterly, semi-annual or annual basis) that is typically calculated as a percentage of net sales of the products commercialised using the licensed intellectual property.
In addition, the licensor may be entitled to receive one or more milestone payments upon the occurrence of one or more specified milestone events in the development or commercialisation of the licensed product. For example, where the licensed product is a drug candidate, development milestones may be payable to the licensor upon the first dosing of a patient in each of a Phase I, Phase II or Phase III clinical trial.
Similarly, a commercialisation milestone might be payable to the licensor upon the licensee’s first achievement of annual net sales of the licensed product above some specified threshold (eg, annual net sales of licensed product in the United States above $500 million). Although the right to receive royalties and/or milestones is usually tied to the licence, it need not be. Any right to receive a future payment under a contract can be monetised (eg, an earn-out payment in an M&A transaction).
Of course, determining the actual dollar amount or value of future royalties, milestones and other contingent payments that a licensor will receive under a licence agreement is not an exact science. Because royalties are calculated as a percentage of net sales of licensed products, much depends on variables such as:
- the commercial success of the licensed product(s);
- the scope, strength, validity and duration of the patents and other intellectual property;
- protecting against generics in each of the relevant jurisdictions (eg, the United States, the European Union and Japan);
- the provisions of the underlying licence agreement (eg, whether there are any offsets or deductions that can be applied against the royalty);
- the availability of regulatory exclusivities;
- the size of the addressable patient market (including the potential for any label expansions);
- pricing and reimbursement by payors; and
- regulatory pathways and risk profiles (eg, the risk of adverse events or failure to obtain or maintain regulatory approval).
Yet careful modelling and analysis can allow royalty investors and their advisers to reliably assess and quantify each of these factors and risks and assign a present value to the future royalty streams. It is this present value that, after taking into account an appropriate discount factor, provides the basis for the purchase price for the royalty stream.
Georgia-Pacific factors or determining lost profits under Panduit.
In other respects, valuing royalty streams can be just as difficult (if not more so) than determining lost profits. Unlike lost profits analysis, where the historical sales of the infringing product are already known, valuing a royalty stream involves the assessment and quantification of the estimated future net sales of a licensed product over the term of the licence. Where lost profits analysis looks backward in time, royalty stream analysis looks forward. That said, there are certain similarities between the two. Indeed, concepts used in lost profits analysis, such as convoyed sales and price erosion, are directly analogous to those used in royalty stream valuation (eg, to assess the impact of off-label sales and generic competition on the pricing and market share of the branded drug product).
That being said, valuation models for royalty streams have become quite sophisticated, and they are far more predictable (and reliable) than the subjective analysis of a jury in the damages phase of a patent infringement litigation.
Advantages and disadvantages
So why would a licensor want to monetise its royalty stream? There are several reasons.
First, monetisation allows the licensor to receive an up-front lump-sum payment in exchange for its rights to receive future royalties. This allows the royalty seller to realise the full value of the royalty stream immediately and deploy it in ways that make the most sense for the organisation. For a university, this may include building a new building or funding its endowment. For a foundation or other non-profit, this could mean funding many other research programmes to have more opportunities to further its charitable mission. For biotech companies, this could mean obtaining non-dilutive financing that could be used to accelerate one or more clinical programmes or to fund the acquisition of additional assets (eg, acquiring or in-licensing additional drug candidates).
It is likely that few of these things would be possible based on royalties alone if the licensor had to wait to receive full value for its royalties over the lifecycle of the licence agreement. With the covid-19 pandemic materially affecting everyone from universities and non-profits to biotech companies, being able to monetise an existing asset now to help make up for shortfalls in revenue has obvious advantages and is particularly pertinent. And because patents (and thus the royalty streams derived from them) generally have a lifecycle of 20 years from filing, the up-front payment received in exchange for these royalties can be substantial. As an example, in 2014 the Cystic Fibrosis (CF) Foundation sold a portion of its royalty stream in Kalydeco (ivacaftor) and certain drug candidates for the treatment of CF for $3.3 billion. The foundation was able to use these proceeds to fund the discovery and development of many additional therapies to treat CF.
inter partes review, opposition or litigation proceeding, it is the royalty purchaser that will bear the economic impact when generics come onto the market and sales of the licensed product plummet (the so-called ‘patent cliff’).
This happened in June when generic drug maker Mylan successfully invalidated claims of a key patent on Biogen’s multi-billion-dollar multiple sclerosis drug Tecfidera. Mylan’s successful challenge allowed it to launch its generic version now, instead of having to wait until 2028 when the patent was originally expected to expire – a turn of events that some analysts have predicted will cost Biogen most of the $3.3 billion in annual revenue that the drug generated for the company.
Similar risks exist on the regulatory front. Two months after Agios sold its royalty stream on approved acute myeloid leukaemia (AML) drug Idhifa for $255 million, the drug was found to have no overall survival benefit in a Phase III clinical trial for patients with relapsed AML, calling into question the future anticipated market share for the drug. Numerous other examples abound.
By receiving the full value of the royalty stream up front, the licensor/royalty seller has its money in the bank and is not affected by the many potential risks that can negatively affect the timing, duration and/or amount of a royalty entitlement. This makes budgeting and planning much more predictable.
What are the downsides? One is that a royalty purchaser will typically apply a discount rate to the present value of the anticipated royalty stream, compensating the investor for taking on the various risks alluded to above. In that sense, the royalty seller will be receiving less than the full value of what it otherwise would be entitled to. Another potential downside is that the royalty seller may underestimate the true value of its royalty stream. As discussed above, the valuation of royalty streams can be quite complex; if a royalty seller is not careful, it can easily sell its royalty entitlement for too low a price and leave significant value on the table. This is why it is crucial for royalty stream buyers and sellers to engage professionals experienced in royalty stream valuations to conduct a valuation study.
Another potential downside is the loss of an ongoing payment stream that can be used to fund budgets from year to year. This is effectively the flip side of the benefit of receiving a single lump-sum payment up front. For publicly traded companies, Wall Street will want to be comfortable that the proceeds will be put to good use and create leverage and/or synergies for the company to further advance its business in ways that may not have been possible absent incurring substantial debt or issuing additional equity (which would dilute the existing shareholders and may not be feasible given financial market dynamics at the time).
And what about the royalty investor? They get the benefit of investing in a relatively predictable and stable income stream (subject to the risks identified above) and the ability to participate in the life sciences industry in a highly targeted fashion without having to invest in the traditional equity markets. In addition, the return on investment that the royalty investor receives will certainly outperform the yield on a 10-year treasury (especially in this economic environment). Moreover, by investing in multiple royalty streams, royalty investors can diversify their portfolios and hedge against the risk that any single investment performs poorly. Finally, because royalty investors apply a discount rate to the value of the royalty stream, they can usually obtain quality assets at a discounted price.
Engaging in royalty monetisation requires significant preparation. A lot of due diligence is required to identify any issues (and there are always issues) that could or will affect the seller’s ability to monetise its royalty stream. The licence agreement that forms the basis of the royalty stream should be carefully reviewed and analysed to identify everything that could affect the stream’s timing, amount and duration. Royalty reductions, offsets and other adjustments should be analysed to determine potential applicability and the impact of the royalty being sold. In addition, the royalty seller will need to identify any third-party consents (eg, from the licensee/payor) that may be needed before selling the royalty stream.
The key patents and any other material intellectual property protecting the licensed product from generic entry should be vetted and scrubbed to determine how they will likely stand up in an abbreviated new drug application litigation and whether there are any issues that could affect the validity or scope of coverage of the patents in such a way as to materially affect the royalty stream. Regulatory exclusivities, patent-term extensions and supplemental protection certificates will also need to be assessed to determine the likely length of exclusivity. The diligence phase can often take several months, so it is important to focus on this early and start well before outreach to potential royalty investors begins.
Royalty sellers typically engage a legal adviser with substantial experience in royalty monetisation transactions to coordinate the diligence process, help structure the transaction, draft the deal documentation and negotiate agreements with one or more potential royalty investors. They may also engage an investment banker to assist in the valuation, interface with potential bidders for the royalty asset and run a structured bidding process.
Unless the royalty seller has the resources in-house, it (or the investment bank) may also engage a market analysis firm to assess the market for the licensed product(s) and develop sales forecasts for anticipated sales of those products during the royalty period. The results can then be shared with potential bidders and used to support the royalty seller’s own internal valuation. As a general rule, and time permitting, royalty sellers should allow between three and six months to complete a royalty monetisation transaction.
In the past decade or so, royalty monetisation transactions have moved beyond the simple sale of an existing royalty of a marketed product. Transactions are now being carried out not only for commercial products, but also products that are still in development (eg, the CF Foundation transaction described above).
Indeed, transactions are now being structured that do not involve existing royalties at all. These may be carried out, for example, where the royalty seller does not out-license the product to a third party but instead markets the product itself. In that situation there is no licence agreement (and hence no royalty) to monetise. But the same effect can be achieved by creating a synthetic royalty in which the royalty seller sells a revenue interest structured as a percentage of the company’s net sales of one or more products. This was the approach taken by Ariad Pharmaceuticals when it sold off a partial revenue interest on worldwide sales of its chronic myeloid leukaemia drug Iclusig (ponatinib) for $200 million.
Because there is no underlying licence agreement involved in a synthetic royalty transaction, no consent from the licensee is required and the royalty seller has full and complete information regarding the development and commercialisation of the marketed product (which is rarely the case in royalty transactions involving a licence agreement with a third party that develops and markets the drug). Additionally, in a synthetic royalty transaction, it is the seller (not the licensee) that is responsible for making the payments and that provides the basis for underwriting the transaction, which could be an issue in monetisation transactions in which there is a question mark over the seller’s creditworthiness.
In addition, many royalty-based transactions now take the form of secured debt, where the interest and principle under the loan agreement or note is secured by the royalties (or receivables, in the case of synthetic transactions) that are generated by the commercial product and the associated intellectual property and other material assets necessary to commercialise the underlying product. The draw and repayment terms that apply to such indebtedness are typically keyed to major milestone events in the development and commercialisation of the underlying product(s).
This was the approach taken by Clovis Oncology when it raised $175 million to fund a Phase III clinical trial of patients with ovarian cancer for its drug Rubraca (rucaparib), a PARP inhibitor approved to treat certain forms of cancers. Because the terms for the repayment of the loan were linked to the timing and success of the Phase III trial and payment was secured only by assets relating to Rubraca, the loan was non-recourse to the company.
Other royalty-based financings may also include an equity component (ie, the issuance of stock or warrants) that provide the investor with additional potential upside in the event that the company performs well (presumably, in part, based on the company’s deployment of the additional capital raised in the royalty financing).
Earlier this year, Blackstone Life Sciences and Alnylam Pharmaceuticals announced that they had entered into a broad strategic collaboration under which Blackstone will provide up to $2 billion to support Alnylam’s advancement of innovative RNA interference (RNAi) medicines. The deal was anchored by Blackstone’s purchase of 50% of the royalties owed to Alnylam on global sales of inclisirin – an investigational RNAi therapeutic for the treatment of hypercholesterolemia, which was in Phase III clinical trials at the time. In addition to the purchase of inclisirin royalties, the transaction included:
- senior secured corporate debt;
- the purchase of Alnylam equity; and
- funding for certain R&D activities related to the clinical development of two Alnylam investigational RNAi therapeutic programmes in cardiovascular disease.
While most of the transactions in the royalty monetisation space involve patent royalties on pharmaceutical products, they need not be limited to that. Earlier this year, Massachusetts General Hospital (MGH) sold a portion of the royalties that it receives from Takeda Pharmaceuticals on net sales of Entyvio (vedolizumab) for $94 million. MGH receives the royalties in return for issuing Takeda the exclusive licence to a cell-line developed by doctors at MGH.
Vanderbilt University recently monetised 30 years of royalty payments that it receives from the Vanderbilt University Medical Centre under a trademark licence agreement allowing the medical centre to use the Vanderbilt name. The 30-year deal was broken up into a $1.458 billion senior tranche and a $7.452 million equity component. The university retained the right to enforce the Vanderbilt trademarks and the monetisation did not consolidate onto the school’s balance sheet.
As one can imagine, there is a nearly infinite number of possibilities for monetising royalties and product revenues, and no two deals are alike. These transactions are both highly flexible and non-dilutive, making them an attractive alternative to raising financing in the traditional debt and equity markets.
- Identify assets suitable for potential monetisation. These can include royalty streams, milestone payments, earn-outs or virtually any other significant payment receivable under a third-party agreement. They can also include revenue interests on products marketed by the royalty seller itself. Because royalty investors spend significant time and money on conducting due diligence of these transactions, the valuation of the payment receivable must be significant (eg, typically over $50 million).
- Engage counsel to assist in conducting due diligence of the asset and outlining various options for structuring and completing the royalty monetisation transaction (eg, types of transaction (sale of royalty or revenue interest, structured debt), whether and when to engage an investment banker to assist in valuing the asset and/or running an auction process, and a market analysis firm).
- Complete internal due diligence on the asset, including on the licence agreement (if applicable), intellectual property covering the product and regulatory diligence to identify any issues that need to be addressed and develop an action plan to address them. Many issues can be resolved by carefully structuring the transaction.
- Determine how to use the proceeds.