This is the fifth article in our After Closing Series highlighting frequently occurring post-closing issues that should be considered before signing an M&A agreement.
Acquisitions of private companies often provide for post-closing earn-out payments to bridge a valuation gap between the seller and buyer. This is especially common in acquisitions of life sciences and medical technology companies where the potential value of a company depends on the achievement of milestones such as clinical, regulatory, and commercial events.
While the parties often spend considerable time and expense carefully negotiating and drafting the contingent consideration terms or milestone event, sometimes they do not give enough consideration to other factors that can affect the likelihood of payment, such as the following:
- the specific efforts expected of the buyer in pursuing the earn-out objective
- the frequency and quality of information shared with the seller
- the ability of the milestone requirements to accommodate unforeseeable circumstances that may change the technical course of the milestone achievement process
An unintended result in these situations is that the triggering event can become a hit-or-miss proposition, sometimes to the unhappy surprise of the seller. When these specific events are missed or not achieved in accordance with a too-tightly drafted agreement, a seller's expectation of value in the transaction can be greatly frustrated, even to the point where the seller wishes it had not done the transaction at all.
Below are a few points to keep in mind when drafting agreements:
Specifically define the effort required of the buyer: Deals that include contingent payment provisions should identify diligence efforts to be taken by the buyer in pursuing the objective. Many agreements include a generic "commercially reasonable efforts" requirement without actually defining what it means to be commercially reasonable for that specific deal. The seller should focus on the precise resources and effort it expects the buyer to devote and include those terms in the efforts provision. Specific versus generic typically benefits the seller's interest. But even if the provision errs on the side of generic, it should pack some punch. See an example below:
"Commercially Reasonable Efforts" means operating in a commercially reasonable manner with the objective of achieving each Milestone in accordance with the reasonable expectations of the parties as of the date of this Agreement, including applying such strategy and using such efforts and resources as are reasonably appropriate and necessary to that end.
Require the buyer to provide meaningful access to information: Where relevant, the buyer should be required to provide the seller's shareholder representative with meaningful (i.e., specific) interim (ideally no less than quarterly) reports on progress toward achievement of the contingent payment. The buyer should also maintain and make available to the seller (i.e., its shareholder representative) records reasonably sufficient to ultimately calculate the metrics upon which the contingent payment is based.
Provisions should also be made to enable the seller's shareholder representative to have discussions, and even in-person meetings, with appropriate personnel of the buyer to understand and verify the buyer's calculations and efforts to achieve the payment. Where possible, this access should include (or at least not restrict) the shareholder representative's ability to communicate with former employees of the seller who become employees of the buyer and have responsibility for achieving the contingent payment, notwithstanding confidentiality obligations or other restrictions.
Contingent consideration terms should be results-oriented, not technically oriented: While contingent payment terms need to be technically defined, the seller should not be denied payment if the end-result contemplated by the parties at the time of the agreement in terms of value expectation and delivery occurs. Changes in strategy, competitive developments, and unforeseeable events can occur that lead to a deviation from the specifics of a contingent payment provision.
For example, in a life sciences transaction the parties might agree on a milestone payment based upon a particular type of regulatory approval for a particular product. A competitive product may subsequently get a more favorable regulatory approval and the buyer decides to go down that path instead.
If the situation is truly no harm, no foul to the buyer, the seller should not be penalized because the previously negotiated milestone will not be specifically satisfied. Creative "notwithstanding the foregoing" drafting on the part of seller's counsel can focus payment on results - not technicalities - and maximize the seller's value in the transaction.