Royalties are like the Gumby of the biotech world. They're flexible to fit companies' needs when they're set up, and they can be bought and sold once they're established.
When setting up a licensing deal for a drug, everything is up for negotiation and the different parts -- upfront, milestones, and royalty payments -- are all fungible. Where the majority of the money ends up depends on how much risk each side wants to take.
Upfront payments are risk-free for the company licensing the drug. Just like a sale, that cash comes when the deal closes. Milestone payments are more risky since they're dependent on clinical or regulatory success. Finally, royalties and milestone payments tied to sales are the most risky because they're completely tied to the drug's financial success.
Biotechs willing to take on the extra risk by forgoing some of the upfront cash can usually get a higher royalty rate down the line.
The structure of the deals can be very complex. Momenta Pharmaceuticals (Nasdaq: MNTA ) and Novartis' partnership for developing generic Lovenox started out as a profit-sharing agreement, but when Sanofi launched an authorized generic, it turned into a hybrid royalty and profit-sharing agreement. If another generic ever launches, the agreement calls for straight royalties to be paid to Momenta.
While most royalties are established when a company licenses a drug, it's possible to get cash by establishing a synthetic royalty even after a drug is already on the market. Funds such as Cowen Healthcare Royalty Partners and Paul Capital give biotechs money upfront in exchange for a cut of the revenue from the drug, but the biotech retains the rights to sell the drug.
All royalties, whether they're currently generating cash or not, have a value. In its simplest form, the value is defined by the estimated amount the royalty will produce over the life of the product discounted back to today's dollars. In reality, it's a little more complicated than that, especially for drugs that haven't been approved yet, because the value has to be discounted to take into account the possibility that the drug might not produce the royalties as expected.
And since royalties have value, they can be bought and sold. Sometimes funds buy the royalties. For instance, Cowen purchased the royalties that Aeterna Zentaris (Nasdaq: AEZS ) was due on sales of Cetrotide that Aeterna Zentaris licensed to Merck Serono. More recently, Dendreon (Nasdaq: DNDN ) sold the royalty it was owed on sales of Merck's (NYSE: MRK ) Victrelis for $125 million to CPP Investment Board.
Just like royalties can be structured to fit the needs of companies when established, they can be made complicated when sold. POZEN recently sold most, but not all, of the future royalty and milestone payments it's due from GlaxoSmithKline. Under the agreement, an undisclosed investor gets all the royalties on Treximet and related products now through the first quarter of 2018. After that, POZEN gets 20% of the royalties.
Sometimes it's the company that owes the royalties that ends up buying them back to eliminate the cost. A few years ago Vertex Pharmaceuticals (Nasdaq: VRTX ) sold its royalties on Glaxo's Lexiva and Agenerase back to Glaxo. More recently, BioMarin Pharmaceuticals eliminated the royalty it owed to SA Pathology. The biotech spent $81 million to buy the patents covering its orphan drug Naglazyme from the hospital group in Australia. By eliminating the 5% royalty owed to SA Pathology, BioMarin estimates it'll save $10 million-$15 million per year, paying back the cost of the purchase in six to eight years.
If you're interested in being on the receiving side of the royalties, have a look at PDL Biopharma (Nasdaq: PDLI ) . The company spun out its research group, Facet Biotech, a few years ago, which was eventually bought by Abbott Labs. What's left is royalties collected from its patents on humanized monoclonal antibody drugs including Roche's Herceptin, Lucentis, and Avastin, and Tysabri from Elan (NYSE: ELN ) and Biogen Idec. The company returns most of the cash to shareholders in the form of a dividend that currently sits at 10%.
The company is in the midst of searching out additional royalty streams to purchase, so you'll have to trust that management can make smart purchases, but it means there may be life to the company after the humanized monoclonal antibody patents run out.
If you're looking for more dividend ideas, grab a copy of the Fool's report "Secure Your Future With 11 Rock-Solid Dividend Stocks." Just click here to get your free copy.