When companies develop their product or service, there tend to be many unpredictable turns in the road. Companies start down one path, figure out that a different strategy makes more sense, and make appropriate changes. While this seems obvious, it is surprisingly difficult to account for when the parties negotiate and define the terms of earnouts. SRS Acquiom often see earnout provisions with deadlines or specific requirements that appear to be one way, but not the only way, to reflect the value of the business acquired.

The result is that earnouts sometimes are technically missed but for reasons that are caused by changes in business strategy. It does not necessarily follow that the buyer is not getting the value sought from the company purchased.

Earnouts are sometimes technically missed for reasons that are caused by changes in business strategy, while the buyer may still be getting the value sought from the company purchased.

This is especially true in life sciences transactions because the earnouts in those transactions tend to be long and complex, and it is much more common for those development and regulatory plans to change over time than for them to play out as planned. For instance, the parties might determine at closing that a milestone payment should be made upon the first patient dosing in a phase II study in Europe, provided it starts by a certain date. A typical diligence provision may require the buyer to use efforts that are commercially reasonable in the industry to achieve the milestones. Months or years later, the buyer might have determined for legitimate business reasons that it makes more sense to do a somewhat different phase II study in India rather than Europe, and the change has resulted in a delay of several months. The result is that the parties may know in advance that the milestone defined at closing will not be technically achieved because of likely changes in the execution of the business plan, even though the development of the drug or product is proceeding and value is being created.

This scenario can result in disputes over significant sums of money with no clearly right answer. Moreover, other aspects of the buyer-seller relationship (such as an escrow release) are often impacted because this uncertain potential earnout dispute can be foreseen by both parties long before the milestone is actually missed. To avoid this, SRS Acquiom suggests that the parties acknowledge at closing that nobody really knows how the future development will progress. Parties should avoid setting milestones tied to the plan as it exists at closing, especially for tests that will be years out into the future. Instead, they should focus on the results of what would constitute “success” with respect to this acquisition, or clear value inflection points that cannot be bypassed. If the goal is to take a product to market, parties should base milestones on an event or outcome demonstrating that fact, rather than worry about how to get there. Also, where development cycles are long and interim milestones are necessary, parties should consider providing for an alternative or second milestone as an opportunity to receive the milestone payment (perhaps in an adjusted amount) if plans change and the first designated milestone is bypassed or delayed rather than simply having failed.

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