Product Valuation, Commercial Equation

We discussed earlier variables that affect the final product valuation+ of a drug in the pharmaceutical industry: the drug molecule itself, the biologic target, safety signals+, the target patients, surrogate measures (e.g., for diseases of long onset), and the disease itself (which typically comes in many flavors). The drug molecule is the tangible product, and all the other variables are found within piles of documentation, publications and the narratives spun within the medical community. It’s within the intangibles where blockbuster+ potential is made, but only as supported by the tangible molecule.

For example, if we are successful at convincing the medical community that lowering cholesterol (a surrogate measure) reduces the risk of heart attack (an amalgam of diseases) then we sell more cholesterol-lowering drugs. The lower you can push the cholesterol and continue to make risk reduction claims, the more you sell. The lower the cholesterol level the broader the target audience, and the more likely you’ll see safety signals. The variables are all interrelated.

There are competitors. It’s our cholesterol reducer versus theirs, and they’re not standing still. We position our product within a competitive marketplace through agreements with distributors, through pricing structures, through convenience features wrapped around the tangible product, through advertising, etc. We often don’t just look at the individual product, rather its affect on the firm’s brand image in the marketplace. Brand matters, and we don’t sacrifice overall brand value for a temporary boost in the value of any one product.

The reader should start to sense that any ‘equation’ purporting to arrive at product valuation will be at best a rough estimate. But we only calculate product valuation to drive productive behaviors using pay-for-performance+. So we err on the side of over-valuation.

Commercial Equation+

Bring in the bean counters. We need the 12-18 variables that most affect product valuation and can be affected by superior work during commercialization+. We build an equation that relates these variables to a single measure of product valuation: revenue, our measure of blockbuster potential. Underneath these 12-18 variables are, of course, hundreds. This calculated revenue, our product valuation, is how we track progress during commercialization. And this calculated revenue will be compared to actual revenue once the product is launched into the marketplace. We reassure commercialization partners that the firm will not lowball product valuation (i.e., calculated revenue) by imposing penalties on the firm should actual revenue exceed calculated revenue (e.g., using ratcheting royalties+). We reassure partners that calculation of their royalty will continue, and will be uncontroversial (i.e., top-line revenue), should the product or firm be sold to another entity.

Product Valuation and the commercial equation do not start from a blank sheet of paper: we have rough drafts developed during graduation+ and purchase of the prototype+ by the firm. And these get further refined during the negotiation process for selection of potential commercialization vendor-partners. We have great confidence in projecting the financial value of the commercialized product. We have a good feel for revenues, add-on products, etc. We have a good feel for product cost structures, marketing and selling costs, and other determinants of product value. We understand the competitive landscape and the regulatory hurdles. Taking all these into account, we confidently build a baseline value for our eventual product. Think of this as a rather complex Excel™ spreadsheet that lays out all the major variables in the Commercial Equation to arrive at a projected product value.

Details on how the Commercial Equation gets built and refined over the course of commercialization are complex, but manageable. This one spreadsheet can be worth tens of million of U.S. dollars to the parties involved in the contract. Since competition for the contract is intense, we leverage the insights of all the bidders to come to a workable solution. There is but one Commercial Equation used to calculate product valuation, which determines the performance rewards for all vendors. Everyone involved has a significant stake-in-the-game, and a common interest in the performance of the entire team. Over time, selection of the 12-18 variables for any prototype and the process for keeping the commercial equation up-to-date will settle down. Vendor-partners (and the franchisee+) will then focus on work activities that most drive a good product valuation at the end of commercialization.

Caution

We will have product valuation for all the prototype in commercialization. The temptation to add up these values and include them in the firm's financial forecast will be irresistible. This in turn leads to meddling. We pushed prototype build into separate legal entities, franchisees, to minimize this meddling. It’s back once the firm purchases the prototype.

We minimize meddling through the use of pay-for-performance. Vendors-partners-franchisees care, deeply, about the valuation of their prototype and will mightily resist meddling that endangers that valuation. Franchise benefits+ includes protections against harmful meddling, guarded by an independent franchise operations+, as discussed in the August 2010 home page discussions. The firm will not have unconditional (or even overwhelming) rights to the prototype. Their rights are contingent on agreements built into innumerable legal contracts with all the players in commercialization.