M&A in the healthcare industry, particularly in the pharmaceutical/biotechnology sector, has maintained relatively healthy volumes over the past year compared with other industries. Dealflow has gotten a shot in the arm from flexible approaches to bridging valuation gaps between buyers and target companies -- including by making contingent value rights, or CVRs, part of the consideration offered to a target company's shareholders.

Buyers and sellers in this sector frequently struggle to come to terms on the value of development stage, or pipeline, products. The target company will typically focus on the value of its pipeline products on the assumption that they will be successfully commercialized. The acquirer, by contrast, will typically focus on the risk that these products may never successfully reach commercialization. CVRs that make a portion of the purchase price contingent on achieving specific milestones have helped bridge this valuation gap in several recent transactions. CVRs also can be used in share-for-share acquisitions to provide the target company's shareholders with protection against underperformance of the acquirer's stock. Finally, CVRs can be used to implement arrangements that in private transactions commonly would be referred to as earnouts.

CVRs tied to the future performance of development-stage products. Several recent transactions have featured CVRs with values tied to the future performance of a target company's pipeline products.

In January, Endo Pharmaceuticals Inc. agreed to acquire Indevus Pharmaceuticals Inc. for $4.50 per share plus a CVR entitling the holder to receive up to an additional $3 per share. The value of the CVR in this transaction is tied to Indevus obtaining certain approvals from the U.S. Food and Drug Administration that will permit it to market and sell two of its products -- Nebido, a testosterone-based treatment for male hypogonadism, and an octreotide implant for the treatment of acromegaly and carcinoid syndrome.

In July, ViroPharma Inc. agreed to acquire Lev Pharmaceuticals Inc. ViroPharma's initial proposal to acquire Lev was conditioned on Lev securing FDA approval and orphan drug exclusivity for Cinryze. The introduction of a CVR allowed ViroPharma to drop this condition. The CVR in this transaction entitles Lev shareholders to receive two additional cash payments of 50 cents per CVR -- one upon receipt of FDA approval and orphan drug exclusivity and another if cumulative net sales reach at least $600 million within 10 years after closing.

In September, Ligand Pharmaceuticals Inc. agreed to acquire Pharmacopeia Inc. At the time, Pharmacopeia was struggling to raise capital to finance its ongoing operations and was engaged in a review of its strategic options, most of which appear to have centered around developing Pharmacopeia's dual angiotensin and endothelin receptor antagonist, or DARA program. The CVR in this transaction entitles Pharmacopeia shareholders to receive under specified circumstances a proportionate share of $15 million if Ligand enters into a license, sale, development, marketing or option agreement with respect to the DARA program.

CVRs tied to the future performance of an acquirer's stock or of an acquired business. CVRs can be used to provide post-closing support to the value of an acquirer's stock that is issued to a target company's shareholders in connection with a transaction. Or they can serve to incentivize ongoing performance of a target company's business, commonly known as an earnout.

Where some or all of the consideration being paid in a transaction consists of stock of the acquirer, CVRs can be used to protect the target company's shareholders against downside risk associated with the value of that stock. In this situation, CVRs are often structured such that if the market price of the acquirer's stock over a pre-agreed trading period falls below a specified value, then CVR holders become entitled to receive the amount of any shortfall. The amount payable in this event may consist of cash, stock of the acquirer or some combination of both, and often is subject to a cap. This type of structure can be particularly meaningful in volatile trading markets and in cases where there may be significant downward pressure on a stock due to short-selling, adverse market developments or otherwise.

This type of CVR was used in ViroLogic's (now Monogram Biosciences) 2004 all-stock acquisition of Aclara Biosciences. The parties created a CVR that was used to guarantee the value of ViroLogic's stock for 18 months after closing. The value of each CVR was tied to the average trading price of ViroLogic's stock over the 15 trading days immediately prior to the end of the 18-month period, and the holder of a CVR at that time was entitled to receive in cash the difference between the average trading price and a guaranteed value of $2.90 per CVR, subject to a cap of 88 cents per CVR. Only the first 50 cents of any payment would be made in cash, and any amount above 50 cents could be paid in any combination of stock and cash.

CVRs may also be structured as earnouts, which are arrangements that require the acquirer to pay the target company's shareholders additional consideration if the target business performs as agreed after the closing. This type of CVR can be a particularly useful tool where there is concern about future revenue growth of the target business or a need to incentivize management of the target business to perform. It also allows an acquirer to defer part of the purchase price to a later date or, in some cases, indefinitely.

An earnout CVR is part of Fresenius SE's $4.6 billion all-cash acquisition of APP Pharmaceuticals Inc. In that case, in addition to cash consideration of $23 per share, each APP shareholder also received one Securities and Exchange Commission-registered and tradable CVR per share, which provide shareholders with an opportunity to realize value above and beyond the cash consideration per share by either trading the CVRs in the public markets or, if APP achieves specified Ebitda financial performance objectives, receiving an additional cash payment per CVR of up to $6.

Beyond their use and scope, it is important to understand the legal and technical issues associated with CVRs.

Securities Act of 1933/Securities Exchange Act of 1934. The SEC repeatedly has taken no-action positions on the question of whether the issuance of deferred payment rights, including CVRs, must be registered under the Securities Act of 1933, and in that process has developed a well-defined set of requirements to assist transaction participants in answering that question. In general, CVRs that do not confer on the holder an ownership position in the company that issued them and are not assignable or certificated are deemed not to be securities and therefore not subject to registration under the Securities Act. By contrast, CVRs that do not meet these criteria (for example, because they are listed on a securities exchange) are securities and therefore potentially subject to registration. The SEC registration process with respect to CVRs can be time-consuming and expensive, and registration can subject the issuer of the CVR to ongoing reporting and disclosure requirements imposed by the Securities Exchange Act of 1934, which are particularly onerous for an acquirer that is not already an SEC reporting company.

Trust Indenture Act of 1939. In some situations, CVRs may be subject to the Trust Indenture Act of 1939, which governs the public offering of notes, bonds and similar evidences of indebtedness. If the TIA applies, 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 (the acquirer in the M&A transaction) and the trustee.

U.S. Federal Income Tax Considerations. The Internal Revenue Service generally takes the position that 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. There is contrary authority, however, that would permit a seller to defer taking into account the value of a CVR unless and until it receives a payment under the CVR. Under the latter approach, a seller generally would treat a portion of any payment received as interest income and the remainder of the payment as capital gain.

If CVRs are issued in connection with an M&A transaction that is intended to qualify as a tax-free reorganization, the parties need to carefully consider how CVRs will be treated under tax rules requiring that the acquirer's stock comprise a minimum percentage of the total consideration (40% to 100% depending on the nature of the transaction). Depending on how the CVRs are structured, they might not be treated as stock under these rules, and as a result cause the transaction to fail to qualify as a tax-free reorganization.

Financial Accounting Statement 141R. Under newly-effective accounting standards, earnouts and other forms of contingent consideration used in M&A transactions, such as CVRs, are to be recorded as liabilities at fair value on the closing date of the transaction rather than at a later date when the contingency is finally resolved. The fair value of contingent payments that are to be settled with cash would then be subject to further adjustment in each accounting period during the lifetime of the contingency. Contingent payments that qualify under the rules to be classified as equity (that is, they can be settled with shares of the issuer and certain other requirements are met), however, would not be subject to further adjustment.

CVRs can be a useful tool to assist buyers and sellers in public company pharmaceutical/biotechnology deals to bridge valuation gaps that might otherwise impede successful transactions. Because of the technical issues associated with their use, care must be taken to structure them properly. The extent to which CVRs recently have been used in these types of transactions, however, shows that these technical requirements most often can be addressed.

Benjamin K. Sibbett is a partner in the New York office of Clifford Chance LLP, and Inderpal Singh is an assistant general counsel in the New York office of Pfizer Inc.