A tiny biotech announces that it licensed a drug candidate to a big pharmaceutical company, and suddenly the biotech's shares skyrocket.

But why? Assuming the rights to the drug are being exchanged at market value, the value of the company's assets hasn't changed -- theoretically at least. 

It's about the greenbacks
The upfront cash may justify the deal on both sides, but it also transfers the risk from the owner, which now has cash, to the licenser, which has to wait for future revenue that may never materialize. Decreased risk has value. The old adage "a bird in the hand is worth two in the bush" holds true for licensing deals.

At the most basic level, an upfront payment increases the enterprise value of the company because of the increase in cash on the balance sheet. But many deals also decrease cash-spending rates, because the company licensing the drug takes over paying some or all of the drug development costs. The lower cash burn increases the value because companies are ultimately valued on their future cash values; the reason you occasionally see biotechs trading at less than current cash-on-hand is that investors are anticipating the company will burn through that cash before anyone would be interested in acquiring them.

An endorsement
There's some credence to the theory that a large pharmaceutical company licensing a drug means that the drug might be more likely to work. After all, the licenser usually gets to have its experts review data not available for public consumption.

But it's important to remember that the license just means the drugmaker thought it was a good bet; that is, the upfront payment justified the potential payoff. That's not the same as saying the drug will most definitely work.

There are plenty of examples of drugs that were licensed for relatively cheap upfront payments even though the drug had little chance of passing clinical trials or getting approved by the Food and Drug Administration.




Upfront payment


Riquent La Jolla Pharmaceutical BioMarin Pharmaceuticals (Nasdaq: BMRN) $15 million Died in phase 3 development
Flurizan Myriad Genetics (Nasdaq: MYGN) H. Lundbeck $100 million Died in phase 3 development
lorcaserin Arena Pharmaceuticals (Nasdaq: ARNA) Eisai $50 million FDA turned down marketing application
Contrave Orexigen Therapeutics Takeda $50 million Up for FDA review

Source: Company releases.

What goes up ...
If partnering a drug helps increase value, then getting the drug's rights back often causes the value to drop. Last month Pfizer (NYSE: PFE) handed rights to cancer vaccine rindopepimut back to Celldex Therapeutics (Nasdaq: CLDX), which saw its stock drop by as much as 40% after the announcement. Exelixis (Nasdaq: EXEL) was in a similar situation recently when Bristol-Myers Squibb (NYSE: BMY) surrendered its rights to XL184.

Regaining the full rights to a drug theoretically increases the assets of the company, but when that happens, investors tend to focus on why the drug was handed back. The inference is that the drug wasn't worth developing, but investors should be careful with that kind of blanket assumption. Just because one drugmaker doesn't think a drug is worth developing doesn't mean the drug isn't valuable. A simple explanation is that the licenser is developing a competing drug that it likes better.

More art than science
Determining whether the biotech got a good deal can be difficult. You can look at the potential sales of the drug and base the value on historical deals. But there are a lot of moving parts, and the details for some of those parts, like milestone payments and royalty rates, are often not disclosed.

Ultimately investors just need to be satisfied knowing that, as long as the biotech doesn't give away the farm, a drug deal is likely to increase the share price.