Bridging Valuation Gaps in Public M&A in the Pharma, Biotech, and Other Life Sciences Industries

Acquisitions of public companies in pharma, biotech, and other life sciences industries are increasingly using deal structures designed to bridge valuation gaps between buyers and target companies. Even though the peak biotech valuations of 2021 are now well in the rearview mirror, there is still often a significant disconnect in value expectations between buyers and sellers, especially when it comes to pipeline assets. As big pharma companies look to fill gaps in their pipelines, they are increasingly seeking solutions either to leave behind early-stage assets they do not wish to own and fund, or to pay for them only when their value proposition crystallizes. Two techniques for addressing these transactional objectives are spin-off mergers and contingent value rights (CVRs). These deal structures are getting more airtime in deal negotiations and are becoming, in the case of CVRs, a more established feature of public M&A, especially in healthcare transactions.

Spin-Off Mergers

A spin-off merger is a transaction in which the target company separates certain of its assets into a separate company (hereinafter referred to as the hypothetical “SpinCo”), then distributes the shares of SpinCo to its shareholders and, immediately after the spin-off is completed, merges with a third-party buyer. Spin-off mergers are often considered by buyers in the biopharma industry who wish to acquire a target company’s clinical or near-clinical stage products, but who are not interested in its early-stage products. They provide a means for the buyer to leave behind the assets it does not wish to own (or to pay for) and for the target shareholders to continue to realize value from those assets. This is especially true for buyers facing patent expirations, who may be seeking to supplement their portfolios with revenue-generating in-market or near-market assets without the burden of cost-intensive pipeline products.

Spin-off mergers are often used in private deals to bridge valuation gaps. They are also often considered, but so far have been rarely implemented, in the public company M&A context. The first public company spin-off merger in the pharma space was Johnson & Johnson’s acquisition of Swiss-listed Actelion (announced in January 2017), in which Actelion spun out its pre-clinical drug discovery operations and early-stage clinical development assets into a separate R&D company. This was followed by a spin-off merger involving a US-listed pharma company (announced in May 2022), when Biohaven Pharmaceuticals agreed to spin out its pipeline assets before being acquired by Pfizer in an all-cash merger.

The reason spin-off mergers are so rarely pursued in practice is that they typically entail significant complexity, long implementation timetables, and continuing interdependencies between the parties. Spin-off mergers present significantly greater execution complexity relative to whole company acquisitions, in terms of defining the transaction perimeter, allocating assets and liabilities between the parties, and effecting their actual separation, which may require numerous third party and regulatory consents. Addressing shared intellectual property, including who will keep the IP and what cross-licenses may be put in place, is of particular importance and may present unique challenges in biopharma where different drug programs can be dependent upon the same or similar underlying intellectual property.

Spin-off mergers can take several months longer to complete than an acquisition of the entire company (assuming no regulatory or financing delays for the acquisition). In addition to any legwork required in connection with reorganizing the target company’s existing business to position it for the spin-off, a spin-off merger requires SpinCo to file a registration statement with the SEC, which includes IPO-level disclosure of the business being spun-off, as well as audited carve-out financial statements for the business. Preparing the registration statement and clearing the SEC review and comment process usually adds several months to the transaction timetable, given that merger proxies typically do not require the same level of SEC scrutiny. Note, however, that some of these complexities can be less burdensome in an early-stage pipeline spin-out, as the asset perimeter may be easier to define and separate, and the simplicity of business operations for the early-stage business can make the preparation of audited financial statements easier.

Another complexity that arises in spin-off mergers is the need to stand up SpinCo as a stand-alone public company—and whether this is feasible in terms of capitalization, management, public company infrastructure, and stock exchange listing eligibility. SpinCo will need to be adequately capitalized to have sufficient cash runway to operate its business and fund its activities. Given the assets that are going into SpinCo (which are often early-stage and cash-flow negative), this may not be easily achievable. One way to solve for this is for SpinCo to obtain initial financing from the buyer as part of the overall deal package. In doing so, the buyer may seek to participate in the downstream economics, e.g., through a convertible instrument or through royalty rights with respect to SpinCo products in conjunction with or as an inducement to provide the financing.

Another question that must be addressed is who will lead SpinCo and whether the management and scientific team who are familiar with the pipeline assets placed into SpinCo will go with the business that is acquired by the buyer. If the thesis of the deal is that the buyer wants the leadership team to stay with the acquired company, SpinCo may find itself without the right people to guide it to success. Finally, it may be questionable whether SpinCo, on its own, will attract sufficient investor float and will meet the eligibility criteria to be listed on a national stock exchange—the inability to list may be fatal to the ability to execute a spin-off merger.

Finally, spin-off mergers do not lend themselves to a clean break between the buyer and SpinCo. In addition to buyer financing arrangements, the parties often need to enter into transition services agreements, contract manufacturing or facilities sharing arrangements, IP licenses, and data sharing protocols. As such, they create several interdependencies between the buyer and SpinCo, which can add to the negotiation timetable at the front end and can take years to untangle post-closing.

Contingent Value Rights (CVRs)

A potential alternative to a spin-off merger in situations where the two parties have differing views as to value are CVRs. CVRs represent the right of the target company shareholders to receive payments when specified milestones are achieved. They are not typically transferable (a feature necessary so that they are not treated as securities and do not require SEC registration) and are issued to the target shareholders at the time of closing as a component of the acquisition consideration.

While contingent payments in the form of milestones and earn-outs are commonly utilized in private company M&A, contingent value rights—their counterparts in public M&A—have historically been used less frequently. However, in the current environment, CVRs can be an attractive tool in deal structuring. In 2022, there were more CVR public deals than in 2020 and 2021 combined, and in January 2023, all three public pharma acquisitions announced at the JP Morgan (JPM) Healthcare Conference—AstraZeneca’s acquisition of CinCor Pharma, Ipsen’s acquisition of Albireo, and Chiesi’s acquisition of Amryt Pharma—included CVRs.

Some buyers disfavor CVRs due to the potential for litigation with a large number of CVR holders over whether the buyer has complied with its contractual undertakings to achieve the applicable CVR triggers. CVR agreements often contain commitments by the buyer to use a specified level of efforts (usually commercially reasonable efforts or variations thereof) to achieve the payment triggers, with the exact standard of efforts being one of the most heavily negotiated points in the CVR agreement. While buyers often push back on the inclusion of an efforts clause or push to narrowly define it, public deals without efforts clauses are rare. All three of the public pharma acquisitions announced at the JPM Healthcare Conference contained efforts undertakings to achieve the applicable milestones.

Buyers who wish to have contractual certainty as to what their obligations are, but who are not able to get a “no efforts” standard, may seek in the alternative provisions which state that the buyer is not required to do certain enumerated things (e.g., additional clinical studies not previously contemplated) or “safe harbor” provisions which specify that if the buyer has devoted specific resources to achieving the trigger (e.g., minimum dollar spend), it will be deemed to have complied with the efforts undertaking.

Other mechanisms buyers have used to try to limit litigation exposure is to provide that the CVR holders can enforce their rights only through the rights agent under the CVR agreement (and not individually) and that only a minimum percentage of CVR holders (commonly ranging between 30% and majority) can direct the rights agent to bring claims for breach of the efforts covenant. While this type of mechanic does not eliminate the risk of litigation, at least it has the benefit of consolidating any claims over the CVR through one channel and proceeding.

Applications Beyond Life Sciences

Pharma, biotech, and other life sciences deals provide a natural context for the inclusion of CVRs, as the value of a particular drug may change dramatically based on the achievement or failure to achieve a major development or other milestone. They are also a natural forum for the consideration of spin-off mergers, as companies often have early-stage pipeline products they may see significant potential in, but for which buyers may not be willing to pay. Nevertheless, buyers outside these industries may soon begin to tap into these deal structures as dislocations between stock price and intrinsic value, heightened volatility, and economic uncertainly may force more parties to think about how to bridge valuation gaps in order to execute on deals that may have strong strategic sense but where it may be difficult to reach a meeting of the minds on deal price.