Let me bridge the Gap
In M&A transactions, the determination of the value of a target company may sometimes give rise to a debate. For example, typical valuation methods may have their limits when it comes to the potential of undeveloped or early-stage assets. The difficulty in predicting the outcome of contingent events (e.g. major litigation involving the target), may also have a material impact on valuation. Contingent Value Rights (CVRs) may be a useful tool to bridge the valuation gap between the buyer and the target while, in certain cases, preserving potential future value of certain assets for the target’s shareholders.
What is a CVR?
A CVR is a right granted by the buyer to the target’s shareholders to receive one or more additional payments upon the achievement of certain milestones or agreed upon triggering events.
A CVR is flexible and can be used in a variety of circumstances. As an example, for a biotech company with a molecule in early-stage development involving high risks and uncertainties for which the buyer is not prepared to attribute any material value, a CVR could be structured with conditions to adequately protect all interested parties, such that for example:
- payments would be made to the target’s shareholders only after FDA approval; and
- payments would be based on a percentage of sales/license revenue to be derived by the buyer from a molecule, less development costs (which may be subject to limitations, such as a global cap).
A CVR could also be used to provide for additional consideration to the target’s shareholders upon the settlement of material litigation involving the target. It can also be useful in the case of targets that operate in industries where “production variables” increase the complexity of valuating assets and future revenues, such as the mining industry. In such case, a CVR can be linked to the development of projects, achievement of milestones, amount of a certain product produced and fluctuation in relevant benchmark prices, etc.
Beware of Canadian securities law implications
The instrument evidencing amounts owed under the terms of the CVR may be deemed to be a “security” under applicable Canadian securities laws. If so, it will be essential to ensure that all provisions that apply to the issuance of securities under applicable Canadian securities laws be complied with, and to verify the extent of any post-closing reporting obligations in Canada as a result of the issuance of CVRs to Canadian shareholders.
What are the Pros of CVRS?
- they can bridge valuation gap;
- they can increase deal certainty;
- they allow for the allocation of risks between buyer and the target’s shareholders; and
- they can protect future potential value of certain assets for the target’s shareholders.
What are the Cons of CVRs?
- potential for dispute depending on the complexity of the terms and any payments calculation;
- negative potential effect on the buyer resulting from (i) potential multi-year operational constraints depending on the terms of CVRs, (ii) payment overhang, (iii) balance sheet liability, etc;
- possibility that the buyer may be subject to public reporting obligations in Canada so long as the CVRs are outstanding; and
- potential credit risks since payments under the terms of CVRs depend on the solvency of the buyer and CVRs are unsecured claims by holders unless provided otherwise.
As noted in this post, CVRs have their limits but are worth considering as one of the tools available in structuring M&A transactions.