Dealmaking in the life sciences sector took a major hit in 2022: the year was one of the lowest recorded years by value since 2017, with only $105 billion in merger and acquisition (M&A) deals completed by November 2022. The biopharma sector saw deal value fall by 42% compared with 2021, a decrease largely driven by a lack of megadeals and strategic partnerships. Similarly, M&A investment fell 53% compared to the full year in 2021. However, Q4 2022 marked a turning point.
At the end of November 2022, large biopharma companies had approximately $1.4 trillion of “firepower,” an 11% increase from 2021. Keeping in pace, Q1 2023 is off to an active start. M&A is expected to more closely resemble prior years with a total deal value in the $225–275 billion range across all subsectors. Licensing deals and strategic alliances remain a significant focus for biopharma companies as they seek to strengthen their Phase III pipelines while also taking advantage of lower valuations for preclinical and Phase I/II assets.
Industry Specialization: The Future of Life Sciences Deals?
Life sciences dealmaking is complex, with numerous deal structures at play. Knowing that innovation is necessary for the life sciences ecosystem, form is becoming increasingly less important than function. The fundamental goals for each party in a life sciences deal are to bridge valuation, de-risk the science, and reach successful commercial launch.
- “Scientific Renaissance”: The breakneck speed of innovation in the life sciences field, combined with inventor collaboration throughout the ecosystem and competing stakeholder interests, mean that dealmaking is unlikely to ever truly grind to a stop. For practitioners, industry knowledge, transactional creativity, and strategic thought partnership are critical for successful deal execution.
- Biopharmas’ business development and corporate development teams are becoming increasingly creative with deal structures by blending elements from traditional M&A transactions with partnerships and co-commercialization elements, along with spinoffs, options, and other creative mechanisms to de-risk research and development (R&D) spend and capital uncertainty.
- These hybrid structures are increasingly used with cutting-edge modalities and platform technologies, such as gene therapies, cell therapies, antibody drug conjugates, and immunotherapies, among others.
Three Key Differentiators in Life Sciences Dealmaking
The Ecosystem
It is very rare for an asset or platform to be developed 100% in-house. No other industry has such a tightly knit system of interrelationships among the key players—academics/hospitals, startups, biotechs, big biopharma—each creating a complex web of ownership issues, competing interests, and priorities. In life sciences, therapeutics typically change hands over many years, and understanding the risks that come with this sort of gated development, such as questions of inventorship and ownership, is critical.
- Upstream agreements: Unlike straight M&A deals that are typically constrained by shareholder rights and other regulations, licensing and partnering deals enable parties to de-risk transactions with increasingly creative mechanics and structures. In turn, these agreements become “upstream agreements,” which are critically important for a dealmaker to assess in this space. Loosely, an upstream agreement is a partnership agreement with a third party pursuant to which a party in-licenses or otherwise maintains control of patents, know-how, or other intellectual property (IP) rights. These are generally very bespoke, and material provisions can vary widely. One therapeutic asset could be governed by multiple upstream agreements with various material obligations.
- Flow-down obligations: For each upstream agreement, there are obligations that will “flow down” to the licensee or sublicensee, including contractual clauses or conditions regarding sharing clinical trial data or information related to IP improvements. One of the most important obligations is the diligence obligation to use commercially reasonable efforts to develop and commercialize an asset. As one can imagine, the specifics of such provisions can vary widely depending on the stage of the asset, the projected R&D spend, the projected patient population, competitive market forces, etc.
The Asset Lifecycle
Fundamentally different from other industries, an asset’s lifecycle through the life sciences ecosystem has complex diligence and upstream obligations that flow down to the buyer/licensor. Given the nature of the businesses, it is critical to perform specialized diligence around IP, US Food and Drug Administration, healthcare reimbursement, and regulatory, licensing, partnering/collaborations, solvency, and international compliance.
Beware the ‘Poison Pill’
Given the amount of licensing and collaboration transactions that life sciences startups enter into, often with very limited resources, we frequently see companies entering into complex material agreements without specialized counsel. Unfortunately, this is when serious mistakes can be made that create potential landmines when the company seeks to further partner the asset or seeks additional fundraising. These are sometimes called “poison pills” and they have a very different meaning in the life sciences sector versus the public M&A context.
When applied specifically to life sciences transactions, a “poison pill” is a clause or provision in an upstream agreement that creates problematic flow-down obligations—for example, a very broad obligation to share confidential information, know-how, inventions, future patents, improvements, etc. with an upstream licensor, unrealistic milestone and royalty obligations that overly burden the margins given development costs, or issues related to the diligence obligation to develop and commercialize the asset. If the risk is too high or the upstream licensor won’t renegotiate to limit these rights, a future acquiror or partner may walk from the deal rather than face future litigation or risk “poisoning” their platform.
The Science
Earlier-stage assets generally have lower valuations because of the cost and risk associated with clinical development and commercialization. As the assets move to Phase 3 or Marketed, there are higher premiums and bigger upfront costs at the trade-off of less risk.
For a practitioner in this industry, it is critical to understand the type of modality or technology (i.e., the science!). For example, the risks associated with a gene-editing deal versus a small molecule deal are dissimilar. Therefore, the constructs and mechanics that corporate lawyers use to solve for those risks are very different, regardless of the form of the transaction.
Given the nuances of life sciences dealmaking, it is not uncommon to have 25 pages of scientific and industry-specific definitions, regardless of whether it is a licensing and collaboration agreement or an asset purchase agreement. What is critical for practitioners to realize is that, since there are not quality standard form agreements, the biggest problems often arise due to what is not reflected in the contract versus what is.
Five Considerations When Conducting Specialized Diligence
- If the entire value of the company is one or two intangible assets, it is important to confirm that the company actually owns them.
- Determine if there are any upstream obligations to the previous owners/investors because they will become your upstream obligations.
- Watch for provisions in upstream collabs that can “poison” a company’s platform—for example, know-how related to complex gene-editing processes.
- Look for grant-backs of know-how/IP and other bespoke obligations.
- Understand that it is a duty to share improvements upstream to competitors and report unusual change-of-control provisions in upstream agreements that will get triggered by the deal.
Economics: What Makes Dealmaking Different
Whether a partnership deal or an M&A deal, economics are often very similar and reflect the R&D stage of the asset and expected market opportunity. While it would be nearly impossible to get a deal to zero risk, there are many creative mechanisms to de-risk the situation as much as possible. One trend emerging in the industry is an increase in licensors/sellers requesting firm diligence obligations (i.e., anti-shelving protections).
Bridging Valuation Gaps
Earnouts are commonly used in private target transactions to bridge valuation gaps. When the target is public, however, two types of deal structures are becoming more common in life sciences transactions:
- Spinoff mergers: The target company separates some of its assets into a separate company and distributes the shares of this company to its shareholders. After the spinoff is completed, the spun-off company (SpinCo) then merges with a third-party buyer.
- Spinoff mergers may be used to move certain assets and liabilities into a new company in connection with an anticipated sale (e.g., to move a target company’s clinical-stage products into a new vehicle but not the target company’s early-stage products).
- This can be helpful from a valuation perspective because it allows a potential seller to separate those assets that are difficult to value from those that are more concrete.
- This structure is not without challenges, as the SpinCo must be set up as a standalone public company, and there are oftentimes remaining interdependencies between the SpinCo and the parent company that must be contracted around.
- Contingent value rights (CVRs): CVRs serve the same purpose as an earnout in a private transaction—namely a value bridge given that the sellers only receive additional consideration if events that are likely to, or do, result in additional revenue for the buyer are achieved.
- This can be particularly helpful in the pharma space since the value of a drug, for example, can change drastically depending on its ability to achieve a major development or milestone.
- The market tends to see more CVRs in a shift from a seller’s market to a buyer’s market, as was seen in 2022 when there was more public CVR deals than in the previous two years combined.
- As is the case with earnouts, CVRs typically contain a hotly negotiated covenant that spells out what the buyer does, and does not, have to do in order to achieve the payment triggers (Efforts Clause). The Efforts Clause can take time to negotiate and, regardless of what it says, compliance is ripe for litigation.
- To mitigate risk, a buyer should push to eliminate the Efforts Clause; specify that CVR holders can enforce their rights only through the rights agent, not individually; specify that only a minimum percentage of CVR holders can have the rights agent bring claims for breach of the Efforts Clause; reduce the relative size of the CVR; and ensure that payment milestones are clearly defined and objectively determinable.
Trends to Watch in 2023
- Renewed interest in solvency and bankruptcy issues and increased attention toward the financial health of a partner when considering a collaboration or partnership due to increased capital constraints and stricter lenders. As a result, we are seeing creative de-risking strategies emerge.
- Impact of Inflation Reduction Act (IRA) on pharmaceutical pricing. While much remains to be seen as to how the IRA will impact pricing long term, it is clear that there will be significant impacts, potentially for indications and therapeutics that come with a very high R&D spend. As a result, partners are starting to consider bespoke provisions in deals to address downstream pricing impacts. Expect to see this become more common.
- Increased antitrust/anticompetition oversight and enforcement action. US and EU federal agencies have increased their focus on increasing competitive activities in the pharmaceutical markets, and this trend is unlikely to change in the near term. Partners/buyers may need to consider alternative structures and accept a fair amount of regulatory risk on deals of all types.
- Committee on Foreign Investment in the United States (CFIUS)/government regulations on US-China transactions. Despite some uncertainty when US President Joseph Biden issued a series of executive orders in fall 2022, the recent CFIUS approval of the F-Star Therapeutics deal was well received by the markets and could pave the way for increased US-China biotech deal activity. China remains a major market and we can expect to see territorial out-licensing to pick up speed again.
- Increased focus on enforcing CRE diligence obligations to capture downstream economics. With the ongoing capital crunch creating headwinds for many biotechs, companies may begin to review their existing partnerships and test whether those partners have actually just “shelved” the asset (and explore what their remedies might be for an alleged diligence failure). This could potentially lead to increased arbitrations and deal renegotiations in the near term.
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