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Contingent Value Rights: Contingent Value Rights: Bridging the Valuation Gap in M&A Deals

Structuring 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 THURS DAY, S EPTEMBER 8, 2011

Today’s faculty features: Igor Kirman, Panel Chairman, Partner, Wachtell Lipton Rosen & Katz, New Y

• rk

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

• rk

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

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

• rk

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CVRs: Bridging the Value Gap

Igor Kirman, Program Chair, Wachtell Lipton Igor Kirman, Program Chair, Wachtell Lipton 212.403.1393 IKirman@wlrk.com Robert Arsov, Credit Suisse 212.538.7032 robert.arsov@credit-suisse.com Andrew Ment, Covington & Burling 212.841.1012 ament@co com ament@cov.com September 8, 2011

Covington & Burling Credit Suisse Wachtell Lipton

Table of Contents Table of Contents

• Overview of CVR Securities
• Sanofi-aventis/Genzyme Case Study

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What are CVRs? What are CVRs?

• Contingent
• Value
• Rights

g

• 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-Driven Price 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
• r performance metrics

p

• Can also conceptually divide CVRs into “Financial Performance-

Based” and “Event-Based”

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Price-Protection CVRs Price 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 i market 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
• f acquiror’s stock

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Price-Protection CVRs Price 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 d valuation period

• Covenants/events of default
• Anti-dilution adjustments

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Event-Driven CVRs Event 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
• f 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 CVRs Event 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 rights

Non 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 Considerations Other 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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Other CVR Considerations Other CVR Considerations

• 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
• r receive dividends) or otherwise represent an ownership interest in the

buyer buyer

• 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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Other CVR Considerations Other CVR Considerations

• 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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Other CVR Considerations Other CVR Considerations

• 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)

Other CVR Considerations Other CVR Considerations

• 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 year

CVR 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

Other CVR Considerations Other CVR Considerations

• 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
• f 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

Other CVR Considerations Other CVR Considerations

• 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
• f 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
• n the issuer’s income statement
• n the issuer s income statement
• Mark-to-market accounting may apply for listed CVRs

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Other CVR Considerations Other CVR Considerations

• 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 i the 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 CVR realized 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 Gap Bridging the Gap

• CVR security originally proposed as a means of bridging valuation

gap between sanofi aventis and Genzyme gap 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/ h price equal to or greater than $80/share

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Dispute: Alemtuzumab Dispute: Alemtuzumab

• Chief dispute in valuation was potential of a drug in Genzyme’s

pipeline alemtuzumab pipeline, alemtuzumab

• Alemtuzumab had already been approved by the FDA for treatment of

leukemia, and was currently in Phase III trials for treatment of multiple sclerosis sclerosis

• 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 / year

p 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 80 Not 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 d milestones 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 i alemtuzumab or confusion over payment mechanics

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Not in the 70s and Not a Hard 80 Not 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 CVR Resulting CVR

Maxim um Total Paym ent 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

• r 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 jurisdictions Product Sales Milestone #2: $3 for achieving sales of the “Product” of $1.8bn within four consecutive quarters Product 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

• f 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 Milestone Approval Milestone

• Payment tied to receipt of FDA approval of alemtuzumab for

treatment of multiple sclerosis on or before March 31 2014 treatment 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 Milestones Product 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 Milestone Production 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 d decided 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 Issues Other 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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Other Major CVR Issues Other Major CVR Issues

• 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
• f 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 ld quantities 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

Other Major CVR Issues Other Major CVR Issues

• 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

Other Major CVR Issues Other Major CVR Issues

• Enforcement

I 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
• btain 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 Reaction Market Reaction

• Since issuance, have traded between $0.96 and $2.75

C 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

• f 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