Types of real options

The different types of options model the different ways a company can react to new information.

The management’s flexibility is thus embedded in several different real options. The different real options where it is possible to either exercise it or let it pass are described as simple options (Copeland & Antikarov, 2003, p.121). The multifaceted real options are described as advanced options (Kodukula & Papudesu, 2006, p.145).

First we will discuss the simple real options we perceive as most important for the biotech industry and then the advanced options which are most often encountered.

Financial Options Real Options

‐ Short Maturity, usually in months. ‐ Longer maturity, usually in years.

‐ Underlying variable driving its value is equity  price or price of a financial asset.

‐ Underlying variables are free cash flows,  which in turn are driven by competition,  demand and management.

‐ Cannot control option value by manipulating  stock prices.

‐ Can increase strategic option value by  management decisions and flexibility.

‐ Values are usually small. ‐ Major million and billion dollar decisions.

‐ Competitve or market affects are irrelevant to  its value and pricing.

‐ Competition and market drive the value of a  strategic option

‐ Have been around and traded for more than  four decades.

‐ A recent development in corporate finance  within the last decades.

‐ Usually solved using closed form partial  differential equations and simulation/variance  reduction techniques for exotic options.

‐ Usually solved using closed‐form equations  and binominal lattices with simulation of the  underlying variables, not on the option  analysis.

‐ Marketable and traded security with  comparables and pricing info.

‐ Not traded and proprietary in nature, with no  market comparables.

‐ Management assumptions and actions have  no bearing on valuation.

‐ Management assumptions and actions drive  the value of a real option.

3.1.3.1 Simple real options 3.1.3.1.1 Option to abandon

If a project develops worse than estimated and fails to live up to the expectations, the project management can consider abandoning the project and thus saving future costs related to the project (Kodukula & Papudesu, 2006, p.102). For projects where the NPV is very marginal the abandon option is particularly important as even minor changes to the estimates can change the outlook from profitable to loss-making.

3.1.3.1.2 Option to license

Often biotech companies do not have the capital, organization and distribution power to maintain several late-stage drug development projects and/or market them. The option to license gives the companies the right to sell some degree of the project often to a larger pharmaceutical company, who has the capacity and funds to market the drug worldwide if that is needed. In exchange for these rights the biotech company receives capital on an ongoing basis in the form of milestone payments and royalties. This allows the company to maintain a constant focus on research without having to wait for a drug to be launched and in this manner new capital is injected.

For biotech companies this is a very important option as it allows them to focus on several different drug development projects and thus maintain a diversified product portfolio (Copeland

& Antikarov, 2003, p.126).

3.1.3.1.3 Option to defer

The option to defer can be viewed as a trade-off between risk and return (Bogdan & Villiger, 2008, p.54). In a high-uncertainty environment the option to wait can be used to get more information about the market potential or the abilities of the drug and thus defer the decision on continuing or discontinuing the research program until a more certain outlook for the sales potential has been obtained. By waiting to further invest in the drug development the cash flows will occur later in the future and consequently be discounted with a higher factor. Also the protected period for patented sales will be shortened and it will compete with generic productions earlier.

The value of the option to defer will diminish with the degree of competition in the industry. By waiting, the competitors will get the opportunity to obtain a first mover advantage if they choose

to invest. Thus the higher the barriers to entry in the industry are, the more valuable an option to defer is (Kodukula & Papudesu, 2006, p.126).

3.1.3.1.4 Option to expand

In industries with a high growth rate the option to expand can be very useful and value-adding (Kodukula & Papudesu, 2006, p.110). Projects with a low or even negative NPV may in the long run provide added possibilities if the market develops in the desired direction. But these

possibilities only occur if the initial investment has been made. So in order to make a profitable investment at a later point in time it is essential that the foundation has been laid. It can be the expansion of a manufacturing plant if demand rises (Copeland & Antikarov, 2003, p.12) or the testing of a drug in one market before the decision is made on whether to launch in all markets (Bogdan & Villiger, 2008, p.55).

3.1.3.1.5 Option to contract

This real option incorporates the possibility to scale down the project if the market does not develop quite as anticipated. It can be production facilities that need to be scaled down if demand suddenly fluctuates. Accordingly it is important that the management is aware of that future option when the facility is being designed and built. Also the option to outsource parts of the value chain is considered an option to contract (Kodukula & Papudesu, 2006, p.116). Thus this option has had growing importance for nearly all industries in the last decades due to wage increases in the Western World.

3.1.3.1.6 Option to switch

In markets with high uncertainty and long time horizons the option to switch can be of high value. Due to the low visibility in the markets sudden changes in consumer demand can be very difficult to predict 5-10 years ahead. The project can be designed in such a manner that it is possible to alter the final output if consumer sentiment differs from what was expected. It could be the possibility of an automobile producer to change the motor from gasoline-driven to a gas-electric hybrid if the environmentally-friendly wave kicks in sooner than expected (Mun, 2002, p.241). Or the possibility for a detergent producer to switch from a powder solution to a liquid solution if that is what consumers dictate.

3.1.3.2 Advanced real options 3.1.3.2.1 Compound option

A compound option can be described as an option on options (Copeland & Antikarov, 2003, p.12). In multiphase projects this option is very common as the initiation of one phase is dependent on the completion of the earlier phases or in other words the exercise of the earlier options (Kodukula & Papudesu, 2006, p.61-62). Therefore the value of compound options is contingent of the value of other options (Copeland & Antikarov, 2003, p.163). Due to this cohesion between several real options a compound option is described as an advanced option.

3.1.3.2.2 Rainbow option

When there is more than one type of uncertainty embedded in the option, it is called a rainbow option (Copeland & Antikarov, 2003, p.221). This is often attached to development projects as there is a technological risk regarding the efficacy and safety of the product and then a market related risk which determines the sales potential.

3.1.3.2.3 Learning option

If some kind of resolution of the uncertainty either related to the technological risk or the market risk occurs during the span of a real option it can be called a learning option (Kodukula &

Papudesu, 2006, p.62). The example of making a pilot test of a drug in one market before making a full scale launch, as described in the part about the option to expand, would be considered a learning option.

Figure 3.1: Own construction   

License

Expand

Contract

Switch Defer Abandon

Compound Rainbow Learning License

Expand

Contract

Switch Defer Abandon

Compound Rainbow Learning

A combination of simple options constitutes advanced options

3.1.3.3 Compound, learning and rainbow options

In a bigger perspective all the different simple real options of a drug development project can be seen as parts of a compound, learning and rainbow option as illustrated in figure 3.1. At the end of each phase in the development process any of the options available can be chosen or things can continue as planned based on the findings of the most recently completed phase. The options in the earlier phases can especially be viewed as rainbow options as both the technological risk and the market risk are very much present. As the project approaches market launch the

technological risk will diminish and at the end the options will almost solely be based on market risks and thus can no longer be considered rainbow options.

For drug development projects the single most important option is the option to abandon a project when it is not profitable anymore. The other mentioned option also creates value but not on an everyday basis as the option to abandon does (Bogdan & Villiger, 2008, p.56).