Addressing downside risks of build-to-buy deals

Build-to-buy transactions, where a buyer collaborates with an innovator/seller to fund and guide the development of a new product that the buyer can then decide to purchase (whether through a merger, stock sale or asset acquisition), present a great opportunity for potential acquirers and early stage companies. They allow buyers to make a targeted investment in new drug products without the overhead and risk associated with handling development entirely in-house, and they allow sellers to partner with experienced professionals, obtain research funding and agree to potential exit opportunities—both parties retain flexibility and the opportunity for significant upside if all goes well.

Reverse royalties

If a buyer funds the development of a build-to-buy product, but does not acquire it, the result is a potential windfall to the seller, with the seller retaining all rights to the product without any obligations to make the buyer whole for their funding. This reality may create misaligned incentives because a seller who is confident in their new product might view a “failed” build-to-buy as a better outcome than an acquisition by the buyer, as the seller can benefit from the R&D funding, and then go to market with their product and hunt for a better deal. Reverse royalties preserve the possibility that a buyer may break even, or even realize a return on its investment, in situations where the buyer does not acquire a developed product, and align the incentives of buyers and sellers regardless of whether the buyer acquires the new product.

Under a reverse royalty structure, once a buyer has determined not to purchase the built-out asset, the buyer becomes entitled to royalty payments if that asset later generates revenue. The scope of a reverse royalty will be subject to negotiation, as sellers will seek to limit any reverse royalty (a) in time, (b) in amount and (c) to only certain products reflecting the state of the asset at the time the buyer stopped funding the development work. Buyers should consider carefully what limitations they are willing to accept on their reverse royalties, and should be clear conceptually as to whether they want to be made whole for funds spent on research (in which case a seller may be more willing to accept the concept, subject to a cap equal to the amount of funding provided) or to reap financial upside from the buyer’s contribution to the development of the relevant asset.

Fallback licenses to funded intellectual property

Buyer personnel are often heavily involved with the development of drugs by sellers in build-to-buy transactions, and as a result buyers must carefully consider how to disentangle the work of those personnel during and after the partnership from the work they did with the seller. To help ensure clear intellectual property ownership of future developments, buyers should consider obtaining from the sellers a license to any intellectual property developed during the “build” process. Buyers should be prepared to negotiate the terms on which such license will be granted—in particular, the scope of the license and whether the buyer will make additional payments to the seller for the license.

If a buyer was closely involved in the “build” process but will not obtain a license to the developed intellectual property, it should still obtain a license or similar right to any know-how its personnel may have gained in connection with an abandoned build-to-buy—potentially through a residual information clause that focuses on protecting the inchoate knowledge those personnel retain in their memory (and that cannot be neatly excised, returned or destroyed). Buyers, especially those engaged in the development of technologies or therapies similar to those developed by their seller-partners in a build-to-buy, need to ensure that their personnel who engaged closely with a seller are free to continue with their duties in the ordinary course without a risk that a seller will make a claim that some future development of the buyer results from the misappropriation of know-how owned by the seller and developed during the build process.

Next steps

Reverse royalties and fallback licenses to funded intellectual property are only a few of the considerations that we address with our clients to protect their interests and maximize the benefit of build-to-buy transactions. Please contact the authors or the Hogan Lovells attorneys with whom you regularly work to discuss your specific build-to-buy needs.

This is an article in our 2023 series, “Life Sciences Transactional Insights”, which aims to provide key practical takeaways for our transactional colleagues by anticipating the needs of their regulatory, intellectual property, and business stakeholders. Our dedicated team of life sciences and health care licensing and commercial transactions lawyers understand the challenges and opportunities that strategic alliances and other partnering relationships present. We draw on the depth of our life sciences practice and work seamlessly with our regulatory experts to provide unparalleled transactional support. Ensure you are subscribed to Hogan Lovells Engage to receive our insights.

Authored by Spenser Karr and Cullen Taylor.