An “earnout” in an M&A purchase agreement contractually requires a buyer to make an additional contingent payment or payments if certain specified events or performance targets are met. Earnouts in life sciences transactions are often tied to operational accomplishments. This is especially true within the bio/pharma realm where future payments are typically linked to clinical trial endpoints, including patient enrollment and data milestones, regulatory submissions and/or approvals, or drug indication and molecule milestones.
However, because the earnout is measured in the period following the acquisition, in order to achieve the earnout, it is the buyer – not the seller – who is in control of the asset. Sellers have a strong incentive to require that the buyer exercise maximum efforts in order to achieve the earnout and often negotiate for buyer to provide some post-acquisition assurance that they will try to achieve that earnout.
For this reason, the efforts level required by a buyer post-acquisition to achieve an earnout is often intensely negotiated between the parties. Efforts levels come in many flavors: a more buyer-friendly approach may permit a buyer to take any action, including terminating a product line at the center of an earnout milestone, regardless of the impact it would have on achievement of the earnout; a more seller-friendly approach may grant a seller board participation rights (as a voting member, advisor, or non-voting observer), information rights to monitor the company’s development, or veto rights over certain actions (such as terminating a key employee or changes to a clinical trial); and variations in the middle may require that a buyer use “diligent efforts”, “reasonable efforts”, or “commercially reasonable efforts” (and other variations thereof) during the post-acquisition period. There are many varietals of compromises that can be negotiated between the parties depending on the sensitivities at issue.
As we have described in detail elsewhere, many jurisdictions have their own case law interpreting the levels of efforts required to carry out the standards that are often used in purchase agreements. This case law can vary and often does not delineate a meaningful distinction between such standards, regardless of any perceived hierarchy among practitioners. Unsurprisingly, interpretation of the efforts clause used is a common source of post-acquisition disputes among parties.
In order to avoid interpretation of these standards by the courts, if an efforts standard will be articulated in a purchase agreement, it may be preferable for the parties to define the efforts level contractually in a way that reflects the parties’ intent with respect to their regulatory and commercialization obligations. The parties often focus on whether to apply an objective outward-looking standard that looks to standard practice within the industry or of similarly situated companies or a subjective inward-looking standard that looks to the buyer’s or the seller’s past practices with respect to similar assets. Efforts standards may also account for specifics of the acquired product/asset, such as safety and efficacy, labeling, and likelihood of commercial success or regulatory approval. When parties choose to include a defined efforts standard in purchase agreements, courts are more willing to consider extrinsic evidence, either of the buyer’s past practices or the practices of the industry as a whole. This makes it more likely that the contract will be interpreted as the parties intended.
Timing and other considerations
Buyers should also beware that once they covenant to exert a certain efforts standard, their obliged efforts level may be construed to apply across the entire duration of the milestone period, which in life sciences transactions can be for many years following the closing of the acquisition. Accordingly, in negotiating their future obligations, it benefits buyers to practically consider how proactive they are able and willing to be when taking over a new asset. Buyers should also take care to document their efforts post-acquisition. When it comes to fulfilling their obligations under an acquisition agreement, there may be little opportunity to cure any lapse in efforts along the way.
Finally, it may be wise for buyers to negotiate for alternative dispute resolution (ADR) mechanisms specifically applicable to the earnout provision. These resolutions can take many different forms which often resemble alternative dispute resolutions found in other commercial contracts, such as choice of law and/or forum provisions and referral of disputes to (binding or non-binding) arbitration or mediation. An earnout-specific resolution mechanism may also take the form of a buyout provision, which gives the buyer the opportunity to buy out of the milestone to avoid future disputes.
While earnouts can help move a deal forward in the near term, they are not without future risks. Buyers need to think strategically about where an asset will fit into their current and future business plans, and the steps they will be willing to take to get them there.
Please contact the authors or the Hogan Lovells attorneys with whom you regularly work to discuss your specific M&A needs.
This is an article in our 2023 series, “Life Sciences Transactional Insights”, which aims to provide key practical takeaways for our transactional colleagues by anticipating the needs of their regulatory, intellectual property, and business stakeholders. Our dedicated team of life sciences and health care transactional lawyers understand the challenges and opportunities that strategic alliances and other partnering relationships present. Our mergers and acquisitions team helps our clients innovate with cutting-edge M&A strategies that enable them to lead the way in the life sciences industry. We draw on the depth of our corporate, commercial, and regulatory practices to provide unparalleled transactional support. Ensure you are subscribed to Hogan Lovells Engage to receive our insights.
Authored by Shaida Mirmazaheri and Adrienne Ellman.