SRS Acquiom has served as shareholder representative on 94 transactions that involved the acquisition of privately-held life sciences companies. Earnout provisions, those that provide sellers with future compensation should certain milestones be met, are much more common in life sciences deals than in other types of transactions: 79% of biopharmaceutical deals, 78% of medical device deals, and only 13% of non-life sciences deals where SRS Acquiom serves as the shareholder representative. Earnouts are significant: on average, the value of post-closing earnouts spans from 0–10X with an average on these deals of 2X the amount of funds paid at closing. The terms of earnout provisions can be many years or even decades in length, and whether milestones are met is prone to frequent disputes between buyers and sellers.
Milestones are met just under half of the time. SRS Acquiom recently took a look at its data for insight. Several things can be done to minimize risk of disputes.
Earnouts Are Achieved About Half the Time
Of the hundreds of earnout milestones specified in merger agreements for the life sciences deals in SRS Acquiom’s database, some 83 have come due at the date the sellers originally expected the milestones to be hit or missed. Of these, 40% have been met and paid, 5% are delayed but likely to be met, and just over half have been missed (51%) or are likely to be missed (4%).
Thus far, medical device milestones have been achieved at a slightly higher rate than biotech milestones (45% versus 36% by count of milestone event). However, more biotech milestones are delayed and may still be achieved in the future. Development-stage milestones have been achieved at a slightly higher rate than commercial-stage milestones (42% versus 37% by count of milestone event), and the difference may grow as some delayed development milestones are achieved.
Earnouts are Prone to Disputes for Many Reasons
Changes in development/regulatory strategy. Earnouts can be technically missed due to changes in strategy that do not necessarily mean the buyer is not getting value from the company purchased. Disputes are more common when milestones are based on narrowly defined technical scientific standards and not based on ultimate results such as regulatory approval. Life sciences transactions tend to be long and complex, and development and regulatory plans may not play out as originally envisioned. A milestone payment based narrowly on the results of a particular trial methodology may not be technically met if another methodology is chosen for legitimate business reasons, even if the tests prove successful and the drug or product is subsequently approved for market. On the other hand, contractual diligence provisions may call for the buyer to pursue the original plan, setting up a potential dispute with sellers if the buyer wishes to change the plan for any reason.
Development delays leading to missed contractual deadlines. Approximately half of all milestones in life sciences deals included in the most recent SRS|Acquiom Life Sciences M&A Study are triggered only if they are achieved by a certain date. In M&A negotiations, these deadlines are often set within one to two years of the expected achievement date shown on the development plan included in seller’s data room. In SRS Aquiom’s experience, subsequent delays are the rule, not the exception, for many different reasons. As soon as the time ‘cushion’ is reduced or eliminated, selling shareholders worry not only that they won’t get paid, but that the buyer in fact has an incentive to delay a little longer to avoid payment. This often triggers low-level disputes that may or may not flare into formal legal proceedings depending upon subsequent events.
Parties should acknowledge at closing that development often progresses unpredictably, and instead of setting milestones tied to the plan at closing, they should focus on the scenarios that would constitute “success.” If the goal is to get a product to market, then parties should base the milestone on an event demonstrating that achievement, and not worry about how to get there. Parties should include an alternative or second milestone in the agreement to account for scenarios where plans change and the first designated milestone is bypassed or delayed, but buyer continues to pursue the acquired programs.
Parties should choose a shareholder representative with the experience, time and resources to maintain a productive relationship between buyer and seller to manage issues as they arise, and create an honest and open conversation surrounding deal terms and evaluations. Representatives should be experts who can interpret intricate deal terms, catch potential disputes early, and who have the negotiating skills to settle disputes around milestones as efficiently as possible.
For Further Details
Download the most recent SRS Acquiom Life Sciences M&A Study.