The impact of conditional payment mechanisms on alliance outcomes
Conditional payments are commonly used as one component of the structure of biopharmaceutical alliances. Recent research by Silico Research and IBM showed that 81% of bioparmaceutical partnerships use some form of conditional payment, such as options, milestone and license payments and royalties (n=130). Milestone payments were the most frequently used mechanism with 74% of surveyed partnerships using conditional payments. Option mechanisms, a financial engineering technique imported from the capital markets, were used in 6% of partnerships. Non-conditional upfront payments occurred in 54% of the partnerships.
Conditional payment mechanisms are intended to de-risk the partnership for the party making the payments and motivating the party receiving the payments to achieve important goals or milestones. It follows that if the conditional payment mechanisms are effective then alliances using conditional payment mechanisms should be more successful than alliances that have no element of conditional payment. However, our research suggests that conditional payments are not proving effective. The research showed a correlation of just 0.19 (p = 0.0193) between the use of conditional payments and the success of the partnership.
So what is going on here? Partnerships relying heavily upon conditional payment mechanisms can run into a number of potential problems. A partnership is differentiated from a contract involving a customer and a supplier by an element of shared risk. The correct balancing of risk and reward for both parties is an important element in maximising the chances of the partnership achieving its maximium potential benefit for both parties. If the unequal bargaining power of the parties in negotiations entails too much of the risk being assumed by one of the parties then the partnership will lose much of the benefits inherent in a partnership structure and is more likely to become destabilised at some point during the life of the partnership. The party assuming too much risk eventually becomes demotivated, cuts corners, stops sharing information and looks for an exit from the partnership. This deterioration in the partnership may not become apparent to the other party until it is too late to implement remedial measures.
Because of the lack of data to price the risk appropriately, alliances using complex financial engineering techniques are particularly risky.
We believe that a partnership structure reliant upon financial engineering techniques imported from the financial markets, such as options, is particularly prone to risk of failure. The risk from using options as part of the alliance structure takes two forms. To be an efficient financial engineering tool, options rely upon a complex mathematically-based calculation of risk based upon Monte Carlo simulation, Black?Scholes options-pricing models and other mathematical techniques. This is rational in the financial markets where risk can be measured against thousands of similar transactions over years. Applying similar techniques to licensing deals without a similar volume of comparative data, by necessity, runs a greater risk of mis-pricing the value of the option being granted.
Whether or not the financial risks have been correctly priced, a partnership based on complex financial engineering techniques runs the risk of being misunderstood by one or other of either parties involved in the partnership. It is one thing for a transaction being misunderstood by a financial institution with thousands of similar assets in its portfolio and billions of dollars in reserves, but quite another for a pharmaceutical or biotechnology company relying upon the partnership where such misunderstandings may well be terminal. Having signed the partnership agreement misunderstanding the full implications of the financial struture the partner at the losing end of the financial mechanism will do everything that it can to renegotiate the agreement, failing which, it will try to terminate the agreement.
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