Getting deals done in this uncertain market is difficult, to say the least. Prices have yet to stabilize. Buyers are facing extreme difficulty in securing financing and are concerned about overpaying in a declining market. Sellers are struggling with a dramatic fall off in valuation and are often unwilling to sell at current prices, believing that the market is unfairly discounting their prospects and share price. As a result, M&A practitioners have had to find ways to resolve this stalemate so that deals can still get done. Enter the contingent value right (CVR).
CVRs are a tool for bridging the gap between the buyer’s concern (and the concern of its lenders) about overpaying in volatile times and the seller’s reticence to agree to a price in the face of low valuations. Through a CVR, you can construct a price protection mechanism that will provide an upward adjustment post closing where sufficient value has been created to warrant a higher price. Everybody wins: buyers can alleviate concerns about overpaying and sellers get full value for their assets.
In effect, a CVR is a price adjustment that is only triggered once a threshold financial milestone has been achieved or other value creating event has occurred. The theory behind the CVR is that there is enough uncertainty surrounding the triggering event that the buyer is unwilling to pay for it up front; but, if it does occur, the buyer would be happy to pay out more to the seller. In that case, the holder of the CVR receives additional cash or securities, usually based on a formula.
CVRs elegantly provide for a flexible price adjustment that can address highly contingent yet potentially profitable events (such as the settlement of litigation or the use of tax losses), and this makes CVRs a particularly effective and compelling tool in uncertain times. They have been used together with cash or stock or both (or with other securities) as a means of payment in a number of recent transactions to address the value unleashed as a result of triggering events such as threshold financial performance, successful takeovers or dispositions, debt restructurings, financings, lawsuit settlements, income trust wind ups, use of tax losses, etc.
In its purest form, where there is concern about future revenue growth of the target business or a need to incentivize management of the target business to perform, a CVR can be structured as an earnout very effectively so that the buyer is required to pay the seller additional consideration only if the target business performs as agreed after the closing.
A CVR can also be used to deal with future events with uncertain outcomes that may deliver great value, such as the target getting a favourable result in material litigation or regulatory approval.
In perhaps its humblest form, a CVR is an excellent tool on the wind up of an income trust or similar structure where costs and indemnity claims may be uncertain. Through a CVR, holders can participate in the funds left over (if any) from a pool created to pay unknown legacy liabilities and wind up costs.
Use of CVRs Across Sectors and Industries
Recently, we have seen CVRs used in a number of pharmaceutical and bioscience transactions where the contingent event was the receipt of required regulatory approvals for a new drug. However, CVRs have been used for many years in the context of all kinds of deals across several sectors and industries including manufacturing, oil and gas, mining and financial services. For example, a CVR has been used to:
- entitle the holder to receive an additional cash payment where the target’s net sales reach an agreed threshold within a prescribed number of years after closing.
- entitle the holder to a proportionate share of a cash pool if the target entered into a license, sale, development, marketing or option agreement with respect to certain intellectual property being developed.
- guarantee the value of the buyer’s stock for a period after closing where the value of each CVR was tied to the average trading price of the stock over the 20 trading days immediately prior to the end of the period, and entitle the holder of a CVR to receive (in cash) the difference between the average trading price and a guaranteed cash value per CVR, subject to a cap.
- provide the holder (where the CVR is both registered and tradeable) an opportunity to realize value above and beyond the cash consideration per share by either trading the CVR in the public markets or, if the buyer achieves specified EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) financial performance objectives, receive an additional cash payment per CVR up to a cap.
- entitle the holder to receive an additional cash payment per share if the target obtained certain approvals from the U.S. Food and Drug Administration that would permit it to market and sell one of its new drugs.
Legal and Technical Issues
There are certain unique legal and technical issues associated with CVRs.
Securities – Typically, CVRs are structured so that they do not confer on the holder an ownership position in the company that issued them and are not assignable or certificated and are deemed not to be securities. In some circumstances, however, CVRs are specifically structured so that they meet the criteria to become a security and are listed and registered.
Trustee – In some situations, CVRs may be issued pursuant to a trust indenture or similar agreement. If so, a trustee will need to be appointed to look after the interests of the CVR holders and a written indenture setting out the terms of the CVRs will need to be entered into by the issuer of the CVRs (i.e., the buyer in the M&A transaction) and the trustee.
Tax – The specific facts and the nature of the right will determine whether a seller must take into account the value of a CVR received as of the closing date for purposes of computing the seller’s capital gain or loss on the sale of its shares or whether it can defer taking into account the value of a CVR unless and until it receives a payment under the CVR. Clearly, the tax treatment is an important issue that needs to be considered in structuring the CVR particularly where the CVR is issued in connection with an M&A transaction that is intended to qualify as a tax-free reorganization.
Accounting – There are accounting issues in considering whether an earnout or other forms of contingent consideration used in M&A transactions, such as CVRs, is to be recorded as a liability at fair value on the closing date of the transaction or at a later date when the contingency is finally resolved. Important to this analysis is whether the contingent payment is to be settled with cash or with shares.
The innovative use of CVRs can be of great assistance in resolving price issues in M&A transactions. You can expect to see them used more frequently in these current volatile economic times where it is even more difficult for buyers and sellers to agree on price. CVRs provide a way to overcome disagreements or uncertainty about the underlying value or performance of the target. However, because of the technical issues associated with their use, care must be taken to structure CVRs properly, although these technical requirements can almost always be addressed.