Beyond Borders: Global biotechnology report 2010

and prevention of influenza in exchange
for purchasing an 18% interest in the
Netherlands-based company for US$443
million. J&J also purchased 18% of Elan,
receiving certain rights to Elan’s Alzheimer’s
program. J&J agreed to provide US$500
A closer look
Valuing milestones
million of further development funding for
the program in addition to what was initially
a US$1 billion payment for the equity
interest in the Irish company.
However, the deal was almost undone
by a side agreement that would have
The M&A environment was fraught with challenges in 2009.
As the financial crisis unfolded, “valuation gaps” — chasms
between the expectations of sellers and the realities of the
market — opened up. To bridge these gaps, transactions
frequently included contingent consideration such as payments
upon the achievement of development or commercial
milestones. In the US, a new accounting rule established by the
Financial Accounting Standards Board (known as “SFAS 141R”)
which became effective in 2009 requires such contingent
consideration to be valued and accounted for prior to the
resolution of the contingency.
Under SFAS 141R, acquirers must estimate the fair value of
the contingent consideration at the time of the acquisition.
Buyers must also update that fair value every quarter until all
contingencies are resolved.
In determining a value for the contingent consideration,
one challenging issue is the use of an appropriate discount
rate for research stage milestones, which by their nature
carry significant risk. Company disclosures have included
discount rates ranging from 6% to 26% applied to probabilityadjusted
payouts for technical milestones. Clearly, there is
little consensus about the degree of risk accounted for in the
probability adjustment and in the discount rate. It’s worth
pointing out that there is less risk around a contingent payment
than the associated research project because there is less
uncertainty around the contingent payment than the ultimate
cash flows associated with the project.
The need to monitor and value contingent liabilities after the
deal has closed creates additional challenges. There is the
burden of updating timing, probabilities and forecasts on a
quarterly basis. Any change in fair value flows through the
allowed J&J to fund Elan’s acquisition
of Tysabri rights from Biogen Idec if the
Massachusetts-based company was ever
subject to a change in control. After
Biogen Idec protested in court claiming the
side agreement violated its arrangement
Michelle Mittelsteadt
Ernst & Young LLP
company’s income statement. When a research contingency is
ultimately resolved, there could be a “loss” (if the research was
successful and the contingent milestone liability is trued up to
actual and paid) or a “gain” (if the milestone is not achieved
and the related contingent liability is reversed). As a result,
acquisitive companies will need to predict the “Day 2” impact on
the financial statements from the time the deal is contemplated.
One of the biggest changes in the new accounting guidelines is
the capitalization rather than expensing of acquired in-process
research and development projects (IPR&D). These assets
are not amortized to expense until the R&D is completed and
technical uncertainty is resolved, at which time the asset is
amortized over its remaining useful life. Typically, the asset
value is amortized after commercial launch.
Given the new accounting treatment of these assets, there is
far more scrutiny on the valuation of these projects, particularly
in regard to the unit of account. For example, when a drug
candidate is acquired, should the value be calculated on an
aggregate basis for all indications for all geographies, or is it
more appropriate to value separately each individual indication
being pursued in each major regulatory geography? Clearly
this becomes important when testing for impairment after
the acquisition and when amortizing the asset. Over the first
year of adoption, companies are still trying to determine their
accounting policies in this matter, but there has been a trend
toward consolidation on a global basis for a given indication,
given the relative value of the major markets.
Clearly, there are more valuation challenges under the
new accounting standards, and acquiring companies must
contemplate these challenges earlier in the deal process because
the impacts on reported financial results are long-lasting.
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