Pharmaset, Inc. AcquisitionThe reason of the low probability

Pharmaset, Inc. AcquisitionThe reason of the low probability of FDA
approval for Fosbuvir is that another company, Pharmaset, Inc., is working on a similar drug, called FosbuvirP, and is very close to getting FDA approval and a patent. If Pharmaset gets a patent, Fosbeck’s own application will be denied. Therefore, instead of developing Fosbuvir internally, Fosbeck can acquire Pharmaset. Pharmaset already has manufacturing facilities in place and FosbuvirP is its only product. The book value of the company’s fixed assets is $3 B, which will be depreciated using the straight-line depreciation over the next 10 years. Pharmaset expects to receive the FDA approval and patent by the end of this year with sales starting next year. Its next year revenues are expected to be $4 B with subsequent annual growth of 50% over the next three years, after which the sales will be stable for another 7 years. After that the drug will lose the patent protection and its manufacturing is expected to stop. The CoGS are expected to be 20% of revenues and SG&A expenses are $3.5 B a year if the drug is produced and zero otherwise. In other words, in case of FDA approval Pharmaset’s revenues and costs will be similar to Fosbeck’s, but SG&A expenses will be higher. If Fosbeck were to acquire Pharmaset, it would be able to bring SG&A costs down to Fosbeck’s level. The probability of FDA approval is 40% and the probability of patent obsolescence remains the same as before – 5% each year.

Mergers and Acquisitions. Target (Pharmaset) Valuation
Pharmaset’s management would be open to the sale in the valuation range of $ 20 to 24 Billion. Please estimate Pharmaset’s value to Fosbeck, if it gets acquired.
RecommendationsUpon reviewing Fosbeck’s choices, what project(s) would you recommend?
Venture Capital Financing Finally, to further reduce its risk Fosbeck considers to keep acquired Pharmaset as a separate company. In this case Fosbeck will eventually shift its R&D to Pharmaset, which will continue as a viable business even after the initial patent expires. Therefore, we can ignore the probability of a patent becoming obsolete. However, if FDA approval is not received this year, Pharmaset will go bankrupt, in which case its assets will be sold at residual book value.
A venture capital (VC) firm Menlo Ventures is willing to provide financing of up to $5 B in acquisition of Pharmaset.
If the VC agrees to invest in Pharmaset, it plans to exit after eight years at which time it expects that the company’s value would be eight times its year 8 EBIT.
Menlo Ventures offers three different ways of structuring the financing:

-Straight common stock where the VC will not receive any dividend for the first four years and will receive 20% of NOPAT as a dividend for the remaining four years. The tax rate for Pharmaset is 38%. In addition, the VC will receive a 20% ownership of the company’s equity at the end of eight years.
-Redeemable convertible debt with 10% coupon rate (interest is tax-deductible). The debt will be converted for 15% ownership of the equity of Pharmaset at the end of eight years. In the case of bankruptcy the debt will be immediately redeemed at its face value or at the residual assets’ book value, whichever number is lower.
-Redeemable preferred stock with 7.5% dividend plus warrants for 15% of the equity for an exercise price of $150 M. In the case of bankruptcy the debt will be immediately redeemed at its face value or at the residual assets’ book value, whichever number is lower.

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