Contingent Value Rights: Bridging Valuation Gaps in Biotech M&A Deals

Written by Timothy Chan

Introduction

Picture this: you’re an entrepreneur and you’ve come up with a product that could potentially impact the wellbeing of many people for the better. You have spent hours researching your idea and have attracted the attention of many interested individuals. One of these individuals’ wants to purchase your idea, and offers you a lump sum of $100. However you, having poured your heart and soul into this product, believe that the offer undervalues your idea, and that the product should be sold for much higher – around $1000. 

While this oversimplifies the world of acquisitions in the Biotech industry, a ‘valuation gap’, or differences between target and acquirer’s valuations of the target company, is an issue faced by many small biotechs when being bought out by larger pharmaceutical companies. This is largely because the target company is often in early-stage development, and thus cannot be valued using earnings metrics (DCF, earnings multiples etc) as they do not sell product. Consequently, both parties (target and acquirer) use qualitative measures such as potential to value the target company, which are subjective and hard to numerically define.. There are also significant risks associated with early-stage development, as FDA approval and subsequent sales are not guaranteed, meaning that the target company’s valuation of itself is likely to be much higher than what the acquiring company is willing to pay. 

So, if company A wants to buy company B for $1M, but company B believes that they are worth $2M because of a product with strong potential, how can these two companies reach a fair conclusion to facilitate the acquisition process? There are several approaches that can be used to solve this problem, one of them including the issuing of a financial product: Contingent Value Rights (CVR). 

What are Contingent Value Rights (CVRs)?

Contingency Value Rights (CVRs) give target company shareholders the right to receive a benefit if a future event (increase in earnings, stock price etc) occurs within a set timeframe post-acquisition. These benefits can either be monetary (such as a cash payout or lump sum) or stock-related, where shareholders with the CVR receive additional shares in the acquiring company. 

However, as these Contingent Value Rights are inherently linked to the acquiring/amalgamated company’s future performance, the associated benefit to target shareholders is not guaranteed and will only be granted if the specified target (earnings, stock price, FDA approval etc) is met within a set time frame. 

CVRs are hence distinct to traditional company issued unsecured debt (unsecured corporate bonds etc), as companies are not obligated to make fixed interest payments to CVR holders. Furthermore, in the event a company liquidates, while unsecured debt holders have a lower priority claim on the company’s assets relative to secured debt holders, CVR holders do not have a claim on the company’s assets, and as such will be paid last in company liquidation.

CVR’s have been around for a decent amount of time (since the 1980s) and tend to be customised instruments – securities tailored to the issues of acquirers and targets. There are some fundamental key features of CVR’s however, that allow them to be classified under two umbrella terms:

1. Price-Protection CVR’s

2. Event-Driven CVR’s

Price-Protection CVR’s

When one firm acquires another, the share price of the target firm rises whilst the share price of the acquiring company falls. This is because the acquiring company typically pays a premium (acquisition premium) on top of the target company’s agreed valuation to entice target shareholders to sell their stock, often taking on debt or exhausting its cash reserves to do so. This change in capital structure, in conjunction with issues regarding synergies and conflicting corporate cultures between target and acquirer creates significant uncertainty for investors, leading the acquiring company’s stock price to drop. In this scenario, a CVR allows existing shareholders to be compensated for this price drop if they are receiving equity rather than cash, protecting them from a capital loss. 

Event-Driven CVR’s

Event-Driven CVR’s are also used in M&A where the payout to the target’s shareholders is contingent on a future theorised event. This event may be based on various performance metrics (measured earnings, stock price etc) or a certain event occurring (FDA approval, success of clinical trial etc) and seeks to compensate ex-shareholders for the opportunity cost of selling their stock rather than a loss in value associated with the acquisition (as seen in price protection CVR’s).

How are CVR’s used in the biotech space?

Event-Driven CVR’s are much more commonly used in the biotechnology industry. To understand why – it’s important to understand the fundamentals of the biotech space, and how M&A is shaped in this industry. 

The industry itself is characterized by high levels of uncertainty and risk. This is because biotech firms are heavily reliant on the success of drugs in development, successful clinical trial results and regulatory approval

 can significantly impact the valuation of a biotech company. As such, biotech firms commonly derive their value from the development of key products and their achievements. For example, a breakthrough in a drug could see the company’s value significantly increase

So what are some events that may trigger the payout of a CVR in the biotech industry? 

Figure 1: Key Components and Trends of CVRs in Life Sciences Public M&A Deals (Harvard Law School Forum on Corporate Governance)

According to Harvard Law School Forum on Corporate Governance, 37% of contingencies tied to future performance are linked to regulatory approval – that is the payout of CVR’s are dependent on a target’s drug or product receiving approval from the FDA or licencing agreements. 

Another common payout trigger for CVR’s in the biotech industry is the sales performance of the target’s drug. For example, if the drug achieves specific revenue or sales targets within a time frame, the target holders may be entitled to additional payments – ensuring the target benefits from the success of the drug beyond regulatory approval. 

It is important to note that these “payout trigger events” are almost never used in isolation – rather multiple triggers are used comprehensively to manage risks at various stages of the drug’s lifecycle, capturing the full range of value drivers and the drug’s success, thereby making it a valuable tool biotech M&A deals. 

Case Study: 

Bristol Myers Squibb is an American multinational pharmaceutical company headquartered in Princeton, New Jersey. It is consistently ranked as one of the world’s largest pharmaceutical companies, with a current market cap of 100.7 billion. In 2019, Bristol Myers Squibb acquired Celgene, another pharmaceutical company specialising in the research and development of cancer and immunology drugs, for approximately 74 billion. 

As a result of this deal, Bristol Myers Squibb issued CVR’s, structured to provide value based on the achievement of certain milestones related to Celgene’s drug portfolio. In particular, under the acquisition agreement, there were three different trigger events that needed to be met in conjunction, in order for Bristol Myers Squibb to payout Celgene’s shareholders (with a monetary value of $9). These three trigger events were:

1. FDA regulatory approval of ozanimod (a drug for multiple sclerosis) by December 31 2020

2. FDA regulatory approval of liso-cel (a drug for B-cell lymphomas) by December 31 2020

3. FDA regulatory approval of ide-cel (a drug for relapsed multiple myeloma) by March 31, 2021

The milestone of approval for ozanimod was met, as FDA approval was granted. However, the milestone of approval for liso-cell by December 31, 2020 was not met, and as such the CVR agreement between Bristol Myers Squibb and Celgene was terminated on January 1 2021, making the CVRs no longer eligible for payment. 

CVR’s have strict time frames – even though ide-cel was approved by the FDA on the 5th April 2024, and liso-cell in June 2022 (now sold under the brand name Breyanzi), since approval was not met before the deadlines, the CVR was terminated. 

Conclusion

CVRs are strategic tools in the realm of biotech mergers and acquisitions. They offer several benefits to the acquiring company - in particular acquirers can mitigate risk associated with drug development by paying a portion of the purchase price. While buyers mitigate risk through CVRs, sellers also benefit if the drug achieves a certain milestone after acquisition, thus making CVR’s effective tools to help both parties in an acquisition achieve their strategic objectives and bridge the valuation gap.  

References:

https://corpgov.law.harvard.edu/2023/06/16/key-components-and-trends-of-cvrs-in-life-sciences-public-ma-deals/

https://www.wlrk.com/webdocs/wlrknew/AttorneyPubs/WLRK.26465.19.pdf

https://www.investopedia.com/terms/c/cvr.asp

https://www.bms.com/investors/shareholder-services/shareholder-faq.html

https://www.wlrk.com/webdocs/wlrknew/AttorneyPubs/WLRK.20102.11.pdf 

https://www.paulhastings.com/insights/client-alerts/solving-the-valuation-puzzle-in-life-sciences-transactions-the-pros-and-cons-of-the-cvr