Contingent Value Rights: the Gap in M&A...

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Contingent Value Rights: Contingent Value Rights: Bridging the Valuation Gap in M&A DealsStructuring Deals that Protect Buyers and Sellers, and Lessons Learned from Sanofi‐Genzyme

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, SEPTEMBER 8, 2011

Today’s faculty features:

Igor Kirman, Panel Chairman, Partner, Wachtell Lipton Rosen & Katz, New York

Robert Arsov, Director of Investment Banking Division, Credit Suisse, New York

Attendees seeking CPE credit must listen to the audio over the telephone

Andrew W. Ment, Partner, Covington & Burling, New York

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CVRs: Bridging the Value Gap

Igor Kirman, Program Chair, Wachtell LiptonIgor Kirman, Program Chair, Wachtell Lipton212.403.1393

[email protected]

Robert Arsov, Credit Suisse212.538.7032

[email protected]

Andrew Ment, Covington & Burling212.841.1012

ament@co [email protected]

September 8, 2011

Covington & Burling Credit Suisse Wachtell Lipton

Table of ContentsTable of Contents

◦ Overview of CVR Securities

◦ Sanofi-aventis/Genzyme Case Study


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What are CVRs?What are CVRs?

◦ Contingent

◦ Value

◦ Rightsg

◦ Sometimes also called “CPRs” (Contingent Payment Rights)

R bli i f h i ddi i l id i ◦ Represent an obligation of the issuer to pay additional consideration upon specified trigger events


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Price-Protection Vs Event-DrivenPrice Protection Vs. Event Driven

◦ Price-Protection CVRs

• Essentially hedging instruments that guarantee/set a floor on securities used as consideration in transactions

◦ E t D i CVRs◦ Event-Driven CVRs

• Provide for payments linked to achievement of certain specified events or performance metrics p

◦ Can also conceptually divide CVRs into “Financial Performance-Based” and “Event-Based”


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Price-Protection CVRsPrice Protection CVRs

◦ Security that provides for a payment (either cash or securities) if the k t i f i ’ t k i b l t t imarket price of acquiror’s stock is below a target price

• Also often contains a “floor” capping the potential payout under CVR

◦ Example: CVR that provides for payment of the difference between market price of acquiror’s stock in one year and a “target price” of $50, with “floor” of $25

• If acquiror’s stock is at $30 in one year, CVR holders receive $20

◦ As hedging instruments, trading value should move inversely to value of acquiror’s stock


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Price-Protection CVRsPrice Protection CVRs

◦ Several issues to consider• Form of consideration: cash versus stock

◦ If stock, consider method of valuation and need for registration/shareholder approval

M t it D t • Maturity Date ◦ Option to extend maturity (extension typically carries increase in target price

and “floor” price)

◦ Early redemption/termination of CVRs (in some cases, will terminate y p / C ( ,automatically if acquiror’s stock exceeds threshold over defined period)

• Ability of acquiror to repurchase◦ For price-protection CVRs, repurchases typically prohibited, at least during

l dvaluation period

• Covenants/events of default

• Anti-dilution adjustments


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Event-Driven CVRsEvent Driven CVRs

◦ Payments can be triggered by a number of different trigger events or performance metrics:performance metrics:

• Achievement of milestone events (hitting sales targets, receipt of FDA approval)

Financial metrics (EBITDA/re enue le els net asset/ orking capital • Financial metrics (EBITDA/revenue levels, net asset/working capital levels)

◦ Functionally similar to earn-out

P d f t i t ( t f liti ti di tit • Proceeds from some uncertain event (outcome of litigation, divestiture of assets, escrow release from indemnification)

◦ Particularly common in biotech/pharmaceutical transactions

• Milestone payments are already commonly used by such companies as part of research collaborations or drug licensing agreements

• Single drugs can have a huge impact on valuation of such companies


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Event-Driven CVRsEvent Driven CVRs

◦ Several key considerations:

• Definition of triggering event

◦ If based on financial metrics, definition of EBITDA, net assets, working capital, etc.; if based on specific event, precise definition of event (for i i f d fi d FDA l b li l i i j i di i )instance, receipt of defined FDA labeling approvals in certain jurisdictions)

• If calculations are necessary, which party will perform

◦ Non-calculating party may have defined audit rightsNon calculating party may have defined audit rights

• Operating restrictions/support obligations for relevant business

◦ E.g. requirement that acquiror use commercially reasonable, reasonable or “dili t” ff t t hi l t i“diligent” efforts to achieve sales metrics

• Reporting obligations

◦ May specify that acquiror’s reports disclose certain financial reports or


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May specify that acquiror s reports disclose certain financial reports or information on current status of litigation

Other CVR ConsiderationsOther CVR Considerations

◦ Documentation of right

• Payment rights can merely be described in acquisition agreement, or can be set forth in separate agreement or formal indenture with a trustee

• Choice of form may influence enforcement rights of CVR holders

• Choice of form may also depend on whether CVR agreement will be Trust Indenture Act qualified


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◦ Securities Act Registration: SEC employs a five-pronged test to determine if CVR issued as part of merger consideration is a determine if CVR issued as part of merger consideration is a “security” that must be registered under the Securities Act

• CVRs are not required to be registered if:

◦ The CVR is an integral part of the merger consideration

◦ The CVR does not have rights common to stockholders (e.g. the right to vote or receive dividends) or otherwise represent an ownership interest in the buyerbuyer

◦ The CVR does not guarantee a minimum payment or bear a stated rate of interest

◦ The CVR is non transferable and non assignable (except by operation of law)◦ The CVR is non-transferable and non-assignable (except by operation of law)

• Typically a key factor

◦ The CVR is not represented by any form of certificate or instrument


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◦ Additional factors cited by the SEC in no-action letters as supporting conclusion that CVR is not a “security” include:conclusion that CVR is not a security include:

• The CVR is not dependent on the operating results of any party involved

• Almost all holders of the CVR will continue as employees

• The value of the CVR payments is a small fraction of the overall consideration

◦ If CVR is stock settled acquirors occassionally “split the baby” by ◦ If CVR is stock-settled, acquirors occassionally split the baby by registering only the shares underlying the CVRs at the time of the merger

N i t ti f CVR th l i t ti f h d l i • No registration of CVRs themselves, or registration of shares underlying CVRs at the actual time of issuance


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◦ Exchange Act Registration: is required if it is determined that the CVRs are “securities” and CVRs are securities and

• the CVRs are listed on a national securities exchange (Section 12(b)), or

• the CVRs are “equity securities” and are held by 500 or more persons and the issuer has assets exceeding $10 million (Section 12(g))

◦ Whether CVRs are “equity” or “debt” is not always clear-cut

◦ Trust Indenture Act Qualification: will be necessary if the CVRs Trust Indenture Act Qualification: will be necessary if the CVRs represent debt securities

• Requires that CVRs be issued under an indenture and that trustee be appointed appointed

• Certain provisions must automatically be included in the CVR agreement/indenture (for instance prohibitions on impairment of payment)


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payment)


◦ New York Stock Exchange Listing Requirements for CVRs:

• At least one million CVRs outstanding

• At least 400 CVR holders

• CVR must have a minimum life of one yearCVR must have a minimum life of one year

• CVRs must have a market value of at least $4 million

• Issuer must have assets in excess of $100 million and must satisfy the i d i i f h f h li d size and earnings requirements of paragraph 102.01 of the listed

company manual

◦ CVRs may be delisted from the NYSE when either:

• The market value of the CVRs is less than $1 million

• The related equity security to which the cash payment at maturity is tied (if any) is delisted


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(if any) is delisted


◦ NASDAQ Listing Requirements for CVRs:

• Issuer must have assets in excess of $100 million and stockholders’ equity of at least $10 million

• Issuer must have annual income from continuing operations before taxes of at least $1 million in most recently-completed fiscal year or in two of the three most recently completed fiscal years. If unable to satisfy these criteria, NASDAQ generally requires:

A t i f $ illi d t kh ld ’ it f t l t $ ◦ Assets in excess of $200 million and stockholders’ equity of at least $10 million

◦ Assets in excess of $100 million and stockholders’ equity of at least $20 million

• At least 400 CVR holders

• Public distribution of at least 1 million CVRs


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• Market value/principal amount of at least $4 million


◦ Accounting Considerations:

• Issuer will record potential payments under CVRs at fair value on the date of issuance (the closing of the acquisition) and then re-measure fair value periodically until all payments are made

◦ The estimated fair value of the CVR payments is based on the present value of the future payments and the probability of being paid

◦ Changes in the fair value of the CVR payments are recorded as a gain or loss on the issuer’s income statement on the issuer s income statement

◦ Mark-to-market accounting may apply for listed CVRs


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◦ Tax Considerations:

• In taxable transactions installment sales rules generally do not apply • In taxable transactions, installment sales rules generally do not apply when the target company is publicly traded or the CVR is readily tradeable

◦ Stockholders of target may not be able to defer gains on contingent Stockholders of target may not be able to defer gains on contingent consideration, even if the CVR payments would occur in a subsequent tax year

◦ However, the “open transactions” rules may permit stockholders to defer h i f h i bl i l i h C i i ithe portion of their taxable gain relating to the CVR in certain circumstances

• Cash-based CVRs received in otherwise tax-free transactions are generally taxable upon receipt of the CVR at the lesser of the gain

li d th t ti d th f i k t l f th CVRrealized on the transaction and the fair market value of the CVR

• CVRs payable solely in stock of the issuer generally do not result in taxable gain if the transaction is otherwise tax-free


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◦ Target stockholder’s basis is allocated among the stock and CVRs received

Bridging the GapBridging the Gap

◦ CVR security originally proposed as a means of bridging valuation gap between sanofi aventis and Genzymegap between sanofi-aventis and Genzyme

◦ Sanofi began with unsolicited cash offer of $69/share for Genzyme

◦ Genzyme board determined that the value of the company was such Genzyme board determined that the value of the company was such that any deal “in the $70s” would be inadequate

◦ Subsequent discussions with sanofi’s financial advisors indicated that they would not be able to pay anything that involved a “hard that they would not be able to pay anything that involved a hard $80” for the business

• Genzyme’s financial advisors interpreted this as refusing to pay a cash i l t t th $80/ hprice equal to or greater than $80/share


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Dispute: AlemtuzumabDispute: Alemtuzumab

◦ Chief dispute in valuation was potential of a drug in Genzyme’s pipeline alemtuzumabpipeline, alemtuzumab

• Alemtuzumab had already been approved by the FDA for treatment of leukemia, and was currently in Phase III trials for treatment of multiple sclerosissclerosis

• Genzyme management predicted that alemtuzumab could be a blockbuster drug once approval for MS was received ◦ Predicted base case peak revenues of approximately $3 billion / yearp pp y $3 / y

• Sanofi management disagreed with Genzyme’s predictions of alemtuzumab’s potential, and predicted a base case of approximately $700 million /year in revenues

◦ The parties proposed an event-driven CVR with payments tied to alemtuzumab milestones: approval of alemtuzumab to treat multiple sclerosis and achievement of sales thresholds


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Not in the 70s and Not a Hard 80Not in the 70s, and Not a Hard 80

◦ Three ways to value the CVR

• Sum of potential payments: maximum potential payments under the CVR (for Genzyme CVR, initially approximately $12-14 per security)

◦ Unlikely to be the “true” value unless high degree of confidence that all il t ld b hi dmilestones would be achieved

• “Intrinsic value”: determine probability-weighted value and expected timing of each payment, and discount to present

◦ If projections are accurate, likely to be the best estimate of “true” value

• Expected trading value: apply an additional discount to the “intrinsic value” to reflect investors’ lack of transparency into sales results of

l b f i h ialemtuzumab or confusion over payment mechanics


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Not in the 70s and Not a Hard 80Not in the 70s, and Not a Hard 80

◦ Which of “intrinsic value” or expected trading value would be relevant depended on expected composition of holders relevant depended on expected composition of holders

• Anticipated that management/biotech investors would look to “intrinsic value” while general retail investors would look to expected trading value

b d d d i l k “i i i l ” i◦ Genzyme board expressed desire to look to “intrinsic value” in determining value of CVRs and total merger consideration

◦ Assume (for instance) a cash price of $74 and a CVR with an “intrinsic value” of $6, but expected trading value of $2-$3

• Genzyme would have achieved a valuation that was “not in the $70s”

• Sanofi would have paid consideration it valued at “not a hard $80”• Sanofi would have paid consideration it valued at not a hard $80


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Resulting CVRResulting CVR

Maximum Total Payment

C l l t d

$14.00

$ 8

“Approval Milestone”

Calculated “Intrinsic Value”

$5.58

$1 for receipt of FDA approval of alemtuzumab for treatment of multiple sclerosis on or before March 31, 2014

“P d t S l

Product Sales Milestone #1: $2 for achieving sales of the “Product” of $400mm within 12 months from product launch, measured separately in various jurisdictionsProduct Sales Milestone #2: $3 for achieving sales of the “Product” of $1.8bn within four consecutive quartersProduct Sales Milestone #3: $4 for achieving sales of the “Product” of $2 3bn within “Product Sales

Milestones”

Product Sales Milestone #3: $4 for achieving sales of the Product of $2.3bn within four consecutive quarters (not including any quarter in which Product Sales Milestone #1 or #2 were achieved)Product Sales Milestone #4: $3 for achieving sales of the “Product” of $2.8bn within four consecutive quarters (not including any quarter in which Product Sales Milestone

hi d)

“Production Milestone”

$1 if the company achieves both of the following in the year 2011: (a) production of 734,600 quality-released unlabeled 400 Unit Vial Equivalents

of Cerezyme from an approved facility and

#1 or #2 were achieved)


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(b) production of 79,000 quality-released unlabeled 35-milligram Vial Equivalents of Fabrazyme from an approved facility

Approval MilestoneApproval Milestone

◦ Payment tied to receipt of FDA approval of alemtuzumab for treatment of multiple sclerosis on or before March 31 2014treatment of multiple sclerosis on or before March 31, 2014

◦ Genzyme was confident that it would receive FDA approval and therefore the CVR would pay at least $1

◦ Sanofi requested addition of an outside date (March 31, 2014)

• Concerned that delay in approval would prevent drug from achieving market penetration and revenue before competing drugs gained foothold

◦ Debate over whether should be triggered by

• FDA approval

A di i A l• FDA or European Medicines Agency approval

• FDA and European Medicines Agency approval


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Product Sales MilestonesProduct Sales Milestones

◦ Series of payments tied to hitting target sales thresholds for the product over defined periods product over defined periods

◦ Payments were structured to pay as the drug’s four-quarter revenues increased (to address sanofi’s stated concern that alemtuzumab

ld t hit t’ l f t )would not hit management’s annual revenue forecasts)

◦ First product sales milestone specifically designed to pay if initial drug sales after launch ramped up according to projected schedule

• Difficulty posed by fact that drug would receive approval at different times in different jurisdictions, and possibility that sales could occur prior to launch

• After negotiation, decided to measure sales in each of six major countries during separate 12-month periods, and measure other global sales during a 12-month period. Also specifically defined “First Commercial Sale” and “Product Launch”


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Sale and Product Launch

Production MilestoneProduction Milestone

◦ In late stages of negotiation, sanofi voiced concern over diligence findings about Genzyme’s production of two other drugs Cerezyme findings about Genzyme s production of two other drugs, Cerezyme and Fabrazyme

◦ Rather than reduce the cash price as initially proposed, the parties d id d dd CVR i d d i f h ddecided to add a new CVR payment tied to production of those drugs

◦ This new “Production Milestone” is tied to Genzyme’s achievement of projected production levels for the two drugs p j p g


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Other Major CVR IssuesOther Major CVR Issues

◦ Definition of “Product”

• Difficult to define, since identical molecule already sold for oncology use and expected to be sold for transplant use

• Issue of derivatives of the molecule or fragments that have same effect

◦ Definition of “Sales”

• Gross sales v. net sales

• Accounting for “sales” received as payment for drug-related services (e.g. patient monitoring) or in pay-for-performance arrangements, or sales of combination products


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◦ Redemption• Sanofi insisted on ability to redeem CVRs at trading value prior to Sanofi insisted on ability to redeem CVRs at trading value prior to

termination date, citing desire to reduce reporting and filing obligations

• Genzyme feared that mandatory redemption would effectively cap value of CVR at trading value, in addition to reducing option value to holders

• Agreed to permit redemption after 3-year lockup period in the event that CVR price and drug revenues were below certain thresholds ◦ Thresholds designed to reflect situation in which alemtuzumab was a “failed

d g”drug”

◦ Repurchase• Concern that sanofi would use market power to repurchase significant

titi f CVR d d t di li idit f th h ldquantities of CVRs and reduce trading liquidity for other holders

• On other hand, recognized that having large buyer in market would be helpful for holders who wished to sell CVRs early to achieve liquidity

• Eventually agreed to allow repurchases subject to market disclosure of


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• Eventually agreed to allow repurchases subject to market disclosure of amounts authorized to repurchase and amount repurchased


◦ Efforts to Achieve Milestones

i i l di i d i ll bl d d• Initial discussions centered over commercially reasonable standard versus stronger standard

• Tension between sanofi’s ability to make commercial decisions about d t d CVR h ld ’ t k i d ’ product and CVR holders’ stake in drug’s success

• Some comfort from fact that sanofi and CVR holders were aligned in their interest in success of drug

f l li d f d i l il d◦ Not perfectly aligned: payment of Production Sales Milestone #1, compared to revenue from the drug necessary to achieve the milestone, would cause net loss to sanofi

• Eventually agreed on defined “Diligent Efforts” standard Eventually agreed on defined Diligent Efforts standard

◦ Broadly requires same efforts as taken for similar pharmaceutical products

◦ Includes specific (non-exclusive) actions sanofi must take, such as seeking pricing approvals and fulfilling obligations under existing licenses


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p g pp g g g


◦ EnforcementI di id l i ht t t k ti id d i ti l• Individual right to take action considered impractical◦ Other than enforcement of right to receive payment, which Trust Indenture

Act requires to be individual

• Debate over threshold at which CVR holders could take action Debate over threshold at which CVR holders could take action ◦ If threshold too high, could impede enforcement or give sanofi opportunity to

obtain blocking stake

◦ If threshold too low, could give holdup value to smaller holders

◦ Reporting Obligations• Concern that alemtuzumab not sufficiently “material” to sanofi to

require that separate information to be included in reports

• Sanofi undertook specific reporting obligations to deliver a separate statement detailing sales of alemtuzumab


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Market ReactionMarket Reaction

◦ Since issuance, have traded between $0.96 and $2.75C tl t $1 0 i t l $4 1 l th th l l t d • Currently at $1.07, approximately $4.51 less than the calculated “intrinsic value” and $0.93–$1.93 less than financial advisors’ estimates of a $2-$3 trading value discount

• On July 28 2011 sanofi-aventis announced that it expected to miss its On July 28, 2011 sanofi aventis announced that it expected to miss its 2011 production milestone for Cerezyme and Fabrazyme, and therefore did not expect to make its first milestone payment to holders of the CVR

◦ According to financial advisors, most institutional investors


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According to financial advisors, most institutional investors who received CVRs in the merger have since sold out of the security

Contingent Value Rights: the Gap in M&A...

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