Blog: Volatility Impacts Frequency of Option-Related Deals
By Gregory Benning
Option-based transactions will play an increasing role in biotech deal-making in 2016-2017, but for different reasons than in the recent past.
As biotech values soared between 2009-2015, buyers and sellers used options to bridge differences between the hot public equity markets and intrinsic value
In 2016-2017, option structures will allow buyers and sellers to offset higher perceived risks created by market volatility and other external risks
[Charts available by request from Back Bay Life Science Advisors, Investment Banking]
Valuing and structuring transaction options to enable strategic goals, funding needs and risk management will be a sophisticated mix of quantitative and qualitative factors.
Biotech option deals will stage a resurgence in 2016-2017, but with different drivers than the past few years. In general, options are used to defer investment decisions, but in the last few years were used more often to bridge significant differences of opinion in valuation, as momentum-driven public market valuations became detached from intrinsic value. In a foreseeably choppy 2016-2017 investment market, options will play a more traditional short-term role: They will become shorter in length, and more tied to near-term data, valuation inflection points and identifiable risk-related timelines. Licensing, partnership and M&A deals take months and sometimes years to put together. When markets move up and down, the resulting chop (as opposed to going steadily up or down) causes risk sensitivities to rise. Options enable bridging time periods of tight capital, high volatility and circumstantially specific uncertainty on either side of a deal: whether cash flow, market, scientific, clinical, regulatory, IP, key employee, organizational, commercial, political, macroeconomic, etc.
Source: RecapIQ. Option deals for June 2011-Present. NBI volatility defined as standard deviation of daily closing price over a 6mo period. Volatility and deal frequency data standardized to respective data sets to facilitate graphical overlay.
Quantifying option value in biotech is unique and complex, given development costs, and the risks during the option contract life and beyond. Option prices are not simply output from quantitative models, upfront payments are often more reflective of cash required to fund operations during the period of exclusivity (plus a buffer period). Parties then determine the appropriate back-end terms tied to that level of upfront financial commitment. Beyond simple fixed deal consideration (whether cash or stock), structured consideration and ongoing development obligations also add complexity to quantitative and qualitative correctly pricing transaction options.It is Back Bay Life Science Advisors’ opinion looking through 2016 towards 2017 that biotech stock market volatility will be high. In particular, political pressure on drug prices regardless of the election outcome will significantly impact day-to-day trading activity. This volatility will not reduce intrinsic value, but from a behavioral finance, perspective will “get into the heads” of investors and deal makers, in the form of higher risk sensitivities.Investors and corporate deal makers should plan to understand real versus perceived risks, and tactically counter this with increased use of transaction options.