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Pharmaceutical Up-Front Licensing Fees, Paul Betten, LES Dec

Pharmaceutical Up-Front Licensing Fees
BY PAUL BETTEN, PH.D.*

Abstract

A general discussion of up-front
licensing fees is presented for market
entry and emerging pharmaceuticals, along with a theoretical discussion on why up-front fees should be
considered as a part of every license.
The same up-front fee discussion
applies to other technologies. This
paper provides practical advice on
how to determine pharmaceutical up-front and milestone fees. A
survey of pharmaceutical up-front
fees, along with a suggested valuation approach, is provided to aid
the licensing officer in valuation and
eventual negotiations.

Introduction

P

harmaceutical and biotechnological technologies have
consistently been areas in
which large licensing fees have been
negotiated. However, there is no information in the open literature on
how pharmaceutical up-front licensing fees are determined. A number of
papers discuss valuation methods,
but these are general discussions
and no specific models or valuation
methods are provided.1,2,3 Thus, the
licensing executive is not only left to
“guess” at a value, but also lacks a
consistent, repeatable, logical method for determining an appropriate
up-front or milestone payment. It is
noted by Degnan and Horton4 from a
survey that only 60% of licensors ask
for an up-front fee. One may wonder
why, but could it be because there are
1. L. Somogyi, “Determining Royalty Rates in
Health Care,” les Nouvelles, December 1993.
2. M. Yamasaki, “Determining Pharmaceutical
Royalties,” les Nouvelles, September 1996.
3. M. Pohl, “Valuing Pharmaceutical I.P.,”
Pharmaceutical News, Vol. 8., No. 1, 2001, pp.
42-45. Also see “Valuing Pharmaceutical I.P.” ,
available at http://licensinglaw.net/Library.asp
4. S. Degnan and C. Horton, “A Survey of Licensed Royalties,” les Nouvelles, June 1997.

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no well documented or referenced
methods for determining up-front
fees? Because a pharmaceutical
has to pass through several Food
and Drug Administration (FDA)
approvals, milestone payments are
often associated with FDA approval
for a particular phase. In this paper,
milestone payments are discussed
and are assumed to be part of the
up-front fee valuation, where one
may think of the initial up-front fee
as being split into several installment
(milestone) payments.
Running royalties are another area
of interest, and may be used in negotiations as a trade-off for up-front
fees. As the focus of this paper is
up-front fees, running royalties are
mentioned here only for completeness. The 25% rule provides a basis
for calculating a first royalty estimate (Note: the 25% rule suggests
taking 25% of the product profits as
a running royalty). Additional royalty information can also be found
in general “industry standards”
tables. According to two recent
surveys,5,6 average pharmaceuticals
running royalties are calculated to
be 5.1% (an average over the years
of 1980-2000) and 7.0% (an average
over the years of 1986-2002). These
recent values are within a wider
range suggested in the licensingout survey of royalties provided by
McGavock, et. al7 where 67% of the
pharmaceutical rates are in the 5%10% range. The McGavock survey
is widely quoted and reproduced in
a number of sources including the
AUTM Handbook.

The purpose of this paper is to
present a basis for understanding that an up-front fee should be
considered as a part of any license.
This paper continues the up-front
fee valuation process by providing
a suggested valuation approach
based on total lifetime market sales,
along with a survey of university
pharmaceutical up-front licensing
fees. It is hoped that this survey will
provide a reference and consistent
approach for the licensing executive
to determine the initial value of these
up-front fees.

5. R. Goldsheider, J. Jarosz, and C. Mulhern,
“Use of the 25 Per Cent Rule in Valuing IP,”
les Nouvelles, December 2002.
6. Licensing Economics Review, “Industry Royalty Data Summary,” December 2002.
7. D. McGavock et al., “Factors Affecting
Royalty Rates,” les Nouvelles, June 1992.

*Paul Betten is the Software Licensing
Manager and Senior Account Manager
for Business Development and Marketing at the Technology Transfer Office,
Argonne National Laboratory, Lemont,
Illinois.

Why Ask for an Up-front Fee?

There are many reasons one can
propose asking for an up-front licensing fee:
• Itʼs standard business practice
and we are acting in a business-like
manner.
• Our policy requires an up-front
fee for licenses (similar to a down
payment on a house).
• We need to recoup patent and
administrative costs.
• We need to partially recoup R&D
expenditures.
• All licensors in the field ask for
one!
• We want to maximize institutional income.
• It gives both the institution and
the inventors immediate returns.
• It increases licensee commercial
commitment.
• The licensee shows more commitment by paying an up-front fee.

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December 2003

Product Sales and Marketing Cycle

Most people who have taken a
marketing course have seen the
product sales and marketing curve,
and the related profit curve, as
shown in Figure 1. This sales curve
is generic in shape and applies to
products ranging from “hula hoops”
to airplanes to nuclear reactors, with
only the cost and time coordinates
varying with product type. Products are generally considered to
have four stages: (1) Introduction,
where the product is introduced and
sales are slow in starting and gaining market acceptance, (2) Growth,
where the product is started to be
accepted by the public and sales
grow rapidly, (3) Maturation, where
the product has reached saturation
in the market and additional sales do
not occur, and (4) Decline, where the
product is decreasing in market acceptance, sales decline, and the product is eventually abandoned. Profits
from product sales follow a similar
behavior; however, there is a time
lag after product introduction before
profits occur. This lag occurs because
initial product startup and marketing costs, as well as other “sunken”
costs, must be repaid before profits
can occur. Profits also stop in the
decline stage of a product because
they are directed toward product
manufacturing shutdown costs. It is
important to note that Figure 1 represents a successful product life cycle.

As will be noted later, only about 1
in 10 of the introduced products will
be wildly successful, with the other
9 failing or having only limited market success.
The dream of most product managers is to find another product use
in a totally different field of use. This
diversification, known as market segmentation, permits a rise in sales and
profits because product cost reductions can occur as a result of eliminating or reducing the sales stages
of Introduction and Growth, and the
sunk costs associated with building
the first plant are already returned.
Nylon is a typical example of market
segmentation in a product in which
initial sales were limited to industrial
uses, but quickly spread to clothing,
tire reinforcement, carpet fibers, automotive components, etc.
Understanding how a technology
fits into the product sales cycle is an
important factor in determining the
up-front licensing fee. That is, the
initiation of product profits will depend on the time needed to develop
the Introduction and Growth stages.
Licensees may be reluctant to commit
a large up-front licensing fee if profits are perceived to occur many years
in the future. This is especially true
for pharmaceuticals and emerging
technologies where the product and
market are not well defined or there
is a substantial time delay before
market penetration.

Figure 1. Product Life Cycle Sales and Market Entry Curve
Additional New Use
Market Segmentation
+

Product Sales

Dollars

• It provides a trade-off mechanism for royalties using a net present
value calculation.
• It represents the “current” value
(lump sum) of the technology.
One could consider an up-front
fee analogous to the down payment
on a home mortgage. The larger the
down payment, the more the bank is
convinced that the home purchaser
is seriously committed to buying
and paying off the mortgage. Thus,
an up-front fee demonstrates the
seriousness of the licenseeʼs intent.
The larger the up-front payment, the
larger the financial commitment to
commercialize the technology.
Another viewpoint this author
currently favors is to view an upfront fee as the “now” value of a
technology, and the running royalties as the “future” value of a
technology. Letʼs consider a pharmaceutical example. As is noted in
Table 1, which summarizes FDA
approval percentages as a function
of clinical trial stage, only about 1
drug in 5,000 will make it through
the Federal Drug Administration
(FDA) drug approval process from
pre-clinical trials to drug approval
and commercial release. Specifically,
the table indicates that out of 5,000
pre-clinical drug trials, only 5 will
make it into the FDA approval process (99.9% failure rate). Of those 5,
about 1.3 will fail during each phase,
with only one actually making it to
market (80% failure rate). These are
extremely high failure rates, and
conversely it is reasonably safe to
conclude that 4,999 of the licensors
will never see any running royalties
on sales. Thus, if running royalties
represent the future value of the
technology, 4,999 of the drugs will
have no running royalties and the licensor will receive no income other
than the up-front or milestone fees.
For the one licensee who makes to
market it, the future value will be a
“big hit” involving running royalty
payments. For the licensor, however,
the up-front fee, either as an annual
option payment or milestone payment, will be the only licensing
income seen. Thus, the up-front
fee represents the “now” or current
value of the technology.

0

Profits

Introduction

Growth

Maturity

Time

Decline

+

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The licensee should be aware
of the total product life cycle, as
shown in Figure 2, to fully understand the sunken costs in developing a new product and how those
costs can impact the up-front licensing fee. Figure 2 represents a
generic product curve, as in Figure
1, where time and cost are shown
as coordinates. For simplicity, it is
assumed in this example that all
sunken costs are absorbed by different departments within a single
organization. The total product life
cycle starts with an inventor having
an idea and reducing it to practice,
with expenditures being made and
covered for by the current project.
If the idea is patentable, a patent is
filed, and this is denoted by an increase in sunken costs. Patent costs
are then covered by another part of
the organization, generally the legal
or technology transfer department,
depending upon the organizationʼs
policies. (For universities, licensees
may be sought at this time, as well
as sponsored research for prototype development and small-scale
manufacturing operation. This is
also the “valley of death” where
R&D funding runs out but no commercial organization is interested in
providing funding until pilot plant
data are available.) The technology
transfer process now starts in earnest
and effort proceeds on developing a
pilot plant and operational parameters for large-scale manufacturing.
Often, the pilot plant production will
be used for creating a limited volume of products for market testing
or for the Introduction market stage.
Sunken costs now become greater as
the pilot plant is built and production increases. If all goes well, the
organizationʼs marketing department starts advertising seriously to
create a product “buzz” so that the
public will want the product. This
incurs still more sunken costs. Thus,
as noted in Figure 2, a substantial
sunken cost has been incurred by the
company when the product is ready
for introduction into the market, yet
no sales have occurred. Once sales
and market gains occur, profits begin
to accrue, and the sunken costs are
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recovered slowly as sales increase
and the transition to the Product
Sales and Marketing Cycle (Figure
1) develops. The total expenditures
to develop a product, or the sunken
costs, are often referred to as the total
replacement cost (TRC). The TRC, or
more often a certain percentage of
it, is often used in technology valuations to estimate the “value” of the
technology. How the TRC can be
related to up-front fees will be discussed subsequently in this paper.
It is generally stated that for general product development only one
product is successful from among
1,000 ideas. That is (as indicated in
Figure 2 by the product numbers at
the top of the figure), 1,000 ideas
develop into 100 trial products that
are further reduced to 10 products
introduced into the market, but
only 1 product will be a success.
It is this one success that pays the
sunken costs for the 1,000 ideas, 100
trial products, and 10 market introduction products. If a company is
skillful, it may be able to provide
2 or 3 market successes out of its
10 market entry products, and that
will provide an even bigger return
to the company. Similar success statistics occur for venture capitalistsʼ
investments in startup companies.
Out of 10 startups, a good return
is one “home run,” perhaps two
“doubles” and two “singles,” with
the rest being “strike outs.”8

For pharmaceuticals, the total
product cycle curve in Figure 2 is
applicable; however, more sunken
costs occur as the product cycle
curve is changed to accommodate
additional spending in each of the
three phases of the FDA approval
process noted in Table 1. Literature
indicates that drug research and development (R&D) costs are rising, as
is the success rate of drug approvals.
In 1993 the FDA9 reported that $390
million of R&D funds are needed to
develop a new drug, and this represents the pharmaceuticalʼs total sunk
cost needed to be recovered so that
a new drug can become profitable.
In 1998, Merckʼs annual report 10
indicated that it takes $500 million
and 10-15 years of effort to develop
1 drug out of 5,000. The following
year, the FDA9 reported new drug
costs and success rates as identical to
those reported in the Merck report.
In 2003, the Pharmaceutical Research

8. AUTM Startup Course, “Investors and
Capital Sources,” Terry D. Bibbens, Small
Business Administration, September 25,
2000, Arlington, Virginia.
9. Food and Drug Administration (FDA),
“From Test Tube to Patient: New Drug Development in the United States,” 2nd Edition,
1995 (Order code 8307, 017-012-00400-8). Updated in 1999. Also see FDA web page: http:
//www.fda.gov/dfac/secial/newdrug/begin.htm
10. Merck & Company, “Merck 1998 Annual
Report,” p. 6. Also see http://www.merck.com/
overview/98ar/p6.htm.

Figure 2. Total Product Life Cycle Birth to Death Expenditures
1000 Ideas

100 Trials

Licenses Sought

Idea

+

Dollars

The Total Product Life Cycle

10 Products

1 Success
Sales Curve
Profits

Reduction
to Practice
0

Patent Filed
Pilot Plant

Time

Shutdown
Costs

+

Total Expenditure/Profit Curve
Marketing
Starts

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and Manufacturers Association11 indicated that the total R&D cost for
a new drug has risen to an average
of $802 million, and that only 3 out
of 10 new drugs brought in enough
revenue to cover the average development cost12.

Valuation and Total Replacement Cost

In the physical sciences, two methods have been suggested for determining up-front fees. Heller13 suggests using the standard industrial
classification (SIC) codes to estimate
the lifetime net sales in a market, for
a specific product and market share,
and then using an empirical factor
as a multiplier times the total market
sales to determine the up-front fee.
For sales (a) less than $1 million,
Heller suggests a multiplier between 0.5 and 0.9% (0.005-0.009) for
a minimum and maximum value,
(b) between $1 and $50 million,
Heller suggests a multiplier between 0.1 and 0.6% (0.001-0.006) for
a minimum and maximum value,
and (c) for sales over $50 million, a
multiplier of 0.01-0.1%(0.0001-0.001)
is suggested. Thus, if total market
sales are estimated to be $2 million,
and an average factor of 0.3% (0.003)
is used, the suggested up-front fee
would be $6,000.
In another method, Betten14 suggests that emerging technologies
use a multiplier with the R&D
modified replacement cost (MRC)
to determine the up-front fee. The

logic is that market sales are probably more than three to five years
away, and the market is too difficult to estimate. Betten suggests
varying the multiplier from about
5% of the MRC for a non-exclusive
license, and up to 15% of the MRC
for exclusivity. The MRC is generally taken to be about 25-33% of the
total replacement cost or, stated another way, “knowing what you now
know,” how much time and unique
instrument costs are needed to recreate the technology? For example,
if the TRC is taken to be $1 million,
the MRC would be about $250,000
(assuming the 25% factor for ease of
calculations), and a non-exclusive license up-front fee would use a 5%
multiplier, resulting in a suggested
up-front fee of $12,500.

A Pharmaceutical Total Market
Valuation Model

In the pharmaceutical area, as
noted earlier, some authors1,2,3 suggest using a multiplier of the total
market value of the product; however, no specific factor is provided.
In an ad hoc discussion at an AUTM
meeting, an emerging pharmaceutical drug rule-of-thumb was provided. The valuation process starts with
determining the total lifetime sales
market. If there are multiple products possible from this drug, and
there is interest in several countries,
then the market should be estimated

for each product and each country. A
multiplier of 0.5% (0.005) times the
total market value is used to estimate
a “total valuation” for the drug. Surprisingly, this multiplier is within
the range suggested by Heller for
physical science technologies. The
up-front fee is taken to be a percentage of this total valuation number,
depending on the FDA phase. In
this instance, when the drug is in
pre-clinical trials, the up-front fee is
taken to be about 10% of the valuation, with the remaining 90% to be
split into milestone payments and
back-loaded with higher payments
in later FDA phases. One may arbitrarily suggest 20, 30, and 40% of the
valuation number for milestone payments at the end of Phases 1, 2, and 3,
respectively. Alternatively, one could
suggest an increase of 30% per phase
(i.e., a 30% increase per each of three
phases would add up to 90%). For
example, if the estimated total sales
market is $1,000 million, the drug
total valuation would be 0.5% of
sales, or $5 million. The up-front fee
would be 10% of the total valuation,
or $0.5 million. The remaining 90%
of the total valuation, $4.5 million,
would be arbitrarily split into milestone payments for the completion
of each phase at 20, 30, and 40% of
the total valuation. This translates
into suggested milestone payments
of $1 million, $1.5 million, and $2
million for Phases 1, 2, and 3 respec-

11. Pharmaceutical Research and Manufacturing Association, “Most Drugs Never
Recoup the Average Cost of Development,”
http://www.phrma.org/publications/quickfacts/
16.04.2003.717.cfm. Also see: J. A. DiMasi, R.
W. Hansen, and H. G. Grabowski, “The Price
for Innovation: New Estimates of Drug Development Costs,” Journal of Health Economics
22 (2003): 151-185.
12. Pharmaceutical Research and Manufacturing Association, “Most Drugs Never
Recoup the Average Cost of Development,”
http://www.phrma.org/publications/quickfacts/
16.04.2003.717.cfm. Also see: H. G. Grabowski, J. Vernon, and J. DiMasi, “Returns on
Research and Development for 1990s New
Drug Introductions,” Pharmacoeconomics,
Suppl. 3, 11-29 (2002).
13. P. Heller, Texas A&M University System,
College Station, Texas, August 1999 AUTM
Central Meeting.
14. P. Betten, “5% Solution to Pricing Software
IP,@ les Nouvelles, September 1999.

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tively. If a drug is already in Phase
1 and licensing occurs, the up-front
fee of 10% and the Phase 1 fee of 20%
could be combined into a fee of 30%
of the total valuation. These up-front
and milestone fees are always technology– and market-dependent,
with final values left to the skill of
the negotiators.

Survey of Pharmaceutical Fees

In late 2001 a survey of 10 universities was made to determine
the pharmaceutical licensing fees
the universities negotiated in preclinical trials and the different FDA
phases. About 160 data points were
collected; the results are shown in
Table 2. The universities asked for
business confidentiality on the data
so only a range and low and high
payments are provided. The survey
indicated that pre-clinical payments
are in the $10,000-$50,000 range and
tend to be annual payments until
the drugs enter FDA testing. Once
in the testing phase, milestone payments are generally associated with
approval in each phase, with the
payments increasing as each phase
is passed. In some instances a milestone payment is associated with the
individual new drug (IND) application. In the later phases, milestone
payments may be associated with
the new drug application (NDA)
or the product license application (PLA). When the NDA/PLA
is filed/approved, the universities
indicated milestone payments in
the range of $500,000 to $2 million.
Low and high values are noted in the
table, and these can vary greatly depending on the potential market. It is
noted that in collecting the data, not
all universities collected milestone
payments at the end of each FDA
phase, with payments at the end
of Phase 1 (IND filing) and Phase
3 (NDA/PLA) approval being the
common occurrence. In subsequent
discussions with the universities,
most agreed that one should try to
collect milestone payments at the
end of each testing phase; however,
this is not always possible. It may be
that drug technologies, the markets,
and the corresponding negotiations
are complex, and other factors enter into the negotiations that make
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milestone payments inapplicable at
every phase.

Conclusions

The ability to determine up-front
fees in the pharmaceutical area is
more of an art than a science, with
high weighting on negotiation skills.
There are essentially no open-literature publications on the value
of up-front fees, how to determine
them, and a strategy for their use.
A discussion of the “hows”, “whys”
and logic of determining up-front
fees has been presented. Another
purpose of this paper has been to
present selected methods or models
that can be used to determine such
fees. A pharmaceutical model based
on taking a percentage of the total
lifetime market sales is provided.
Surprisingly, this pharmaceutical
model is somewhat similar to another model used in the physical
sciences. In addition, a survey has
been compiled to provide a basis to
empirically select such fees based on
university-industry standards.
The determination of up-front fees
is complex and confusing because of
a lack of valuation models and the
difficulty in making an accurate
but representative assessment. At
one end of the spectrum there is
hesitancy (by either the licensee or
licensor) to reveal what was paid
because the fee may be very low
and the technology may be perceived as having been given away.
At the other end of the spectrum,
the ability of licensee or licensor to
estimate total lifetime sales is an indeterminable problem. It is only an
educated guess, even when consultants are used, and such a number
can be documented only at the end
of the drugʼs life. Few can predict

their lives several years ahead, let
alone accurately predict the total
lifetime market sales of a drug over
the course of a decade or two. It is,
of course, left to the negotiators to
sort out these issues and eventually
evaluate the drug technology and
determine whether it merits the
proposed licensing fee. It is hoped
that a licensing staff may be able to
use the methods provided here to
provide consistent, repeatable, and
reasonable estimates of up-front fees
that will gain the trust of users in additional future valuations. Further, it
is hoped that this paper will encourage others to report their methods or
to develop other models and surveys
to further develop a larger database
that future licensing staff may draw
on—not only to help determine upfront fees—but to gain new insights
into the process of valuation.

Acknowledgements

The author would like to thank
Michael Moore, University of Minnesota, Minneapolis, for his comments and insights on reviewing
the survey data. The author would
also like to thank those universities
that participated in the survey.
This manuscript has been created by
the University of Chicago as Operator
of Argonne National Laboratory (“Argonne”) under Contract No. W-31-109ENG-38 with the U.S. Department of
Energy. The U.S. Government retains
for itself, and others acting on its behalf,
a paid-up, non-exclusive, irrevocable
worldwide license in said article to reproduce, prepare derivative works, distribute copies to the public, and perform
publicly and display publicly, by or on
behalf of the Government.

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