Question

Assume that you are on an audit team reviewing the purchase price calculations for accounting treatment of a recently completed acquisition of a target entity. The following are background facts:

The acquirer and target are both in the pharmaceutical industry. The target has been a startup that has been in business for about three years. Its activities have focused on the development of drugs treating Alzheimer's conditions. The founders of the company have raised equity capital for the company primarily through sale of Preferred stock. The company has a modest amount of debt associated with the purchase of computers and laboratory equipment.

The startup has gathered some of the brightest scientists in the field who joined the target because of their interest in the specific research areas, and their desire to benefit financially from the stock options provided to them by the startup entity.

News releases by the acquirer note the following:

• The target company currently has no sales revenue.
• Non-compete agreements have been signed by the three founders of the company and detailed valuation reports have been reviewed by the auditors and found appropriate to support their valuation at $15 million total.
• The company headquarters are located in Los Angeles about a mile from the USC campus
• The carrying value of the assets of the target company are $20 million
• Before a drug is allowed to be made available for sale, five stages (levels) of approvals need be acquired from the Federal Drug Administration agency.
• The target company has 15 drugs under development and in various stages of FDA approval
• The typical percentage of drugs receiving full approval by the FDA maybe in the range of 15% of those initially submitted for approval. In this case, it is hoped that the high-quality work by the target company will result in an approval rate of perhaps twice the typical level
• Approvals for new drugs typically take several years before approval due to the long term testing required to assess drug usefulness and possible side effects.
• The transaction will result in the acquisition of all of the stock of the target company by the acquiring entity.
• The purchase contract arrangements include $300 million in cash paid to the target company shareholders
• A contingency payment of up to $75 million will be made to the target company shareholders if all 15 drugs are approved by the FDA within a two-year period of time.

The audit team has been asked to meet with the CFO to discuss the acquiring company’s plans for the accounting treatment for the transaction. The email related to the plans for the meeting included the following brief schedule identifying $375 million as the purchase price paid for the assets included in the deal.

Purchase Price:                                 $375,000,000

Cash                                                   $300,000,000  

Contingency payment.                     $75,000,000

Question: Maintaining the concept of “professional skepticism” discussed during the course, please provide specific observations, (no longer than three sentences) related to the accuracy of, or problems with, the $375 million purchase price identified above?

Answer 1

first of all understand what are the terms of the aquisition to comment on purchase consideration.

So my comment would be

" The company has offered the total consideration of $ 375 million which includes the contingent consideration of $ 75 milion, the acquistion terms are ' A contingency payment of up to $75 million will be made to the target company shareholders if all 15 drugs are approved by the FDA within a two-year period of time.'

but the probability of occurance of such event is very less likely because normal industry standards show that only 15% of the drugs submitted for approval gets approval in actual, even the competence of the target company is to achieve double of the probability i.e. 30% in such case max 5 (4.5 rounded) drugs will get approval before they get for long term testing.

so that chances that contingent consideration will be disbursed are very less and management should reconsider the consideration terms. "

i know this got a little bigger than 3 sentenses but its for your understading, please compress the same so that it get precise.