What is a contingent consideration liability?

In it’s Q4 2020 earnings release AbbVie (NYSE: ABBV) reported that it recorded a $4.7 billion increase in the contingent consideration liability for the drug Skyrizi. This expense wiped out ABBV’s net earnings for the quarter. Therefore, I decided to do some research to try to understand what a contingent consideration liability is.

What is a contingent consideration?

Contingent considerations are financial instruments employed in complex business transactions. Their purpose is to share risk associated with the transaction between buyers and sellers. A contingent consideration is an obligation of the buyer to transfer additional assets (cash, equity, physical assets) to the seller if future events occur or conditions are met.

The buyer gets to pay for the purchase in installments. Additionally, future installments are often tied to performance goals. Thereby, the buyer gains protection if the acquisition turns out less valuable than initially estimated. On the other hand, the seller receives better terms and does not have to adjust the price downward to account for the risk upfront.

What about the liability part?

Contingent consideration is classified as a liability or equity. Both classes are measured and assigned a fair value on the acquisition data. However, the two classes differ in how they are handled after the deal closes.

The fair value of a consideration classified as liability is re-assessed at each reporting date. Furthermore, changes in value are included in the income statement.

On the other hand, a consideration classified as equity is never re-assessed. This in turn decreases income statement volatility. Even though the equity classification is the more preferred one it is much harder to achieve.

What’s the deal with the contingent consideration liability for Skyrizi?

AbbVie acquired the rights to lead future development and global commercialization on Skyrizi in a 2016 deal with Boehringer Ingelheim. The financial terms of the deal specified that: “[…], AbbVie will make an initial upfront payment of $595 million. Boehringer Ingelheim will be eligible to receive additional development and regulatory milestone payments and royalties on net sales, the terms of which are not disclosed” (per PR Newswire)

The $4.7 billion non-cash expense recognized as part of the Q4 2020 income statement is most likely part of the undisclosed additional payments and royalties. It appears that the aforementioned undisclosed terms were classified as a contingent consideration liability. Therefore, it is likely that ABBV’s future income statement will contain additional Skyrizi related expenses.

Furthermore, this deal is a good example of a contingent consideration in action. AbbVie made this deal looking to acquire a drug that would help it maintain its dominance in the Immunology market. That would require the new drug to reach multi billion dollar a year in sales to offset expected lost revenue due to Humira losing patent protection. However, full price tag for a drug with that potential would definitely be much more than $595 million.

On the other hand, it took AbbVie until early 2019 to launch Skyrizi. Paying billions of dollars in 2016 to acquire the rights to the drug outright, would have been much riskier for AbbVie. The drug could have failed in any of the subsequent trials. It could have never reached the market. That in turn would have meant a huge investment write-off for the company.

Including a contingent consideration in the deal allows AbbVie and Boehringer Ingelheim to share the risk in bringing the drug to market. Now that the drug has successfully launched allows the companies to also share the rewards.

Additional Resources

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