Contingent value rights key to PE financing of pharmaceuticals

By Wang Zhijian, Zhonglun W&D Law Firm
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A contingent value right (CVR) is a value right linked to a certain important event, e.g. if expectations are not achieved or fall below par, the relevant value or rights and interests can be cancelled or reduced. CVRs play a relatively major role in the private equity (PE) financing of pharmaceutical enterprises.

王志坚 Wang Zhijian 中伦文德律师事务所 高级合伙人 Senior Partner Zhonglun W&D Law Firm
Wang Zhijian
Senior Partner
Zhonglun W&D Law Firm

A key step in PE financing is valuation of the target enterprise. However, reaching a consensus on the value of a product currently undergoing research and development or a pending invention patent is difficult, as is valuation of the same. These factors may ultimately result in failure of the transaction.

The research and manufacture of a new pharmaceutical product must undergo pre-clinical research of the process, quality standards, pharmacological effectiveness, toxicology, stability, etc., then proceed to clinical research after the securing of the clinical approval document, then proceed to application for approval for production after completion of the clinical research, only at which point can production then commence and the opportunity for entering the market be chosen. The foregoing procedures are time consuming and involve complicated and numerous approval stages.

Even if the approval document is secured, the anticipated returns are yet to be seen. For example, a chemical pharmaceutical undergoing research is often a generic version of a product that has been released onto the market abroad but has yet to be released on the market in China, and once a heavyweight chemical generic drug hits the market, it spawns numerous copiers, so if the first generic maker is unable to achieve high market returns within a short period of time, the later generic makers will quickly carve up the market, and the first generic maker’s profits will drop. Accordingly, the value of a product undergoing research is difficult to accurately determine, and there will be a serious discrepancy in the valuation of the target enterprise by the parties.

In such a situation, the provision of a CVR clause in the transaction agreement can erect a price protection mechanism, promoting the smooth completion of the transaction. The essence of a CVR clause is that if, after completion of the transaction, a greater anticipated value is created, contingent value rights can bring an upward price adjustment, or, alternatively, no adjustment may be made, or they can bring a downward price adjustment.

For example, the agreement could specify that where the new pharmaceutical certificate and production approval document for the product undergoing research, or the patent certificate, are not secured within a certain period of time, the value of the target enterprise will be so much. In this manner, the investor’s unease about paying too much will be reduced and the party seeking the financing will be able to realise the true value of the assets.

Operational finesse

Application of a CVR can be standalone or a combination bundling two events: (1) bundled to the future result of the research and development. A CVR is applied to reflect the value of the target company’s product that is undergoing research. Neither the investor nor the party seeking the financing can guarantee that the research and development of the new product can be completed, or that the new product will be released onto the market and be a success. In this case, a CVR is a good balancing instrument; (2) bundled to the target enterprise’s performance. Such a design is used to incentivise the sustained growth of the target company’s business, ultimately producing a win-win situation for the parties. This, in enterprise private equity financing, is most worth promotion.

Payment based on a CVR clause generally bundles five possible triggering conditions (also known as milestones): (1) securing of the clinical approval document for the target pharmaceutical; (2) completion of the clinical trials for the target pharmaceutical; (3) securing of the approval document for the production of the target pharmaceutical; (4) realisation of the mass sale of the target pharmaceutical; and (5) realisation of a certain net sales turnover of the target pharmaceutical.

Specifics of the clause

If the CVR clause specifies the securing of an evidentiary document, such as a new pharmaceutical certificate, production approval document, patent certificate, etc., the securing of such document, the date of securing the same, the number of enterprises that secure a production approval document and the temporal order in which they secure the same will be marks of the realisation of the CVR clause. The design of the CVR clause needs to be privately formulated based on the features and claim points of the product and the parties’ enterprises.

If the CVR clause specifies that the sales turnover of a certain product after it is released on the market is to serve as the criterion for determining the value, there may exist a problem of verifying the product’s sales turnover. The parties may have different opinions on the product sales figures and the truthfulness of such figures.

To reasonably resolve such a problem, we would recommend that the parties to the transaction jointly appoint a neutral third party to verify the product sales volume, the recovery of payments, details of the sales territory and even the reasonableness of the sales policy, and specify that the outcome of the verification is to be approved by the parties. The neutral third party could be a lawyer specialising in the medical field, who would do the investigation and verification based on the relevant materials on the supply channels, etc., provided by the parties, issue an investigation report and submit it to the parties.

A CVR clause is a bargaining process until the parties are able to find a mutually acceptable compromise. Users have to be aware that a CVR is a complex instrument, with its future use full of uncertainty, and if ineptly used can produce an effect opposite to that anticipated. No transaction party hopes that the CVR clause will become the subject of a legal action and pose a challenge to the performance of the company or the interpretation of the milestones.

However, given that such factors as financing, valuation, oversight and the above-mentioned challenges aggregate in a certain transaction, a CVR is an extremely important and effective instrument for the completion of a transaction.

Wang Zhijian is a senior partner at Zhonglun W&D Law Firm and is the chairman of the healthcare practice and head of the Chengdu office; Zhang Di, a legal assistant at the Chengdu office, contributed to this article.

Co-writer Kang Qi is a teacher at Sichuan College of Traditional Chinese Medicine

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