While deal-makers remain optimistic about the pace of business development in the drug industry, external forces continue to drive a wedge between the valuation expectations of buyers and sellers – leading to an increase in contingent value rights, earn-outs and other structured mechanisms that can require some fancy negotiating footwork.

At a recent meeting hosted by Southern California biotech trade group BIOCOM, Campbell Alliance's Ben Bonifant explained the factors that are pushing down valuations.

First, buyers see little room to increase drug prices in the future. According to Campbell's 2011 Dealmakers' Intentions Survey, buyers started the year by creating valuation models based on a 2 percent average annual price increase in the U.S., flat pricing in Europe and a 0.7 percent price decrease in Japan.

Yet those averages masked a surprisingly broad variance in individual expectations, Bonifant noted, with models for U.S. prices ranging from a 5 percent decrease to a 5 percent increase. Such variance makes it difficult for sellers to figure out what's realistic.

Second, Bonifant said increasing competition is driving down valuations in the buyers' eyes. He noted that while there were four VEGF-targeted compounds and eight EGFR-targeted compounds in the clinic in 2000, there were 20 VEGF and 14 EGFR-targeted compounds in the clinic in 2010. Such an increase in competition leads to a decrease in market share assumptions.

Third, discount rates in deal evaluations are increasing, Bonifant said, which lowers asset valuations. And fourth, the cost of clinical trials is increasing, which further drives down valuations.

David Sabow, vice president of investment banking at Canaccord Genuity Inc., noted another factor during a recent presentation at Foley & Lardner's Life Sciences Conference. In 2009, public company stock prices were so depressed that it wasn't uncommon to see acquisition premiums of 50 percent. But as stock prices have recovered, "premiums have retracted a lot" and are now more in the 30 percent range, he said. Yet some sellers still have those higher premium stars in their eyes.

Bridging the Gap

Despite lowered valuations, deal-making activity continues apace. One reason might be that sellers have few alternatives, thanks to a nonexistent public offering window, declining venture investments and tough capital markets. But structured deals including contingent value rights and earn-outs are also helping to bridge the valuation gap.

"Valuation gaps have become more and more prevalent, and earn-outs are one way we can get deals done," Sabow said.

Bassil Dahiyat, president and CEO of Xencor Inc., agreed that "people are willing to pay and pay a pretty penny if they can pay later." He added that such deals do not have to be centered around "biobucks" but can include achievable milestones, codevelopment rights and other mechanisms that provide the seller with true value.

Structured deals have certainly become the norm: Just last week, Cubist Pharmaceuticals Inc. acquired Adolor Corp. for about $190 million up front plus $225 million in contingent payment rights tied to certain regulatory approvals and commercialization milestones.

And when Biotie Therapies Oyj acquired Newron Pharmaceuticals SpA last month, it, too, used milestone payments tied to regulatory filings. (See ,BioWorld Today, Sept. 28, 2011, and Oct. 25, 2011.)

But such deals can be difficult to structure. The earn-out trigger must be clearly defined to avoid disputes over whether it has been achieved, and the deal structure must keep both the buyer and seller incentivized to fulfill their obligations. (See BioWorld Insight, March 14, 2011 .)

Mark Stevenson, president and chief operating officer of Life Technologies Corp., said he thinks commercial revenue is the simplest earn-out trigger.

Technical achievement of milestones can be more difficult to assess, he said.

James Chapman, partner with Foley & Lardner, noted that tiered earn-out deals are gaining traction. In that structure, achieving a milestone within a certain time frame triggers a higher payment, while a missed deadline might trigger a lower payment. Cubist used this approach in its Adolor deal, with limitations on regulatory approvals resulting in reduced contingent payments.

Deal-Making Trends

Campbell Alliance's Bonifant noted that sometimes, when buyers and sellers just can't close the valuation gap, sellers are choosing to hold onto their assets longer – and in some cases they are reaping the rewards.

Sometimes that reward comes in the form of a better deal down the road.

Gloucester Pharmaceuticals Inc. put out several business development feelers during development of Istodax (romidepsin) for cutaneous T-cell lymphoma, but the biotech ended up keeping the drug all the way through FDA approval, after which it was acquired by Celgene Corp. for $640 million. (See BioWorld Today, Dec. 8, 2009.)

Other times just retaining U.S. rights to a drug through Phase II can be enough to create significant value. Campbell Alliance's report said several companies who followed this strategy got a market value surge of $140 million to $685 million when the positive Phase II data were released. Among the top earners were Onyx Pharmaceuticals Inc. with carfilzomib, Incyte Corp. with INCB18424 and Seattle Genetics Inc. with brentuximab vedotin.

The pressures on asset valuations in deal-making and the potential for such big valuation boosts when rights are retained are driving big pharma and big biotech buyers to consider some new strategies, Bonifant said.

First, some buyers are letting sellers retain U.S. rights and striking ex-U.S. partnerships, he said. Such deals can provide the foundation for an acquisition down the road.

Second, some buyers are recognizing that they'll have to pay more to acquire U.S. rights to a post Phase II product. But as Vical Inc. senior vice president of corporate development Igor Bilinsky said during the BIOCOM meeting, buyers might prefer derisked post-Phase II assets, but "how many of those assets are available?"

Indeed, the Campbell survey showed that both buyers and sellers largely expect Phase II and Phase III deal-making to remain steady, while preclinical and Phase I deals increase. Bonifant said he is "seeing movement among certainly big pharma toward early-stage deals."

But Brian O'Callaghan, president and CEO of Sangart Inc., countered that "if companies are looking at earlier stage deals, it's not their preference, it's by default."

Bonifant also noted that some buyers are countering the growing competition by moving into new areas, and that he sees "new risk tolerance" for fields like stem cells and gene therapy.

O'Callaghan added that if the seller can provide pharmacoeconomic analyses and offer some level of comfort on the FDA's stance on emerging technologies, that can allow the buyer to "overlook some technical risk."