After I wrote about Nanocap a couple of days ago a reader was so kind to point me in the direction of Alexza Pharmaceuticals (NASDAQ:ALXA): another nano cap company that is being acquired by a bigger party. Interesting in this merger is that a part of the consideration is a non-transferable and non-tradable contigent value right (CVR) that can pay out a maximum of $35 million (subject to certain deductions) while the company is being acquired for $22.6 million or $0.90/share. With the stock currently trading at $0.96 you are paying just $0.06 for a CVR that could pay out almost $1.66/share. That sounds like a potentially interesting idea, although when you start reading the merger documents you will realize that it isn’t that simple.

I spend a lot of time the previous days reading the merger documents and trying to understand all the legalese language, and I already had a lengthy blogpost written (some of you might have seen it, since it was online very briefly). But then yesterday the company also published the tender offer statement that is a lot clearer with respect to things as the size of the adjustment payment, the advisory fee deduction and the expected number of CVRs outstanding after the transaction. So this post will be a lot shorter and easier to understand Unfortunately the opportunity is now also smaller since the share price of Alexza increased from $0.92/share to $0.96/share. Studying the merger docs in the previous week was worth it.

# The high-level description

The deal is structured as follows. Alexza is being acquired for $22.6 million by Grupo Ferrer who is paying $0.90/share. When certain sales milestones are reached the CVR will payout, but the payout is adjusted for two items.

- It’s adjusted downwards based on the advisory fees that Alexza is paying to complete this deal. 25% of the advisory fees are subtracted from the milestone 1 payment, and the remainder is subtracted from the milestone 2 payment. These fees are estimated to be $2.2 million in the tender offer statement.
- Because of the complicated capital structure of ALXA with warrants and options there is an adjustment based on whether or not $22.6 million will be sufficient to acquire all outstanding shares. If the company has to spend more than $22.6 million this is subtracted from the milestone payments, while if it pays less it is added to the milestone 1 payment.

In addition to this we have to account for the fact that Grupo Ferrer already has a stake in Alexza that is being excluded from all calculations. In the tender offer statement we find various examples of how the milestones will be calculated, and I have picked the examples for the milestone 1 and milestone 2 payments that I think closely matches what we can expect (I’ll explain later why those numbers are correct):

Milestone 1 PaymentScenario B: If all parameters are the same as in Scenario A above, except that the Closing Payments fall short of $22,620,639.60 by $1,000,000, then the Milestone 1 Payment will be equal to ($3,000,000 – 25% x $2,200,000 + $1,000,000) / 19,811,374 = $0.17.

Milestone 2 PaymentScenarios A, B and D: In Scenarios A, B and D above, the remainder of the fees and expenses of Guggenheim need to be deducted in the calculation of the Milestone 2 Payment. No further adjustments are required in respect of the Closing Payments, which were fully reflected in the Milestone 1 Payment. Therefore, the Milestone 2 Payment will be equal to ($6,000,000 – 75% x $2,200,000) / 19,811,374 = 0.21.

What you can see here is that 25% of the advisory fees are subtracted from the milestone 1 payment and that the remainder is subtracted from the milestone 2 payment. We also see an adjustment payment that is a positive $1 million and that the expected number of CVRs outstanding is a bit more than 19.8 million.

# Valuation

The adjustment payment is calculated based on the difference between the budgeted consideration of 22,620,639 and the money actually spend by Grupo Ferrer to cash out all the shares, options and warrants. The company had the following options outstanding at the end of 2015, and in the first quarter of 2016 27,500 options were issued with a strike of $0.69.

So if we assume that options with a $1.08 strike will not be exercised the capital structure looks as follows and we get exactly the same number of CVRs outstanding as in the example:

To acquire all these shares Grupo Ferrer would need to spend $0.90 * 19.8 million which is just $17.8 million dollar: significantly less than the budgeted consideration of $22.6 million. Unfortunately Alexza has two series of warrants outstanding, besides the 2014 warrants, that are out-of-the-money but are still eligible to receive a cash consideration based on their “fair value”. Note the use of the quotation marks here, because of what I see as a huge flaw in the calculation of fair value these warrants are way more valuable than they should be.

The 2009 warrants can be exercised for 656,664 shares, have a strike at $2.77 and expire in October this year. The 2012 warrants can be exercised for 4,400,000 shares, have a strike at $5.00 and expire in February 2017. So they are really far out-of-the-money and have little time left, but they are valued using the volatility in a 20-day period (that the warrant holders can choice!) in the 100-days preceding the announcement of the merger. Unfortunately the letter of intent apparently doesn’t count as an announcement of the transaction, so there is a +70% intraday move that can be included in the 20-day window. As a result annualized volatility reached 327% and the value of the warrants increased to approximately $3.7 million:

On March 29, 2016, Ferrer’s representatives communicated to Alexza’s representatives its desire to maintain a constant transaction value at the level implied by 20-day trailing volatility equal to approximately 120% and an upfront cash consideration component at a price per Share of $1.04. The volatility of trading price of Alexza’s common stock increased following Ferrer’s Schedule 13D filing and Alexza’s 20-day trailing volatility had reached a peak of 327% on March 24, 2016.

Given this increase, the Black-Scholes value of Alexza’s out-of-the-money warrants increased to approximately $3.7 million from approximately $400,000.Consequently, Ferrer indicated its intent to decrease the upfront cash consideration component based on the final cost of the cash payment to be made to the holders of Alexza’s outstanding warrants in connection with the Transactions.

So we have to add the $3.7 million to the payment of $17.8 million which means that the total payment would be $21.5 million: $1.1 million less than the budgeted consideration. I think the difference is possible caused by the fact that Grupo Ferrer initially thought that it would also need to cash-out the $1.08 options (bullish for the implied value of the CVR), but that doesn’t seem to be the case anymore based on the current market price of Alexza.

So now we can finalize the valuation of the CVRs. I have assumed that there is a reasonable probability of reaching the first milestones and a small probability of reaching the last two milestones. I have no real basis for why I’m picking those odds, but you have to pick something and it seems reasonable to me… Combined with a 10% discount rate that gives me this:

# Conclusion

I don’t think I have ever spend so much time in figuring out how high a merger consideration might going to be, but a very complicated transaction in a nano cap company can be fertile hunting grounds for a great deal. This proved to be the case here, although now with the publication of the tender offer documents most questions have a straightforward answer and as a result the spread has narrowed. I think it’s still a decent deal since I expect that the odds of deal completion are very high and it should be completed a few days after the expiration of the tender offer on 20 June. So picking up some shares might still be worth it.

# Disclosure

Author is long ALXA

brentSo your expected return is 3.5%? What would be the minimum and maximum return distribution?

Alpha VulturePost authorYes, and no. The value of the CVR is discounted with a 10% discount rate to account for the long time it will take before the milestones pay out if they get hit, so assuming those odds of hitting them are correct the expected return is higher. But the 3.5% is the more relevant number, although you could argue that the discount rate should be lower than 10% since the CVRs are like an unsecured debt liability, not equity.

JoelWhat is the basis for the odds you assigned to achieving each milestone?

Alpha VulturePost authorMy imagination, nothing more

DaveIn regards to the odds you assigned to achieving each milestone, don’t you think someone in the pharmaceutical industry has a better chance of analyzing the odds. The percentage assigned in your calculations seem to be “random” guesses. Don’t you feel like your the one legged man in an ass kicking contest? How do negate this risk?

Alpha VulturePost authorThat’s a fair question, my short answer: usually there is a CVR because the two parties can’t agree on the value, and they have the most info. So assuming that the truth is somewhere in the middle is not a bad guess I think.