Every day development-stage drugmakers are faced with a question that will affect the future of the company for years to come: Partner up or go it alone?

Risk and reward. They move in sync with each other. It's the nature of the game.

If a drug company keeps the full rights to its drug, it'll have all the profits down the road. But it might not have enough cash to get to the destination. License out the drug to Big Pharma, and it might live to get there, but at a cost. And if the drug turns out to be a flop? Alone equals death, partnered equals a chance at life.

What do companies get for giving away part of their future revenue stream? The deals can be structured in a variety of different ways, but they almost always come with two components: an upfront payment and later payments based on milestones, fondly referred to as bio bucks (they're like monopoly money, at least until those milestones hit). The bio bucks aren't completely worthless though. Vertex Pharmaceuticals (NASDAQ:VRTX) was able to sell off some of its future milestone payments at a discounted price.

The size of the bio bucks depend on a variety of factors:

  • How much risk remains. Phase 3 compounds, much closer to submission and approval, are worth more than drugs that have just completed the much earlier phase 1.
  • Potential sales of the compound if it's approved. A potential blockbuster is worth more than a drug that treats a small market.
  • The size of the upfront payment. Abbott Labs (NYSE:ABT) made a rather large payment for a drug candidate last year that came with a relatively small milestone payment. Deals can also go the other way, with small upfront and large milestone payments.
  • How much the owner is still contributing to the development of the drug. In some instances, like Exelixis' (NASDAQ:EXEL) deal with Bristol-Myers Squibb (NYSE:BMY), the original developer can give up milestone payments in exchange for codeveloping the drug -- sharing costs today and future rewards.

Not if, but when
Some brave drugmakers still have to find a big brother to partner with even after they've taken the risk and funded the phase 3 development on their own. For drugs that treat a large market, it's just too expensive to field a large sales force to market the drug.

Mannkind tried to get a partner before a Food and Drug Administration decision on its inhaled insulin Afrezza, but it couldn't find any takers -- at least not for the terms that Mannkind wanted. So the company rolled the dice and is now expecting to partner the drug after a hopefully positive FDA decision that should come shortly.

With an FDA approval in hand, Mannkind should be able to fetch more for Afrezza, but a marketing deal will still come with risk for the company that licenses Afrezza. Pfizer (NYSE:PFE) and Nektar Therapeutics' inhaled insulin, Exubera, was a marketing flop while Eli Lilly (NYSE:LLY) and Novo Nordisk (NYSE:NVO) subsequently stopped their inhaled insulin programs. Even though Mannkind waited and removed regulatory risk for a potential partner, there's still marketing risk that a pharmaceutical company may not want to take on. When Pfizer stopped Exubera sales, it had to pay $135 million to give Exubera back to Nektar. To get a deal done, Mannkind may have to assume much of the marketing risk by accepting tiered royalty rates or bio bucks for hitting sales goals.

What investors need to look out for
There's no right or wrong way to develop a drug. The risk-reward ratio usually balances itself out and investors just need to find companies that fit the profile they're comfortable with.

For development-stage drugmakers with no revenue source, the important metric to follow is the cash burn run-rate. The closer a company is to running out of cash, the more likely it is to offer up its pipeline at fire-sale prices just to stay alive.

Investors should also watch management to see if they can deliver on their promises for partnerships. Potential partners almost always get to see more data about the drug than is available to shareholders. If Big Pharma says "no, thanks" even when management says it's looking for a deal, that could be a sign the drug may not make it through the marathon of drug development.

Be careful out there Fools. Biotech can be profitable, but it's still risky.

Exelixis and Vertex Pharmaceuticals are Motley Fool Rule Breakers recommendations. The newsletter is always on the hunt for hot drug stocks and other cutting-edge picks. Click here to see all of our latest discoveries with a free 30-day trial subscription.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Pfizer is an Inside Value choice. Novo Nordisk is a Global Gains pick. The Fool owns shares of Exelixis and has a disclosure policy.