Earnout Payments in Life Sciences and HealthTech M&A: Seller Beware

Earnout provisions are common in life sciences and healthtech mergers and acquisitions, particularly when an acquired company may add significant value after closing. This can occur if the acquired business has a product in Phase 3 clinical trials or a new product with an uncertain sales ramp.

To bridge gaps in valuation expectations between buyer and seller, the parties frequently negotiate earnout payments. These payments, from buyer to seller, hinge on future milestones, such as the FDA approving a drug the acquired company is developing.

Earnout payments can be tricky. Faced with losing control of the business, sellers often seek assurances that a buyer will work to achieve the milestones that trigger payment. Buyers may worry that unforeseen circumstances will change plans for the acquired business. Disputes often wind up in court.

From the Seller’s Perspective: Tips on Negotiating Earnout Payments

To protect the ability to receive earnout payments, a seller can ask a buyer to:

• Operate and fund the acquired business at a set level and period.
• Employ key executives in the acquired business in roles – and with incentives – that will allow them to influence the company’s success.

Sellers also can seek covenants from the buyer not to invest in or acquire a competitor. They can ask for “commercially reasonable effort” and “good faith” covenants specifying that the buyer will continue to operate the acquired business and take steps to achieve the earnout milestones.

In Focus: Recent Case Highlights the Need for Attention to Detail

The Delaware Court of Chancery recently decided a case that highlights the need for sellers to consider the language of earnout provisions thoughtfully and thoroughly.

• The Case: Fortis Advisors, LLC v. Medtronic Minimed, Inc.
• The Acquisition: In 2020, global health care tech company Medtronic acquired Companion Medical, which had developed a smart insulin pen system.
• The Claim: Shareholder representative Fortis Advisors sued Medtronic on behalf of former Companion Medical shareholders.
  • The suit alleged Medtronic breached the merger agreement by failing to make a $100 million earnout payment.
  • The merger agreement contained buyer-friendly language giving Medtronic considerable discretion to develop and commercialize the milestone product.
  • It prohibited Medtronic from acting for the primary purpose of frustrating payment for achieving a milestone.
• The Outcome: In July, the Delaware Chancery Court dismissed claims against Medtronic for failing to make a $100 million earnout payment. The Court:
  • Zeroed in on language in the merger agreement that prohibited Medtronic from actions intended for the primary purpose of frustrating a milestone payment.
  • Found that the allegedly improper actions of Medtronic were not actionable if they were not for the primary purpose of frustrating efforts to achieve the milestone – even if the actions adversely affected whether those milestones would be achieved.

Other cases have focused on the precise wording of “commercially reasonably efforts” clauses, including language about what factors the buyer could or could not consider in evaluating those efforts, such as whether other corporate objectives or the development of competing products could be factored in.

The Bottom Line: Focus on Precision in Wording

It’s important for a seller to invest time upfront to clarify the meaning of terms in earnout payment provisions of a merger agreement. That can help protect a seller’s ability to receive the value they’ve negotiated.

In the Medtronic case, the word “primarily” had a major impact. Other times, the precise definition of “commercial reasonable efforts” and the allowable considerations can sway the outcome. That underscores the importance to sellers of approaching merger agreement negotiations with care.

Sellers should remember that their ability to receive earnout payments may hinge on how a court interprets a word or phrase in the merger agreement.