Pharmaceutical Company: Derivatives

Challenge: 

An early stage pharmaceutical company with one major lead in clinical trials and awaiting FDA approval needed additional funding to finance research and development expenses associated with the drug development. To meet its financing needs, the company issued a convertible callable note which included attached warrants and other features qualifying them as embedded derivatives. In order to comply with SFAS 133, the company asked Valuation Research to analyze the entire note and determine the fair market value of each of the embedded derivatives.

Solution: 

Our analysis detailed the various embedded features, such as the conversion right of the investor to convert into shares of common stock of the company, prepayment rights of the issuer of the note, additional warrants to be issued upon early prepayment of the notes, and interest rate step-up in case of technical default, among other provisions.

We developed a proprietary model that valued the entire note, with the exception of stand-alone pieces, such as the attached warrants. Using this model, we were able to analyze the effect of each of the embedded features on the value of the note. By valuing the note with and without certain features and analyzing the difference between the value indications, we were able to value each feature within the context of the note.

By using an integrated approach, we were able to pinpoint how investors’ and issuer’s behaviors affect each other and, therefore, determine the value of the embedded derivatives. This approach allowed us to value each embedded derivative on the basis of being part of a complex note, which is not simply the sum of the values of several stand-alone securities or derivatives. This approach enabled us to calibrate the model used to the actual face value of the notes, thus adding an extra layer of reliability. Our final valuation of each of the embedded derivatives was reviewed and approved by the company’s Big 4 auditor.