By Kenneth Ehemen
Challenging capital markets and a chilled pharmaceutical company appetite for acquisitions have led to reliance on the “structured acquisition” for the exit of biotech and life sciences start-ups.
Buyers in these acquisitions will typically make a substantial portion of the purchase price contingent on the success of the target’s products in clinical and commercial development, often including more than half of the purchase price in contingent payments. Recent examples include Cubist Pharmaceuticals’ acquisition of Calixa Pharmaceuticals in 2009 ($92.5 million was paid up front, and up to $310 million was payable upon achievement of certain development, regulatory, and commercial milestones) and the Lilly purchase of Alnara Pharmaceuticals in July 2010 ($180 million up front and up to $200 million in future milestones).
This model has gained so much traction because it mitigates the risk for the buyer while allowing the target company’s investors to limit further investment and dilution by exposure to the unforgiving capital markets. While this structure will often bridge the gap to get a transaction completed, it creates additional issues impacting the selling stockholders and the management team that are often overlooked until it is too late to address.
Issues, Complications Of The Structured Transaction
Liquidation Preferences and Payouts. Life sciences companies typically complete multiple rounds of preferred stock financing with liquidation preferences equal or exceeding original purchase prices, plus substantial accrued dividends.
In this example, under a typical capital structure of tiered preferences and participating preferred stock, the Series C preferred would typically receive the first $50 million in consideration, the Series B the next $35 million in consideration, the Series A the next $15 million in consideration, and the preferred and common holders (and optionees) would share the remaining proceeds pro rata based on their share holdings. If there were $300 million in proceeds in a deal all paid up front, the first $100 million would be paid in accordance with the liquidation preferences, and the remaining $200 million would be allocated across the 10 million outstanding shares on a pro rata basis (approximately $20 per share).
With contingent proceeds, the outcome may be less clear under the applicable liquidation preference terms in the target’s charter documents. Is the entire $300 million possible payment allocated across all classes of stock with each class receiving a proportional amount of the up-front and contingent proceeds? Or, do you pay the up-front first to the senior classes and the remaining contingent payments get paid out in the preference waterfall? Complicating matters, handling capped preference multiples (preference goes away once a set amount of proceeds are received) can be confounded by the lack of clarity of all-in compensation at the time of the transaction.
Management/Employee Equity. In a typical acquisition, each stock option will be either exercised or cashed out by an amount equal to the value of a share of common stock at closing, less the exercise price of the options. The gain on these stock options, whether ISO (incentive stock option) or NSO (nonstatutory option), will be taxed at ordinary income rates instead of favored capital gains rates because the capital gain holding periods (generally one year) applicable to the underlying stock shall not have been satisfied. As a threshold issue, in a structured acquisition there may be no or little actual proceeds allocated to common stock at time of closing, requiring a net cash outlay for the option exercise. Compounding this problem, the value of a share of common stock must take into account the expected value of the contingent payments, resulting in a substantially higher tax burden at closing. Based on the transaction outlined above with $100 million up front and up to $200 million in contingent payments, upon exercise or cash out of an option, after payment of the exercise price, the recipient would be taxed as ordinary income on the sum of the initial payment ($0.00) and the estimated value of the contingent payments (which will be a reduced percentage of the full $20 per share), less the exercise price. This would result in paying taxes (and exercise price) at closing but not receiving any proceeds to pay the associated taxes. This situation is not uncommon in these types of transactions and can leave management with several undesirable alternatives for getting value for their hard-earned equity.
Ensuring Buyer Effort on Product Development. The buyer will control the effort after closing to achieve the milestones related to the contingent. The buyer’s priorities may shift after closing, whether through strategic shifts, loss of personnel, budget allocation, relative program performance, regulatory trends, or any number of the variables that can impact product development at a large pharmaceutical company. The buyer may also fail to execute, resulting in delays or poor or less than optimal results. Any of these risks could result in program delay or cancellation and negatively impact any future payments to the seller’s stockholders.
Receiving Less Than Optimal Value for Noncore Assets. Buyers will typically purchase the entire company of the seller and thus acquire all of the assets of the company, including all product candidates and research programs. A buyer may be interested in the entire spectrum of a seller’s development products, particularly when the development products relate to a core platform technology. In other situations, a buyer will be focused on one, or perhaps two, clinical-stage products, and many of the other development products or research programs, particularly the early-stage products, will receive little or no value from the buyer.
Solutions To Common Problems With Structured Acquisitions
Well-Drafted Liquidation Preferences. To avoid the uncertainty regarding liquidation payouts for a structured acquisition, most rounds of financing completed in the last several years include provisions required by the later stage investors clarifying that the fixed consideration comes at the top of the liquidation waterfall. Often, this leaves little or no initial distribution to the junior preferred or common holders/optionees. Also, retroactive allocation adjustment provisions are added in situations where liquidation multiples are reduced once specified levels of proceeds are received by all stockholders. While advantageous for these later-stage investors on a pure dollar basis, weighting the proceeds toward the later rounds may disincent the management team or result in a conflict of motives for the various classes of investors. We encourage all companies approaching potential exits to evaluate their liquidation payouts under these typical structures and to balance the various interests in order to promote a unified effort for the exit transaction.
Restricted Stock/Options for Bonus Exchange. The optimal method for equity planning would involve the use of restricted stock purchases or restricted stock grants in lieu of options. These instruments must be held for at least one year prior to the closing to obtain capital gains treatment, and the planning must be initiated well before the company enters the acquisition process. However, with foresight, these vehicles can help to obtain capital gains treatment and to minimize the impact of recognizing gain on the estimated value of the contingent payments. Alternatively, if insufficient time remains to affect a restricted stock approach, options can be converted into what essentially amounts to a cash bonus plan that replicates the returns the optionee would receive if it exercised its option. These payments will still be considered ordinary income but should avoid taxation on the contingent payments until the payments are actually made. These bonus or carve-out plans can also provide additional flexibility to reallocate deal proceeds to management outside of the existing equity preference structure.
Spinouts And Restructurings Of Noncore Assets. Sellers may want to retain the opportunity to realize value on products or programs that are not of interest to a buyer. Sellers may seek to spin out those assets to a new entity at the time of the acquisition, but that will usually be a taxable transaction that can result in additional tax to the seller and seller’s stockholders. A seller with foresight might instead spin those assets out much earlier in the company’s history when those assets may have low or nominal value, resulting in little or no taxation to the seller or its stockholders at that time. These assets then can be separately financed, developed, or sold/licensed before or after the acquisition. Another approach might be to provide for a defined period after closing, during which the seller’s representative may arrange for one or more licenses or other transactions in which buyer and seller would participate in the proceeds of such transactions, and such payments could be treated as additional contingent payments to the seller’s stockholders.
Covenants/Shareholder Representative Expense Funding/Buyback Rights. A seller can employ several mechanisms to ensure the buyer maximizes the product development opportunity. A seller might include covenants regarding diligent performance, allocation of sufficient resources, and funding of a clinical development or commercialization/marketing plan. The seller may also include a provision allowing for a clawback or buyback of the rights to such product or program if the project is not adequately pursued with diligence. To enforce such rights, and perhaps more importantly to let the buyer know the rights can be enforced, sellers may set aside some proceeds at closing to fund the seller’s representative or representatives (typically the largest investors) to pursue such remedies against the buyer after closing.
Attractive Solution For VCs, Pharma If Structured Properly
The structured acquisition will be part of the landscape for the exiting life sciences company for the foreseeable future. While seemingly the ideal solution for cash-strapped investors and gun-shy pharmaceutical companies, these structures create often overlooked issues for the seller’s stockholders and management teams that are best addressed in the planning stage prior to an actual transaction. Proactive sellers and their management teams, boards, and investors can maximize the deal for all constituencies by conducting a comprehensive review of their existing structure and developing a plan of action.
About The Author
Kenneth Eheman, Jr. is a partner at the law firm of Wyrick Robbins Yates & Ponton LLP and practices in the area of corporate and securities law, including company formation, venture capital financings, private placements, public offerings, mergers and acquisitions, and strategic partnerships. His practice focuses on the life sciences industry.