Questions: [email protected] IP Cost of Capital Model A new model for calculating discount rates for IP projects Mike Pellegrino Pellegrino

Questions: [email protected]

IP Cost of Capital ModelA new model for calculating discount rates

for IP projects

Mike Pellegrino

Pellegrino & Associates LLC

www.pellegrinoandassociates.com

August 20, 2009 © 2009 Pellegrino and Associates LLC. All rights reserved. 2Questions: [email protected]

Agenda

• Why CoC is important

• Current CoC method failings

• Key challenges for IP projects

• Factors important for IP projects

• The new model

• Real-world case studies

• Extensions to the model

• Questions & answers


Importance

• Cost of capital = discount rate– Used interchangeably

• Inverse relationship between discount rate and value

• Simple math:– Greater discount rate = Lower value– Lower discount rate = Higher value

• Non-linear relationship between discount rate and value


Discount Rate Impact on $1 Million Annuity

-

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

0% 20% 40% 60% 80% 100% 120% 140%

Discount Rate

Val

ue

Discount Rate Impact


Current Failings

• Current literature discusses discount rate/value impacts well

• Usually along the lines of…– “…the discount rate should properly reflect

the risks of an investment…”

• Magic question:– How does one determine that rate objectively

for an IP assignment?– No material discussion in contemporary

literature on how to do this


Current Failings

• “Aah, but what about CAPM, Build-up, Fama-French, blah blah methods?”

• Woefully inadequate– All are based on stock price valuations of

companies– Little academic research to suggest any

useful correlation to IP projects– A company represents an income portfolio

• Provides diversification, like a mutual fund• IP projects lack this attribute


Current Failings

• Woefully inadequate (continued)…– Methods any lack precision

• Infection disease FDA drug approval rate is 28.1%• Women’s health FDA drug approval rate is 4.6%

– Obviously, women’s health drug is more risky• Yet, contemporary methods assign same discount

rate


The “Alpha” Factor

• But what about the “alpha” factor?– That enigmatic additional premium that a valuation

analyst adds to account for additional risk– Typically based on “experience” and “professional

judgment”

• Really just a random guess– No objective basis for alpha factors– No proven theoretical model– Not testable– Not repeatable across analysts– Should be able to discredit easily under Daubert


IP Project Challenges

• IP is generally a standalone asset– Lacks diversification a company enjoys– E.g., Lilly lost second Prozac patent

• Still stayed in business• Even though patent was worthless and had catastrophic loss

• IP discount rates not directly observable– No reliable proxies in the market– IP has no comparable in the market by definition

• Inherent in foundations of legal protections

• Several key factors important to IP valuation ignored with existing methods


Important IP Factors

• Several factors are very important in IP valuation– The target rate of return the IP owner seeks– The success rate the IP owner has

commercializing the IP– The amount of time the IP owner has to

generate the return– Associated expenses incurred during the

process

• New model addresses all of these factors


New Model

• A new means to estimate a discount rate for an IP project (or any asset for that matter)– Model considers four factors just mentioned– Works for all types of investors, such as

angels, venture capitalists, and public/private companies

– Works for IP in all stages of development– Works in every major industry– Based on empirical data and testable– Relatively easy to use


Investing 101

• Need to understand investing to understand model– Investor puts in dollars, expects a return– Some investments fail– Some are break-even (AKA “living dead”)– Some are winners

• To meet investor’s target returns, cumulative returns for the winner must cover failures and the living dead


For Example

• Investor puts $1 million each into three deals– First deal is a dud and total loss– Second deal is break even– Third deal is a winner

• Third deal has to provide returns on its $1 million, as well as the other $2 million from the other two investments

• Target return is thus VERY important


Holding Period

• The longer the holding period, the lower the project risk– Allows the investment more time to make up

for losses– Similar analogue to young people investing in

risky assets, while the elderly invest in safe assets—the runway is important

– Lowers implied rate of return and discount rate


Holding Period Example

• Suppose you want to double your money in five years– Q: What is the compound annual return?– A: 14.87%

• What if the holding period were seven years?– Compound annual return drops to 10.41%


Holding Period Example

• Assume $1 million investment, 7 year holding period, seeking 20% compound annual return on investment

• Proceeds at end of 7 years are $3,583,181– $1 million represents return of original

investment– $2,583,181 is the gain on the $1 million

investment at a compound annual rate of 20%

• Assumes that investment is 100% efficient with $1 million


Success Rates

• What happens if investment is not 100% efficient in use of capital?– Remember that most investments will fail– Reality is that available capital will be less

than nominal investment amount

• If a company has a 20% success rate, – It has only $200,000 to generate all returns– Remaining $800,000 is sunk to covers failures– Thus, $200,000 must turn into $3,583,181


Eureka Moment

• Eureka moment:– What compound annual rate of return is required to

turn a $200,000 investment into $3,583,181?– The answer is 51.02%– Best part: one can solve this algebraically

• High-level theory:– Account for the expected success rate of the

investment and solve for the compound annual rate of return needed to meet the target return to the investor over the holding period


• The cost of capital formula

• Basic breakdown:– Calculate compound return on investment– Divide that by success rate to “gross up” total returns

to account for investment losses– Then solve for compound annual rate to achieve

grossed up investment returns– Interestingly, investment amount is unimportant

• Cancels out algebraically

Not So Scary Formula

11(

/1

iodholdingPeriodholdingPer

esuccessRat

)targetRatetalcostOfCapi


The Model

• Accounts for all four key components in IP valuation assignments– Changes to any one factor will adjust the risk

of the investment, hence the discount rate– This is good, as it allows valuation analyst to

reflect current economic environment accurately


Holding Period Impact

• Holding period impact:– 20% success rate, target return of 20%, 5 year

holding period• Discount rate is 65.57%

– Increase holding period to 7 years• Discount rate lowers to 51.02%• Have more time to cover failures, so rate lowers

– 40.95% rate with 10 year holding period

• Exponential relationship between discount rate and holding period– As holding period approaches infinity, cost of capital

approaches target return


Holding Period Impact

Holding Period and Required Rate of Return

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

- 20 40 60 80 100 120

Holding Period (years)

Re

qu

ire

d r

ate

of

retu

rn


Project Success Rates

• Different success rates have different value impacts• Good theoretical basis

– The greater the success, the lower the risk– The lower the risk, the lower the discount rate

• Assume 28.1% success rate, 20% target return, 5 year holding period– Cost of capital is 54.68%

• If success rate is 12.0%– Cost of capital jumps to 83.38%– Must account for increased rate of failure

• Exponential relationship between discount rate and success rate

• With complete success, discount rate = target return– Makes sense—don’t have any failures to pay for


Project Success Rate

Success Rate on Cost of Capital

0.00%

50.00%

100.00%

150.00%

200.00%

250.00%

0 20 40 60 80 100 120

Success Rate

Co

st

of

Ca

pit

al


Target Returns

• Model adapts well to different target returns• Assume 20% success rate, target return of 20%,

and 5 year holding period– Discount rate is 65.57%

• Investor changes return from 20% to 15%– Discount rate drops to 58.67%

• Investor changes from 20% to 25%– Discount rate rises to 72.47%

• Direct linear relationship between discount rate and target return


Target Returns

Cost of Capital Based on Target Return

0.00%

50.00%

100.00%

150.00%

200.00%

0 20 40 60 80 100 120

Target Return

Co

st

of

Ca

pit

al


Investment Expenses

• Target returns should always be net of expenses

• What if you’re a venture capitalist?– Or your company has an internal

management fee on a project?– Expenses are a drag on returns– Realized rate of return necessarily must

increase to account for covering expenses

• Model accounts well for expenses


Expense Example

• Suppose you’re a venture capitalist– Raise $10 million fund from an investor– Promise target return of 20%– 2% management fee, 20% carried interest– Expect to win in 20% of deals

• Investor expects $24,883,200 at end of Year 5– $10 million initial investment, $14,883,200

from returns.


Expense Example

• Venture capitalist must generate $24,883,200 return with $2 million after accounting for failures

• At 2% rate, venture capitalist will incur management expenses of $1 million over 5 years– Win must cover that $1 million to meet target

return– Thus, $2 million must now generate

$25,883,200


Expense Example

• Does not include carried interest– Profit to venture capitalist for acumen– Returns must also cover that– Is 20% of total gain on winners– Must gross up the returns with a somewhat

ugly formula


Expense Example

• CIA = Carried Interest Amount

• TIR = Target Investment Returns

• MF = VC Management Fee

• CI = Carried Interest %

MF)TIRCI

MF) TIRCIA

(%)1(

(


Expense Example

• Carried interest expense calculates to $3,970,800– Gets added to the total returns the $2 million must

generate

• Total needed return is now $29,854,000– $10 million is original investment– $14,883,200 is return for investor– $1 million is for management expenses– $3,970,800 is carried interest

• Investment must generate compound annual rate of return of 71.71% to meet that return


The Final Formula

1

*%

1(/1

iodholdingPeriodholdingPer

esuccessRat

terestAmouncarriedInt

iodholdingPergementFeeannualMana

)targetRate

talcostOfCapi


What About Empiricism?

• Theoretical model is only as good as its reflection of reality– Using real-world data makes for a better

estimate of value– This is where existing methods fail for IP

• With new model, easy to prove– All inputs are directly observable– Math is simple algebra– If the inputs change, the output must change

otherwise the discount rate won’t tie out mathematically to meet the target rate


Empirical Inputs

• Holding period– Directly observable in the market

• Venture capital holding period• Pharmaceutical company development period• Remaining useful life of IP (e.g., statutory life)

– Can change over time as market dynamics change

• Existing methods cannot at all account for this behavior


Empirical Inputs

• Target returns– Again, directly observable in the market

• Could be a corporate hurdle rate• Could be target returns listed in a venture capital fund’s

prospectus• Could be based on historical observed performance

– Can change over time • Is based on future expectations• CAPM, etc. are all based on historical results

– Good luck using any CoC method today based on 2008/2009 regression analysis

– Like trying to drive a car forward looking in the rearview mirror


Empirical Inputs

• Success rate– Of course, directly observable in the market

• We know how many companies succeed/fail• We know success rates of serial entrepreneurs versus first-

timers• We know success rates getting drugs to market• We know success rates for software projects by industry• We know success rates getting medical devices to market• We know success rates of branded consumer products in the

market• We know success rates for … take your pick

– Of course, can change over time as well• No other CoC model can differentiate risk based on absolute

success with such detail


Empirical Performance

• Have yet to find a situation where we lacked data and could not use model– At worst case, it reduces to the fidelity of existing

methods– At best, you get a truer discount rate and a truer value

opinion

• Fire investment manager that does not follow the model– They are just gambling– Historical data works against them– If the inputs are true and sound, mathematically, they

are doomed to fail if they do not follow the formula


Real-World Example #1

• Lilly has a new cancer therapy in it is about to take through preclinical trials– CAPM estimates unlevered CoC is 8.08%– Historical success rate through FDA is 15.8%– 10 year holding period– Cost of capital is 29.98%

• Same situation, but drug is in discovery phase. 1/1000 chance (0.10% success rate)– Cost of capital jumps to 115.65%


Real World Example #2

• Same exact drug and development stage as Lilly, except it’s a venture capital deal– 16.4% historical return as of 9/30/2007– Historical success rate through FDA is 15.8%– Shorter, 8 year holding period– 2% management fee ($166M fund size), 20% carried

interest– Cost of capital is 50.52%, 70% higher than Lilly

• Same situation, but drug is in discovery phase. 1/1000 chance (0.10% success rate)– Cost of capital jumps to 183.41%, 58% higher than

Lilly


Model Extensions

• Built in assumptions:– All investment funds provided up front– No dividends until end of holding period– May not be appropriate for certain assignments

• Trivial to extend the model– Demonstrate in Guide how to extend for differences in

investment timing– Demonstrate in Guide how to account for early

payments in before holding period– Both lowers discount rate as investments must cover

less total return


Summary

• Existing CoC methods fail IP projects

• IP valuation has special needs

• New model addresses these needs

• It works

• Based on empirical data

• Easy to prove mathematically

• Easy to extend


Questions

?

Documents

Questions: [email protected] IP Cost of Capital Model A new model for calculating discount rates for IP projects Mike Pellegrino Pellegrino