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US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries
62.Pre-existing relationships in a business combination
Relevant guidance
Company A in-licenses a Phase I compound from Company B in
20X5. With the in-license agreement, Company A acquires the
global exclusive rights to develop and commercialize the asset,
including rights to manufacture, market, and sell any successful
product. The rights granted are for 25 years, the full protected
life of the intellectual property. Company B retains the ownership
(legal title) of the initial intellectual property.
The acquirer and acquiree may have a relationship that existed
before they contemplated the business combination, referred
to here as a preexisting relationship. A preexisting relationship
between the acquirer and acquiree may be contractual or
non-contractual… [ASC 805-10-55-20].
The terms of the in-licensing agreement are that Company A
pays $300 million upfront and, if commercialized, a 5% royalty
on all sales. Company A is responsible for all development of the
product and any incremental intellectual property completed by
Company A is owned by Company A.
The product has successfully moved to pre-Food and Drug
Administration (“FDA”) approval (i.e., Phase III). Company A
acquires Company B for $2 billion in 20X3, and the acquisition
is accounted for as a business combination. There was no stated
settlement provision provided for by the in-license agreement.
Assume that the market rate to in-license the intellectual property
is the same as above: $300Â million of payments plus a 5% royalty.
However, the market rate to in-license both initial intellectual
property and the incremental intellectual property would be a
20% royalty (which is equivalent to the $2 billion in fair value of
the company). The higher cost reflects the fact that a Phase III
asset is more likely to generate positive cash flows compared to a
Phase I asset.
If the business combination in effect settles a pre-existing
relationship, the acquirer recognizes a gain or loss, measured
as follows:
• For a pre-existing non-contractual relationship, such as a
lawsuit, fair value
• For a pre-existing contractual relationship, the lessor of
the following:
– T he amount by which the contract is favorable or
unfavorable from the perspective of the acquirer when
compared with pricing for current market transactions for
the same or similar items…
– T he amount of any stated settlement provision in
the contract available to the counterparty to whom
the contract is unfavorable… [ASC 805–10–55–21].