Fully Understand R&D Collaboration and Associated Company Implications

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1 Fully Understand R&D Collaboration and Associated Company Implications September 25, 2015 kpmg.com

2 Contents 1 Introduction to Case Study page 2 2 Navigate the complexities of transaction accounting for collaborative Page 4 3 Solution to Case Study Page 18

3 Introduction to Case Study

4 Introduction to Case Study Facts Company Boston, a mid-size biotech company, and Company Cambridge, a decent sized pharmaceutical company, form a new company BosBridge to license a product from Boston. BosBridge is wholly owned and capitalized by Cambridge. Boston holds a fixed price call option to purchase BosBridge for cash which allows Boston to reacquire products through the exercise of this purchase option. Boston has a service provider contract with BosBridge at an arm s length price. BosBridge shall be managed by a Board of Directors Boston will chair the Development Committee (formed to oversee the development of the product) Boston and Cambridge shall appoint 3 directors of the Board and Development Committee 3

5 Navigate the complexities of transaction accounting for collaborative

6 Overview Arrangements involving research & development ( R&D ) activities may take different forms: Contracting R&D services; Financing R&D activities Collaborative R&D. The key factor determining the appropriate accounting for R&D is determining the substance of the arrangement. Some of the common complications while determining the substance of arrangement are that an arrangement may have facets of all types of the structures or the existence of related parties. A careful analysis of all rights and obligations of all parties to an arrangement is necessary to understand the substance of such. 5

7 Facets of R&D service Two parties: Engaging Party (e.g., Biotech or Pharma); and Service Provider (e.g., contract research organizations, CROs ). All risks and rewards from the R&D activities are borne by the Engaging Party: Engaging Party does not out-license any of its product rights; Engaging Party s in-house R&D function determines scope and activities to be performed by Service Provider; Engaging Party retains ownership and control over all R&D. Timing and volatility of cash flows: No cash inflows to Engaging Party; Often, total cash flows from the Engaging Party to the Service Provider are based on market rates for services (often time and materials); Sometimes, Service Provider receives an upfront payment to cover initial expenses. 6

8 Facets of R&D financing Types of investors: Strategic Investors (e.g., other Pharma); Financial Investors (e.g., private equity). Types of funding: Equity (non-controlling interests); Other. Involvement of investor: Strategic Investor will typically be actively involved in R&D and participate in Steering Committee; Financial Investor may Employ certain strategies to minimize cost of capital. Ownership of R&D is not transferred to investor/investor does not license IP. Timing and volatility of cash flows: Investee receives funding; Investor often receives milestones and royalties up to cap; Investee does not guarantee return to Investor (no minimums or floors) Early termination buyout clause may exists. 7

9 Facets of collaborative Definition in accounting guidance: A collaborative agreement is a contractual arrangement that involves a joint operational activity. It involves two or more parties who are active participants in the activities and are exposed to significant risks and rewards dependent on the commercial success of the activity. (ASC 808) Joint operational activities: Often development or exploitation of intellectual property. Two or more parties: Often, all parties are life sciences companies, one common combination is Biotech and Pharma; collaborative are not primarily conducted through a separate legal entity, however, part of a collaborative arrangement may be conducted in a separate legal entity. Active participation: E.g., performing development, manufacturing of clinical or commercial supply, providing a sales force, being part of a joint steering committee; Providing money is not active participation. Cont d on next page 8

10 Facets of collaborative (cont d) Exposure to risks and rewards: Transfer of rights to existing technology (use, develop, manufacture, sell, and/or sublicense), may be limited by time or geography Profit/loss sharing during commercialization (e.g., via royalty or profit split). Timing and volatility of cash flows: Up-front and milestone payments are common; Payments for services or cost sharing between collaborators, potentially in both directions. 9

11 Accounting impacts of collaborative If no legal entity is formed, or for the part of a collaborative arrangement that is outside of a legal entity: Per ASC , participants in a collaborative arrangement shall report costs incurred and revenue generated from transactions with third parties (that is, parties that do not participate in the arrangement) in each entity's respective income statement pursuant to the guidance in ASC An entity shall not apply the equity method of accounting under ASC and to activities of collaborative. ASC indicates that an entity shall evaluate the income statement classification of payments between participants pursuant to a collaborative arrangement based on the nature of the arrangement, the nature of its business operations, the contractual terms of the arrangement, and whether those payments are within the scope of other authoritative accounting literature on income statement classification. However, certain payments may not be within the scope of other authoritative accounting literature, in which case the income statement classification for the payments shall be based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational, and consistently applied accounting policy election. As an example, this guidance notes that if one party to an arrangement is required to make a payment to the other party to reimburse a portion of that party's research and development cost, that portion of the net payment may be classified as research and development expense in the payor's financial statements pursuant to Topic 730. A performance-based method or a milestone-base method is generally used to account for amounts received from funding parties for an R&D arrangement (assuming it is not a financing arrangement). The application of methods are based on facts and circumstances of each situation. Cont d on next page 10

12 Accounting impacts of collaborative (cont d) If no legal entity is formed, or for the part of a collaborative arrangement that is outside of a legal entity (cont d): Performance based method of accounting is based on ASC Under performance based method, revenue is recognized based on lower of non refundable cash received or, amount due based on the proportional amount of the total effort expected to be expended on the contract that has been provided to date. Total Payments Method and Payments Received Method are the two methods based on analogy of Performance based methods. Under the milestone based method, an entity recognizes revenue based on contingent consideration earned from the achievement of a substantive milestone in the period in which the milestone is achieved. This is based on the premise that the additional consideration earned from the achievement of the milestone is indicative of the additional value provided to the customer through either (a) the efforts performed to date by the entity or (b) a specific outcome resulting from the entity s performance to achieve that specific milestone. Cont d on next page 11

13 Accounting impacts of collaborative (cont d) If a legal entity is formed for part of an arrangement: If a legal entity is formed for part of an arrangement, the overall arrangement is a collaboration agreement, but the legal entity part of the arrangement is accounted for under ASC 810, ASC or other related literature. Counterparties may also be subject to analysis under the variable interest model under ASC

14 ASC: is the gateway Voting Interest Entity Variable Interest Entity Control ASC Topic 810 Not Primary Beneficiary Primary Beneficiary Joint Control ASC Topic 323 Significant Influence ASC Topic 323 Financial Instrument ASC Topic 320 or 325 ASC Topic 810 (VIE Subsections) Consolidate 13

15 Step 1: Does the reporting enterprise have a variable interest in the entity? Yes No Yes Step 2: Does the entity qualify for a scope exception under ASC 810? Apply other authoritative literature No No No Step 3: Is the entity a variable interest entity? Yes Step 4: Is the reporting enterprise the primary beneficiary? Yes Step 5: Consolidate Step 6: Review subsequent events 14

16 Considerations Issue Consolidation risk factors Loans to entity Put/ Call Indicator that entity is not sufficiently capitalized Fixed or formula priced options may protect equity investors from losses or cap their returns Power or other non-typical creditor rights granted through the financing instrument The size and/ or seniority of the instrument indicate that it may be exposed to economic risk that is potentially significant to entity In the money currently exercisable call options may provide the holder with power The option instrument may provide the holder with economic risk that is potentially significant to the entity Representation on Joint Steering Committee or Board Power over the entity through contract or through a party that does not hold an equity investment may require assessment under the VIE model Ability to appoint representatives to a joint steering committee may indicate power R&D Funding Paying/ reimbursing R&D costs through an R&D arrangement may protect the equity holders from losses R&D funding arrangement may provide payer with power over entity s most significant activities Arrangement may provide the payer with economic risk that is potentially significant to entity 15

17 Considerations Issue Consolidation risk factors Equity investment Royalty or license payments Investments in IP assets Combined with other potential red flags, the entity may be subject to the VIE model Variable payments may limit economic upside/ downside of equity holders and cause the entity to be VIE Investments in assets (IP) that represent greater than 50% of FV of an entity may trigger consolidation of the entire entity The equity may provide the holder with power Depending on the size of the investment, the instrument may provide the holder with economic risk that is potentially significant to the entity Power, if any, granted through the arrangement Size of payment(s) relative to the entity s projected cash flows Seniority of payments The size and/ or seniority of instrument may indicate that it is exposed to economic risk that is potentially significant to the entity Size of the asset(s) relative to overall entity Other relationships coupled with investment in IP assets (call option, funding, etc.) some of which may provide the holder power Collaboration Involvement in collaborations involving financing, R&D reimbursements, etc. may cause the entity to be a VIE The collaboration arrangement may provide the payer with power over the entity s most significant activities The arrangement may provide the payer with economic risk that is potentially significant to entity 16

18 Considerations Issue Consolidation risk factors Upfront and milestone payments Related parties Upfront and contingent payments are generally considered financing and may indicate that the entity is not sufficiently capitalized The existence of related party investors may result in the entity being a VIE if there is disproportionate voting and economic interests Power, if any, granted through the arrangement The size and/ or seniority of the payment may indicate that the party is exposed to economic risk that is potentially significant to the entity The existence of related parties may result in one of the related parties being required to consolidate the entity Related parties include parents, subsidiaries, equity method investees, members of management, principal owners and other entities that due to the nature of relationship are considered de facto related parties 17

19 Solution to Case Study

20 Solution to Case Study Analysis BosBridge, a JV, would likely be subject to VIE consolidation model as Boston s fixed-price purchase option effectively caps Cambridge s equity returns. BosBridge s economically significant activities are: Research and development Manufacturing Sales and marketing. Cambridge and Boston share control over BosBridge s Board of Directors. Boston has ability to control BosBridge s development committee through its chairman position. Boston has power to direct BosBridge s economically significant activities since it directs majority of those activities. Boston s service agreement may not be a variable interest in absence of fixed-price purchase option or other variable interests held by Boston and its related parties Boston appears to be the Primary Beneficiary of BosBridge. Boston may consolidate BosBridge. 19

21 The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. Service offerings are subject to legal and regulatory restrictions. Some of the services included herein may not be available to KPMG's financial statement audit or other attest service clients KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ('KPMG International'), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International Cooperative (KPMG International).

Revenue from contracts with customers The standard is final A comprehensive look at the new revenue model

Revenue from contracts with customers The standard is final A comprehensive look at the new revenue model What s inside: Overview... 1 Scope...2 Licences and rights to use...2 Variable consideration and the constraint on revenue recognition...5 Sales to distributors and consignment stock...10 Collaborations