License Fees and Revenue Recognition
The out-licensing of technology and other intellectual property has continued to be a very lucrative source of revenue for life science companies. Typically, these arrangements call for significant upfront payments which provide positive cash flow which can be used for the continued advancement of other assets within the licensor entity. The accounting for these arrangements can differ from deal to deal, and as the licensor, it is important to understand the obligations throughout the term of the agreement.
The two methods of recognizing revenue is either at a “point in time”, which means that the revenue is recognized in one lump sum at the point in time that the licensor has satisfied their obligation, or, “over time” which means that the licensor has an obligation to provide ongoing efforts in order for the license to have value, and therefore, the revenue is recognized over the term of the contract.
Here’s an example to illustrate the two concepts. Assume that Pharma Company A licenses an ANDA to Pharma Company B for a period of 10 years for an upfront payment of $500,000, and has also agreed to provide manufacturing of the product, which will be billed to Pharma Company B at market rates (i.e., no discounts will be provided). It is clear that there are two performance obligations that Pharma Company A has to fulfill. First, it has to have the ANDA approved so that it can sign it over to Pharma Company B, and secondly, Pharma Company A also has to manufacture the product.
From a revenue recognition standpoint, the revenue associated with the manufacture of the product is straightforward and would be recognized at the time the title of the goods transfers to Pharma B. The revenue related to the ANDA license fee is a bit more complicated and open to judgment. Assuming there is nothing unique about the manufacturing process, the raw materials are readily accessible on the open market, and, in the event of a contract breach, Pharma Company B could easily have the product manufactured by another pharmaceutical company, then the $500,000 upfront payment has the potential to be recognized at the signing of the agreement when the ANDA license is transferred to Pharma Company B. However, if the manufacturing process is highly specialized, or if the raw materials are not otherwise available on the open market and Pharma Company A’s continued involvement in the procurement process is vital to the ANDA having value, then the $500,000 upfront license fee would typically have to be recognized over the entire length of the agreement.
Having a clear understanding of the proper accounting treatment of these types of arrangements is vital as they could have a material impact on the cash flow, EBITDA reporting, and timing of tax obligations. If you are currently working to understand your revenue recognition and would like to speak with one of our professionals please contact any one of the members of our Life Sciences Team.