Medical Device Link.

Originally Published MX March/April 2002

FINANCE

Valuing In-Process R&D

E. W. (Sandy) Purcell (Houlihan Lokey Howard & Zukin)

Expect the lab to get a little hotter. Medical technology executives should anticipate heightened scrutiny of in-process research and development (IPR&D) acquired in mergers and acquisitions and reflected in the allocation of purchase price to tangible and intangible assets.

Last year, the accounting arbiters scrapped pooling in favor of purchase accounting. They also did away with goodwill amortization. Company executives and their appraisers now must devote more attention than ever to how acquirers allocate the price of buyouts to intangible assets and how much of that price ends up as goodwill. This holds doubly true for IPR&D, an intangible asset that has historically drawn intense review by the Securities and Exchange Commission (SEC).

The stakes for medical technology manufacturers are great. Many medtech companies must roll out new products as the life cycles of their existing products reach maturity. Each year, the medtech industry invests billions of dollars in R&D. IPR&D can easily equal 20–30% of a technology buyout’s purchase price.

Medtech executives typically believe that their hefty investment in R&D is worth much more than allowed by their auditors and the SEC. This is particularly the case with medtech company founders who are scientists with no training in accounting standards.

One area of confusion for medtech executives lies in when to recognize an item as IPR&D. Executives are sometimes surprised when valuation experts rule out early-stage research as IPR&D. To expense a project as IPR&D, a medtech company needs a plausible projection of cash flows to be generated by the prospective device. This projection must rest on a credible estimate of the device’s addressable market. Medtech executives should therefore expect auditors to lump concept-stage projects into goodwill.

Even with cash-flow projections in hand, medtech executives must factor in percentage-of-completion rules under which appraisers discount the value of IPR&D. The earlier the stage of development, the lower the valuation assigned to the IPR&D effort.

On a positive note, if a medtech company is acquired while submitting a project to FDA, the project qualifies as IPR&D, even though the company has completed research and development for the device. The SEC considers the project at risk until it receives FDA approval.

Medtech executives can run into trouble if they overallocate the value of new product development to previous R&D. Imagine that a company spends $50 million to develop a cardiac device. The company later spends just $2 million more to adapt the device to treat a kidney ailment. The SEC will not allow the device maker to allocate all the value of the earlier R&D effort to the new product.

Valuing IPR&D is even more critical now that new accounting rules have raised the bar on proper classification of intangible assets. Knowledge of IPR&D valuation can prove critical to maximizing shareholder value in the medical technology industry.

Copyright ©2002 MX