Contingent Value Rights (CVRs) – Solution for a Valuation Puzzle?
June 30, 2022
By Parash Dodhia and Samit Shah
According to the June 2016 issue of Harvard Business Review, “M&A is a mug’s game, in which typically 70%–90% of acquisitions are abysmal failures.”
- In 2015, Microsoft wrote off 96% of the value of the handset business acquired from Nokia.
- In 2012, Google sold the handset business it previously bought from Motorola for $12.5 billion to Lenovo for $2.9 billion.
- In 2012, Hewlett Packard wrote down $8.8 billion of its $11.1 billion Autonomy acquisition.
- In 2011, News Corporation sold MySpace for a mere $35 million after acquiring it for $580 million.
The potential synergies in a corporate M&A are often hard to value at the time of the transaction. Setting a deal price is often one of the logjams in any negotiation; sometimes it is the only logjam. Valuations done by the acquiree company may factor in some of the future events (like patent approval for drugs in early-stage development) from which the acquiring company may see benefit. However, for the acquiring company, correctly predicting the outcome of those events is contingent upon many factors, and the process may result in disagreement over current valuations. A probable solution to the problems associated with information asymmetry in M&A has been the introduction of more complex instruments. Contingent value rights (CVRs) may be a useful tool to bridge the valuation gap, preserving potential future value of certain assets for the acquiree company’s shareholders.
What Are Contingent Value Rights?
CVRs are instruments which commit an acquiring company to pay additional consideration to the acquiree company’s shareholders if a specified milestone or threshold is achieved in the future. These rights ensure that the shareholders get additional benefits if specific and target events occur, usually within a specified timeframe. CVRs are also referred to as contingent payment rights.
Usage of CVRs
CVRs are extraordinarily flexible tools that can be structured in a variety of ways to suit the facts and circumstances of a particular transaction. A significant portion of CVR transactions occur within the pharmaceutical and life science industry. If a pharmaceutical company’s drug is successful in clinical studies or receives FDA approval, it may be worth billions of dollars. However, if the studies are unsuccessful or if a development-stage drug faces clinical stage failures, then a drug candidate may be worthless. As a result of this heads-you-win/tails-you-lose nature of the pharmaceutical industry, companies that make acquisitions tend to worry about overpaying, while companies that are being acquired worry about selling out at too low a price. CVRs can also be useful in the case of targets that operate in industries where “production variables” increase the complexity of valuing assets and future revenues, such as the mining industry. We expect to see this structure used more frequently in other sectors also.
CVRs are similar to options because they frequently have an expiration date beyond which the shareholders' rights to future benefits will not apply.
Risks Associated with CVRs:
There are also risks associated with CVRs. For the company making the acquisition, there is the risk of providing an incorrect valuation. For the company being acquired, failure to achieve target event leads to financial loss of future payments.
Accounting and Valuation of CVRs:
Accounting treatment for CVRs under U.S. GAAP is governed by the ASC 805 “Business Combinations.” ASC 805 mandates fair value accounting for contingent consideration in business combinations. Before the adoption of ASC 805, contingent payments were usually recognized only when the contingency was resolved.
Companies that make the acquisition shall record a CVR as a liability or as equity, based on the form of purchase consideration payable, at fair value which can be determined by the following approaches:
- Discounted cash flows (net present value of probability-weighted future payments).
- Using derivative valuation methods such as the Black-Scholes Option pricing model.
Fair value of CVRs classified as liability is remeasured at each reporting date, until CVRs are settled and changes in fair value will be recognized in income statement. CVRs classified as equity are not required to be remeasured at each reporting date.
The company that is acquired should record the asset at the acquisition date, if fair value can be determined based on available observable inputs, or estimated using valuation techniques; otherwise, income will be recorded on date of settlement. It has to remeasure, at each reporting date, fair value of asset already recorded. Changes in fair value will be recognized in income statement.
Pros and Cons of CVRs
- Bridges the valuation gap for an unpredictable future event.
- Consensus among the parties leads to faster closure of the deal.
- Acquirer gets liquidity benefits until the achievement of target event.
- Flexibility of crafting a transaction based on the parties’ business expectations and desires.
- Multiple layers of triggering events along with various financial condition brings complexity.
- Acquirer company is required to record an estimated charge at day one for uncertain future payments.
- Failure of target event may raise potential dispute among the parties at future date
Currently there is a lot of untapped potential for the use of CVRs in M&A deals outside the pharmaceutical and life science industry. The global pandemic resulted in a huge market for distressed businesses across industries. Owners of the distressed businesses may use CVRs to derive better valuations and get true value of businesses rather than selling it at a discounted price. On other side, potential buyers of such distressed businesses are also considering the economic benefit they are getting from the deal.