How to treat pharma option deals on income statement? POC, CC, other?

This question comes from my work. I’m in the pharma industry, and my startup company is discussing an option deal with a large pharma company. I just learned about the completed-contract (CC) method (from my CFA studies), and it looks like the pharma company would use this method to record the contract. However, my boss (who has a CFA) says the pharma company would have to expense everything upfront and each year…I think he’s referring to POC (percentage of completion), but I’m not sure. This is the deal we’re talking about. We owe the rights to a drug candidate. We plan to put together an option deal with a major pharma company, and the option would be over 4 years or so. The pharma company buys the option upfront, pays R&D expenses (eg clinical trials) throughout the contract, and then at the end of development, can exercise the option at a prenegotiated price to license the drug outright. I think this qualifies as CC because the estimates of revenue AND costs are not reliable for the pharma company (different story for our startup). The drug can earn nothing to billions of dollars; if it fails during clinical trials, it earns nothing. The expense estimates are unreliable too, because if the drug fails early in R&D, there’s no need for later stage clinical trials. Only the upfront expense to buy the option is known. What do you guys think? The pharma company would love to keep it off the P&L, but my boss has been saying for months that they cannot. Are there specific restrictions regarding pharma development deals/programs? Or is my boss wrong and it’s time for me to step up and have a discussion with him. Thanks in advance!

I realized I needed to clarify further. For the pharma company, they still won’t see revenue/profit until 2 or 3 more years after they’ve licensed the technology via the option exercise. They’ll still need to do more R&D work to get it approved. In that case, when do they expense this? Even in the CC method, they’ll have to expense upon option exercise even though there’s no revenue yet?

The acquirer will (obviously) need to consult with a CPA but, unless this qualifies as a business combination under GAAP (which doesn’t seem to be the case given the limited info you have provided above), the more likely treatment is that the up-front payment would be expensed in the year of acquisition as In-process Research and Development.

What you’re describing is pretty common for development-stage biotechs. Check out Infinity Pharmaceuticals. They have a similar deal with Mundipharma: From the notes (INFI 2010 10-K) Collaboration Agreements In November 2008, we entered into strategic alliance agreements with each of Purdue and Mundipharma to develop and commercialize pharmaceutical products. The alliance includes product candidates that inhibit or target the Hedgehog pathway and FAAH, and product candidates arising out of all our discovery projects in all disease fields that achieve development candidate status on or before December 31, 2011 (with Mundipharma having the right, through the exercise of two consecutive one-year options, to extend such period through December 31, 2013). We refer to such three to five year period as the funded discovery period. Our Hsp90 and Bcl-2 programs are expressly excluded from the alliance. The agreement with Purdue is focused on the development and U.S. commercialization of products targeting FAAH. The agreement with Mundipharma is focused on the development and commercialization outside of the United States of all products and product candidates covered by the alliance, including those targeting FAAH. Under the strategic alliance agreements, we have responsibility and decision-making authority for the performance of early discovery projects and the development of all product candidates on a worldwide basis. There are no joint steering or similar committees for the alliance. Mundipharma is obligated to pay 100% of our contractually budgeted amounts for research and development expenses incurred by us for early discovery projects and product candidates included in the alliance until the later of December 31, 2013 and the commencement of the first Phase 3 clinical trial of such product candidate, which we refer to as the transition date. The contractually budgeted amount for the period between November 19, 2008 and December 31, 2009 was $50 million and the contractually budgeted amount for the years ended December 31, 2010 and 2011 is $65 million and $85 million, respectively. After the transition date for each product candidate other than those arising out of the FAAH project, we will share with Mundipharma all research and development costs for such product candidate equally. Upon completion of the first Phase 1 clinical trial of IPI-940, Purdue and Mundipharma may elect to assume responsibility, at their own expense, for the future development of products arising out of the FAAH project and their sale in and outside of the United States, respectively. We are recording revenue for reimbursed research and development services we perform for Mundipharma and Purdue. We recorded $46.5 million in such revenue in the year ended December 31, 2009. ======== I realize your question deals with the larger company (Mundipharma in the example above), but it’s a good starting point. The options fail the revenue recognition test, so they can’t be recognized on big pharma’s income statement. However, it is an asset, so they may be able to hold it as a long-term investment on the balance sheet, possibly at cost. Caveat - I’m not a CPA. This is just speculation. I may look it up in the standards tomorrow.

Yeah, they’ll record it as an R&D expense. Here’s what I was looking for: MedImmune’s 10-K, describing their research collaboration with Infinity. Quote: In August 2006, we entered into a collaborative agreement with Infinity Pharmaceuticals, Inc. to jointly develop and commercialize novel small molecule cancer drugs targeting Heat Shock Protein 90 and the Hedgehog cell-signaling pathway. Under the terms of the agreement, we made upfront payments to Infinity of $70.0 million, which were recognized as research and development expense in the third quarter of 2006 and agreed to potential development and sales-related milestone payments of up to $430.0 million. (…) We recorded charges totaling $91.7 million during 2006 and $54.2 million during 2005 associated with upfront fees and milestone payments under licensing agreements and research collaborations, which are included as a component of research and development expense in the consolidated statements of operations.

Great. Thanks guys. This was really helpful.