Understanding and evaluating deal considerations in the contract research organization sector An update for private equity investors This issue explores certain financial and tax issues that private equity investors should consider when making investments in contract research organizations (CROs). Financial considerations a proportional-performance method. resulting in out-of-period recognition Revenue recognition—A CRO’s services Under a proportional-performance of revenue that should be evaluated can include multiple elements and extend method, units of measures (e.g., sites as part of the quality of earnings. CRO over several quarterly or annual reporting initiated, investigators enrolled, or labor services typically include multi-element periods, requiring involving significant hours) are identified at the onset of a arrangements that should be evaluated estimation and judgment in recognizing contract, and revenue is recognized based in the context of the CRO’s revenue revenues over the earnings cycle. The on the proportion of units completed to recognition policies. scope of CROs’ services span from date to the total units identified. Revenue planning, administering, and reporting of true-ups can occur throughout the Unbilled and deferred revenue— clinical trials, and revenue is recognized as contract term due to scope changes and Buyers should consider the working services are performed generally under changes in unit of measure estimates capital implications of a CRO when evaluating a transaction. Payment terms Industry trends—A number of industry tend to be prescribed on predetermined change orders less contract cancellations wide trends have impacted CROs, which payment schedules, and as result, a that occurred during the period. should be considered in a buyer’s evaluation CRO’s financial statements may contain • Book to bill ratio—Evaluates the ability of a CRO. a significant amount of unbilled and of the CRO to replenish their backlog deferred revenue. Unbilled revenues with new business by comparing net • Global reach of clinical trials— should be analyzed to assess whether new business generated in the period to Pharmaceutical companies are increasing they supported and do not include any revenue recognized in the period. A ratio the number of clinical trials at sites in the unapproved scope changes or indications of greater than 1.0 signifies backlog growth developing world, which requires that of disputed amounts. Deferred revenue and a ratio below 1.0 signifies contraction. successful CROs have a global presence. represents cash received in advance The proliferation of global clinical trials of services being performed. Buyers • Conversion ratio—The ability of the subjects CROs to multiple regulators should consider whether deferred target to convert backlog to billed revenue. and to foreign currency fluctuations, revenue balances will continue at • Backlog concentration—Concentration which should be evaluated by a potential historical levels (i.e., deferred revenue with one customer may indicate a risk buyer in an effort to identify potential balances are replenished by future cash to the CRO if one significant customer compliance and foreign currency advances). If not, buyers will be left with decreases or terminates its relationship exposures. the performance obligation but without with the CRO. Or, concentration within one • CRO concentration—A number of the corresponding cash flow associated therapeutic area may indicate a risk to the large pharmaceutical companies have with future advances. Upon purchase CRO if clinical trials are cancelled because consolidated their use of CRO service accounting, the buyer only recognizes a of new scientific information, approval of providers, resulting in lost backlog and deferred revenue liability measured at competing product candidates, or as a increased competition among CROs. its fair value to the extent that deferred result of regulatory directives. revenue represents a performance • CRO consolidation—Many CROs, in obligation assumed by the buyer. It is • Aging of backlog—The aging of the an effort to achieve scale to compete in unlikely that the fair value of the deferred revenue backlog may be an indication later stage clinical trials and increase their revenue is to equal the carrying amount of whether the backlog will ultimately be global presence, have executed a number on the deferred revenue on the buyer’s recognized into revenues. Projects can be of recent acquisitions. As a result, a CRO’s books, possibly resulting in less amount delayed due to the completion of requisite historical performance may not fully of revenue being recognized in the post- clinical trial phases or can be an indication reflect recent acquisitions, the impact of transaction period. of a customer’s ability to obtain project which should be considered in diligence. funding. Revenue backlog—Revenue backlog • Pass through expenses—An analysis of Tax considerations represents the future revenues from a CRO’s revenue backlog should include Deferred revenue—A CRO that is an work not yet completed under executed an analysis of the amount of pass through accrual method taxpayer may account contracts, letters of intent, or in some expenses included in the revenue backlog. for advance payments using the deferral cases pre-contract commitments when A significant portion of a contract award method, whereby such taxpayer may defer supported by pervasive evidence that could be a reimbursement of expenses by the recognition of advance payments to an arrangement exists. Revenue backlog the customer – the margin of which may an immediately succeeding tax year if should be considered in evaluating a be significantly lower than the margin on the revenue is also deferred for financial potential acquisition target; however, services provided directly by the CRO. reporting purposes. During due diligence, it buyers should be cautioned on relying is important to evaluate whether the target on revenue backlog as the sole indicator Development stage customers—A CRO’s may be deferring too much income for tax of future revenues. The realization of a customer base may include a number of purposes, as this could create historical CRO’s revenue backlog into revenue can development stage companies that may income tax risk to a buyer. Subsequently, be affected by a number of factors – a not have the requisite funding to complete when a CRO is acquired, the terms of its number of which are outside the control clinical trials. This can cause delays in project contracts and the structure of the deal will of the CRO, including cancellations, starts and completions, and also may result likely dictate the seller’s and the buyer’s changes in scope, or delays by customers in the CRO taking on additional collection tax consequences. In a stock acquisition, or regulatory authorities. Buyers can risk or structuring contingent or equity for example, accounting methods generally evaluate the quality of a CRO’s backlog by based fee arrangements. The composition carryover and a buyer could be forced to analyzing: of a CRO’s customer base should be recognize taxable income in a post-closing tax period without the corresponding cash • Net new business—Measures the analyzed in an effort to identify potential if the target uses the deferral method. As amount of new contract awards and risks of converting revenues to cash. such, it is important to know whether a establishments, which are fixed places target uses the deferral method in order of business that trigger income tax to analyze “debt-like” items and project and/or value added tax (VAT) filing future cash taxes. In deemed and actual requirements. Complying with the various asset acquisitions, for example, the Treasury requirements can be challenging, given Regulations and other authoritative sources that each jurisdiction has its own rules may prevent a buyer from recognizing and regulations. As such, it is important to taxable income in a post-closing tax period; analyze whether a CRO has policies and however, such Treasury Regulations and procedures in place to comply with the other authoritative sources may accelerate various requirements, given that historic tax the recognition of deferred revenue to the exposure could be inherited and future cash sellers. As such, it is important to analyze flow could be adversely impacted. deferred revenue early in the deal process in an effort to manage sellers’ expectations. Trapped cash—Multinational CROs with US parents may conduct their operations outside of the US via controlled foreign corporations (CFCs), which are subsidiaries that are formed in the respective foreign jurisdictions. Often, the undistributed earnings of the CFCs are indefinitely reinvested in the respective foreign jurisdictions, which enables the CROs to shield such earnings from taxation in the US and potential withholding taxes. In a cash- free/debt-free deal, parties often agree to increase the purchase price for any excess cash that is recorded on the consolidated balance sheet. Some of the excess cash may be “trapped” outside of the US in CFCs, meaning that there will be a tax cost to repatriating the excess cash to the US As such, it is important to consider the tax cost of repatriating the excess cash when determining purchase price. Foreign tax compliance—Many multinational CROs have operations in numerous foreign jurisdictions. Such operations may create permanent Life Sciences & Health Care M&A Transaction Services team Phil Pfrang Kyle Woitel