7A Research And Development Affiliates

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					Appendix 7-A
RESEARCH AND DEVELOPMENT AFFILIATES


INTRODUCTION

                      Because GAAP in the United States requires that all expenditures for research and develop-
                      ment (R&D) be expensed, firms have looked for alternative methods of financing R&D that
                      postpone the associated earnings charge. Alternate financing methods may also have the fol-
                      lowing advantages:
                           • Targeting investors who are attracted by the risk/reward characteristics of specific projects
                           • Focusing management attention on specific projects by placing their development in a
                             separate entity.
                      We discuss the two most common forms of these arrangements, R&D partnerships and de-
                      velopment companies. The drug and biotechnology industries have been the most common
                      users of these techniques, perhaps because R&D is focused on the development of discrete
                      patentable products.

Appendix Objectives
                           1. Examine the motivation for the establishment of R&D arrangements.
                           2. Show the effect of R&D arrangements on the amounts and timing of research and de-
                              velopment expense.
                           3. Show the effects of R&D arrangements on reported net income, stockholders’ equity,
                              and financial ratios.
                           4. Compare the effects of R&D arrangements on companies using accounting methods
                              that expense all R&D with those permitting capitalization.

RESEARCH AND DEVELOPMENT PARTNERSHIPS

                      An R&D partnership raises funds from investors. Those funds are then used to pay the com-
                      pany for research. Any patents or products resulting from that research belong to the partner-
                      ship, but the company can either purchase the partnership or license the product. Thus, the
                      company controls the technology without reporting the expenses resulting from research
                      costs, as the “revenue” from the partnership offsets the research expense.
                           This arrangement has many of the attributes of an option; the firm has a call option on
                      the patents or products developed for the partnership, with the purchase price being the exer-
                      cise or strike price. Shevlin (1991) treats such limited partnerships (LPs) as an option and
                      uses option pricing theory to value the LP:

                           The value of the LP call option to the R&D firm may be decomposed into the present value of
                           the underlying project financed by the LP (an asset) less the present value of the payments to
                           the limited partners if the firm exercises its option (liability).1


                      1
                       Terry Shevlin, “The Valuation of R&D Firms with R&D Limited Partnerships,” The Accounting Review, Jan. 1991,
                      pp. 1–21.


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RESEARCH AND DEVELOPMENT PARTNERSHIPS                                                                                             W15

                              SFAS 68 (1982), Research and Development Arrangements, sets criteria to distinguish
                         true transfers of risk from disguised borrowings. The following are indicators that there has
                         not been a true transfer of risk:

                              1. The company has an obligation to the partnership (or investors) regardless of the out-
                                 come of the research. Such obligation may take the form of a guarantee of partner-
                                 ship debt or granting of a “put” option to the investors.
                              2. Conditions make it probable that the company will repay the funds raised by the part-
                                 nership. Such conditions include the company’s need to control the technology
                                 owned by the partnership or relationships between the company and the investors
                                 (e.g., top management invests in the partnership).

                         If there has not been a true transfer of risk, then the company is required to expense the ac-
                         tual research costs and treat funds received from the partnership as borrowings.
                              When the requirements of SFAS 68 are met, however, the company can recognize rev-
                         enue from the partnership to offset R&D costs. The result is, in effect, a deferral of research
                         cost until products are sold (and license fees paid) or the partnership is purchased. Such
                         arrangements are disclosed in financial statement footnotes and analysts should be alert to
                         their effects on reported income.
                              In recent years, a new vehicle has largely superseded the R&D partnership: a separate
                         development company that sells “callable common” shares to the public. The shares are often
                         packaged with warrants of the (parent) company to make the resulting “units” more attrac-
                         tive to investors. The new common shares are callable at prices that promise a high rate of
                         return to investors if the venture is successful. These vehicles are similar to R&D partner-
                         ships in their effects on the firm.


                         Analysis of Firms with R&D Affiliates
                         The impact of R&D affiliates on reported financial results is favorable as research costs are
                         offset by “revenue” from the affiliate. Reported income would be lower if these costs were
                         funded by borrowing (or from the firm’s own assets). Further, obtaining those funds would
                         require additional debt or equity capital. R&D financing arrangements permit the company to
                         conduct research without incurring debt or equity dilution, in addition to avoiding the effects
                         of reporting the research costs as an expense.
                              There is a cost to this capital, however. When the partnership is purchased or the
                         callable common is called, a substantial cash payment or share issuance is required. Given
                         the risk, investors in R&D affiliates require a high rate of return.
                              The second cost factor is the impact when the affiliate is purchased. At that time, the
                         purchase price must be written off as research costs.2 The resulting write-off usually exceeds
                         the amount of funds originally raised. But that write-off is delayed until the partnership is
                         purchased. In effect, these arrangements permit the deferral of research costs, but with the
                         penalty of a high interest factor (cost of capital).


                         R&D Affiliates Outside of the United States
                         In jurisdictions that do not require all R&D to be expensed, the incentives for alternative
                         arrangements are weaker. Under IAS GAAP, as discussed in the chapter, research costs must
                         be expensed but development costs are capitalized and amortized. Canada has similar re-
                         quirements, as seen in the analysis of Biovail that follows. However, given the preeminence
                         of the United States capital market, even non-U.S. firms may use these techniques to enhance
                         their earnings reported under U.S. GAAP.


                         2
                          FASB Interpretation 4 (1975) provides that when an acquisition is accounted for under the purchase method of ac-
                         counting, any portion of the purchase price allocated to R&D must be immediately expensed at the time of the ac-
                         quisition. Chapter 14 contains more discussion of this issue.
W16                                                    APPENDIX 7-A       RESEARCH AND DEVELOPMENT AFFILIATES


      Example: Biovail
      Biovail [BVF] is a Canadian pharmaceutical company. It used several R&D affiliates to fi-
      nance drug development in the 1990’s. We will focus on one such arrangement, Intelligent
      Polymers [INP], incorporated in Bermuda.
           In October 1997, there was an initial public offering of 3.7 million units at $20 per unit,
      resulting in net proceeds after expenses of approximately, $69.5 million.3 Each unit con-
      sisted of:
           • One Intelligent Polymer common share
           • One warrant to purchase one Biovail share at $10 per share (adjusted for subsequent
              stock splits) from October 1, 1999 through September 30, 2002
      Biovail recorded a credit to equity of $8.244 million to reflect the value of the warrants is-
      sued and an equal reduction of retained earnings to record the contribution to INP. The net
      result of the offering was that INP received $69.5 million of capital with no net effect on
      Biovail’s financial statements.
          At the time of the offering, the two companies entered into a series of agreements, in-
      cluding the following provisions:
           1. INP agreed to spend the proceeds to develop seven possible products, paying BVF to
              conduct the required research.
           2. INP would hold the rights to products developed but Biovail would have options to
              purchase those rights at predetermined terms.
           3. Biovail had the option to purchase all shares of INP at the following prices:
              • $39.06 per share before October 1, 2000
              • $48.83 per share from October 1, 2000 through September 30, 2001
              • $61.04 per share from October 1, 2001 through September 30, 2002

      The development agreement resulted in payments from INP to Biovail shown in the follow-
      ing table:

                 Years ended December 31                   1998            1999            2000           Totals

                 Payments to Biovail                       $9.7           $33.0           $55.2          $97.9
                 Biovail’s related costs                   (6.7)          (19.8)          (35.2)         (61.7)
                 Biovail gross profit                       $3.0           $13.2           $20.0          $36.2

           Over the three-year period, INP paid Biovail approximately $98 million for research. If
      Biovail had conducted the research itself, the total cost would have been nearly $62 million.
      The effect of forming INP was to increase Biovail’s reported pretax earnings by the amount
      of the payments received. The significance of these amounts can be seen from Biovail’s rev-
      enues (Exhibit 7A-1), which rose from $111.6 million in 1998 to $309.2 million in 2000.
           In 1999, Biovail paid INP $25 million for the rights to one developed drug. On Septem-
      ber 29, 2000, Biovail exercised its option to purchase all INP shares, for a total price (includ-
      ing bank debt) of $204.9 million. The purchase resulted in a write-off of in-process research
      and development (IPRD) of $208.4 million. The write-off resulted in an operating loss for
      the year of $78 million. The IPRD was far above the actual research expenditures. However
      the creation of INP had the effect of delaying the recognition of these costs in Biovail’s fi-
      nancial statement. It also reduced Biovail’s risk; if the INP research had not been successful,
      Biovail would not have exercised its option.4
           We can see the cost of capital implicit in the creation of INP by examining the invest-
      ment from the investor point of view. Ignoring (for the moment) the Biovail warrants in-



      3
       All dollar amounts in this section are United States dollars even though Biovail is Canadian.
      4
       It is also possible that Biovail would have exercised its option even in the event of failure in order to maintain full
      control of its proprietary technology.
RESEARCH AND DEVELOPMENT PARTNERSHIPS                                                                                             W17

                         cluded in the offering, investors bought INP shares for $20 each. The call prices shown
                         above provide rates of return of 25% per annum. As Biovail shares rose substantially, trading
                         above $45 per share in November 2000, the actual return (including the gain in the Biovail
                         warrants) was even higher. Of course, investors took the risk that the INP research would not
                         have produced marketable drugs.5
                             In economic terms, the Intelligent Polymers capital came at a high price to Biovail.
                         However, the risk reduction may have made the cost of capital acceptable relative to other
                         sources of capital available at that time. The INP arrangement also resulted in postponed
                         recognition of the research costs associated with the development of these drugs. As IPRD
                         write-offs are often seen as “non-recurring” costs, it is uncertain how the financial markets
                         value firms with such charges.

                         Comparison of Biovail Financial Statements: U.S. vs. Canadian GAAP
                         Under Canadian GAAP, IPRD and the acquisition cost of drug rights are capitalized and
                         amortized over the useful life of the products. Both the $25 million paid to INP in 1999 and
                         the cost of acquiring INP in 2000 resulted in asset recognition (rather than being expensed
                         under U.S. GAAP). Biovail had written off more than $105 million of IPRD in 1999 from
                         another R&D arrangement. The difference between the treatment of these transactions be-
                         tween U.S. and Canadian GAAP can be seen in Exhibit 7A-1.


                         EXHIBIT 7A-1. BIOVAIL
                         Financial Data under United States and Canadian GAAP
                         All data in $US thousands, except per share

                         Years Ended December 31                                   1998              1999                  2000

                         United States GAAP
                         Revenue                                                 $111,657          $172,464            $ 309,170
                         Operating income (loss)*                                  45,303           (40,160)              (78,032)
                         Net income (loss)                                         41,577          (109,978)             (147,796)
                         Earnings per share (diluted)                                0.38             (1.07)                (1.16)

                         Total assets                                            $198,616          $467,179            $1,107,267
                         Long-term obligations                                    126,835           137,504               438,744
                         Convertible securities                                                                           299,985
                         Common equity                                             49,888           267,336               237,458

                         Common shares outstanding                                 99,444           124,392                131,461

                         *Includes IPRD charges                                                    $105,700             $ 208,400

                         Canadian GAAP
                         Revenue                                                $ 98,836           $165,092            $ 311,457
                         Operating income                                         35,145             64,117              116,223
                         Net income                                               31,419             52,080               81,163
                         Earnings per share (diluted)                               0.29               0.47                 0.57

                         Total assets                                            $199,919          $635,137            $1,460,967
                         Long-term obligations                                    126,835           137,594               438,744
                         Shareholders’ equity                                      19,091           391,794               839,110

                         Common shares outstanding                                 99,444           124,392                131,461

                         Note: While the treatment of IPRD and the cost of acquired drugs are the principal differences between U.S. and
                         Canadian GAAP, the data also reflect other differences.
                         Source: Biovail 10-K, December 31, 2000



                         5
                          See footnote 4; for this reason, the risk may not have been excessive.
W18                                              APPENDIX 7-A    RESEARCH AND DEVELOPMENT AFFILIATES


               The principal differences are:
               1. Under Canadian GAAP, there is a progressive improvement in both operating and
                  net income, as well as earnings per share. Under U.S. GAAP, the IPRD write-offs re-
                  sult in operating and net losses for both 1999 and 2000.
               2. Canadian GAAP assets exceed those under U.S. GAAP, reflecting the capitalization
                  of drug acquisition costs.
               3. Canadian GAAP equity exceeds that under U.S. GAAP, mainly due to the difference
                  in net income.
           The ratio effects of these differences are the subject of Problem 7A-1.

           Conclusion
           The Biovail—Intelligent Polymers example illustrates the effects of research and develop-
           ment arrangements on the financial statements of the sponsoring company. Such arrange-
           ment can have major impacts on the amount and timing of reported net income, as well as
           the balance sheet and cash flow statements. While ultimately, company valuation depends on
           research (and subsequent marketing) outcomes, the analyst should carefully consider the ef-
           fect of such arrangements on the financial statements of affected companies.


PROBLEMS

           7A-1. [Ratio effects of differences in accounting for R&D arrangements].
                 A. Using the data in Exhibit 7A-1, calculate the following ratios for Biovail for 1998
                     through 2000 under both United States and Canadian GAAP:
                       (i) Return on sales (net income margin)
                      (ii) Return on equity
                     (iii) Asset turnover
                     (iv) Equity per common share
                           Note: use year-end amounts for balance sheet data.
                 B. Discuss the differences between both the level and trend of the ratios computed in
                     part A.
                 C. The price of Biovail shares rose from less than $9 per share at the end of 1997 to
                     nearly $39 per share at the end of December 2000. Discuss which set of ratios ap-
                     pears to be reflected in the market performance of Biovail shares. Discuss any
                     other factors that may have affected the price of Biovail shares during this time
                     period.
                 D. State which of the two methods of accounting for IPRD (immediate write-off ver-
                     sus capitalization and amortization) comes closest to recognition of the economic
                     impact of the acquisition of drug rights. Justify your choice.
                 E. Discuss the limitations of the method chosen in part D.
                  F. Discuss whether the accounting for internal drug research expenditures should
                     differ from that for acquired drug rights.
           7A-2. [Analysis of R&D Arrangements] In September 1997 ALZA (acquired by Johnson
                 and Johnson in June, 2001) contributed $300 million to Crescendo Pharmaceuticals, a
                 newly created company. ALZA formed Crescendo to help fund the development of
                 new pharmaceutical products. Crescendo and ALZA entered into the following agree-
                 ments:
                  1. Crescendo was required to spend virtually all of its available funds to fund the de-
                     velopment (by ALZA) of seven possible new products.
                  2. ALZA granted Crescendo a worldwide license to use ALZA technology in con-
                     nection with product development activities. Crescendo paid ALZA a specified li-
                     cense fee.
PROBLEMS                                                                                    W19

            3. Crescendo granted ALZA options to license products developed, exercisable on a
                country-by-country basis after clearance from the Federal Drug Administration
                (FDA) or appropriate foreign regulatory body. ALZA also had the right to pur-
                chase Crescendo’s right to receive license fees. Both the license fee and the pur-
                chase price were based on predetermined formulas.
           4. ALZA had the right to purchase all Crescendo shares until January 31, 2002 at a
               price equal to the greater of:
                 (i) $100 million
                (ii) The market value of 1 million ALZA shares
               (iii) $325 million less all amounts paid to ALZA by Crescendo under the agree-
                     ment, and
               (iv) A formula based on license fees paid to Crescendo by ALZA over the previ-
                     ous four calendar quarters.
           ALZA could purchase Crescendo shares for cash, ALZA shares, or a combination of
           the two. The option deadline would be extended if Crescendo had not yet expended
           all of its funds.
                 On September 29, 1997, ALZA contributed $300 million to Crescendo, of which
           $247 was recorded as a “non-recurring” expense. Crescendo shares were distributed
           to ALZA’s shareholders and debenture holders as a dividend.
                 Over the next three years, Crescendo made the following payments to ALZA:

                 Years Ended December 31            1998          1999         2000

                 Payments for research              $95.0         $90.5        $68.3
                 Technology fees                     10.7           6.7          2.7
                 Administrative service fees          0.2           0.2          0.2

               ALZA paid the following to Crescendo for three drugs that had been successfully
           developed:

                 Drug license fees                                 $2.4         $4.5

                On November 13, 2000 ALZA paid $100 million to acquire all outstanding
           shares of Crescendo. $45.7 million of the purchase price was allocated to developed
           products as deferred product acquisition costs and $9.4 million was expensed as
           IPRD.
                Exhibit 7AP-1 contains financial data on ALZA for the three years ended Decem-
           ber 31, 2000.
                Use the data provided to answer the following questions.
           A. Prepare income statements for ALZA for the years 1998 through 2000 assuming
               that the Crescendo transactions had not taken place.
           B. Calculate the percentage change in each of the following from 1998 to 1999 and
               from 1999 to 2000, using reported data:
                  (i) Revenues
                 (ii) Expenses
                (iii) Operating income
                (iv) Pretax income
           C. Calculate the percentage change in each of the following from 1998 to 1999 and
               from 1999 to 2000, using adjusted data from part A:
                  (i) Revenues
                 (ii) Expenses
                (iii) Operating income
                (iv) Pretax income
W20                                                APPENDIX 7-A    RESEARCH AND DEVELOPMENT AFFILIATES

      EXHIBIT 7AP-1. ALZA CORP.
      Financial Data
      All data in $millions, except per share

      Years Ended December 31                                      1998         1999       2000

      Net sales                                                   $ 289.4     $ 448.0      $607.2
      Royalties, fees, and other                                    233.1       227.1       281.2
      Research and development                                      124.4       120.8       100.1
        Total revenues                                            $ 646.9     $ 795.9     $ 988.5

      Costs of products shipped                                     (125.7)     (158.4)     (180.2)
      Research and development                                      (182.8)     (183.6)     (190.8)
      Selling and administrative                                    (141.9)     (259.0)     (349.4)
      Merger-related charges                                            —        (45.7)         —
      In-process R & D                                            00000—      00000—      00.(12.4)
         Total expenses                                           $ (450.4)   $ (646.7)   $ (732.8)

         Operating income                                           196.5       149.2       255.7
      Interest and other income                                       26.4        41.6        59.0
      Interest expense                                            00.(56.7)   00.(58.1)   00.(58.0)
         Pretax income                                            $ 166.2     $ 132.7     $ 256.7
      Income tax expense                                          00.(57.9)   00.(41.7)   00.(26.0)
      Net income*                                                 $ 108.3     $ 91.0      $ 230.7

      *before cumulative effect of accounting change


              D. Calculate the effect of the adjustments in part A on each of the following for the
                 three years ended December 31, 2000:
                    (i) Revenues
                   (ii) Expenses
                  (iii) Operating income
                  (iv) Operating margin
                   (v) Pretax income
                  (vi) Pretax margin
                 (vii) Times interest earned
              E. Describe the effect of the Crescendo transactions on each of the following, using
                 the results of parts A through D:
                    (i) ALZA’s reported growth rate for 1999 and 2000
                   (ii) ALZA’s reported profitability for 1998–2000
                  (iii) The volatility of ALZA’s profitability for 1998–2000
                  (iv) ALZA’s reported return on equity for 1998–2000.
                 Hint: Consider the effect of the Crescendo transactions on ALZA’s equity.
              F. Discuss the benefits and drawbacks to ALZA of the Crescendo transactions, using
                 the results of parts A through E.
              G. Considering the Crescendo transactions as a whole, justify the analytical adjust-
                 ments in this problem.