Earn outs, or milestone payments, often are critical elements in medical technology acquisitions. Outside of the medical technology field, an earn out may be the last resort for saving a transaction when the buyer and seller cannot otherwise agree on valuation. However, in a medical technology acquisition, the parties often recognize from the beginning of negotiations that the value of the assets or business in question will depend on future events that cannot be predicted accurately at the time of the transaction.
Due to long regulatory approval cycles, it is not unusual for medical technology companies or assets to trade hands well before products incorporating the underlying technology have been completed or have proven their value in the marketplace. The ultimate value of new medical technologies often depends on factors such as the FDA classification of a medical device, the indications approved for the use of a pharmaceutical product or the scope of patent protection afforded to a particular innovation. Such factors may not be known until years after the completion of an acquisition.
Earn outs and milestone payments, therefore, allow medical technology buyers and sellers to consummate transactions long before they could if they waited for all the significant contingencies affecting valuation of the underlying assets to be resolved.
Milestone Payments Familiar for Medical Technology Companies
Many medical technology companies are quite accustomed to dealing in commercial transactions with the uncertainties of refining and commercializing promising new technologies or concepts. Joint development agreements, which are commonplace among medical technology companies—and are often essential in moving ideas from the laboratory to the marketplace—frequently make use of milestone payments.
Medical technology companies, large or small, may have extensive experience in identifying various economic trigger points in the evolution and commercialization of technologies in their field and in negotiating the payments that should be made at those trigger points.
Milestones Are Different When Used in Acquisitions
Use of earn outs and milestone payments in an acquisition setting is different, however, than the use of milestones in a joint development agreement. In a joint development agreement, the parties have an ongoing collaboration. They often set up mechanisms, such as development committees, to deal with technical and business issues as they arise. In an acquisition setting, the parties generally do not intend to have a continuing collaborative relationship. The buyer is acquiring the business or assets for use at its sole discretion. The buyer may wish to retain the managerial, technical and marketing expertise of the personnel in the company being acquired, but the buyer's purpose in doing so is to advance its own business interests, not for the economic enrichment of the selling party. Nevertheless, in agreeing to a transaction structure that includes earn outs or milestone payments, a seller has certain legitimate expectations about events that will occur after that transaction to facilitate the achievement of those payments.
While medical technology companies may be adept at negotiating earn out and milestone provisions, such negotiations in an acquisition context still can be difficult and contentious. Once a buyer and seller have come to an agreement on the events that will trigger earn out or milestone payments, and the amount of those payments, they may have little appetite for negotiating covenants that relate to the earn out or milestones.
Failure to address such obligations in the transaction documents does not mean they will not exist, however. In the absence of specific covenants related to earn out or milestone provisions, state contract law generally will imply a covenant of good faith and fair dealing on the parties with respect to such provisions.
The application of an implied covenant of good faith and fair dealing to govern conduct related to an earn out or milestone payment may not be a very satisfactory result for either the buyer or the seller. New York courts have described such an implied covenant as encompassing "any promises [that] a reasonable person in the position of the promisee would be justified in understanding were included." 232nd Owners Corp. v. Jennifer Realty Co., 98 N.Y.2d 144, 153, 746 N.Y.S.2d 131, 773 N.E.2d 496 (2002) (quoting Rowe v. Great Atlantic & Pac. Tea Co., 46 N.Y.2d 62, 68, 412 N.Y.S.2d 827, 385 N.E.2d 566 (1978)). The buyer may be unhappy to learn that it is subject to earn out related obligations that it did not even contemplate, much less expressly accept. The seller may be dissatisfied because if a dispute arises over the earn out, it will be forced to convince a court of the reasonableness of its position. Fortunately, express terms in an acquisition agreement will overcome the implied covenant of good faith and fair dealing. Buyers and sellers who take the time to negotiate their obligations related to earn outs and milestone payments should have their agreements honored by the courts.
Broad Provisions Often Are Not Enough
A buyer that recognizes the risks of having an implied covenant of good faith and fair dealing apply to earn out or milestone provisions in an acquisition transaction may seek to eliminate that risk by proposing in the transaction agreement a broad and extensive disclaimer of obligations related to such provisions. Such a disclaimer generally would attempt to negate any obligation to take specific action to enable the earn out or milestone to be achieved. It often would go on to reserve complete authority and control by the buyer with respect to various matters of its business that could relate to the earn out or milestone—such as the extent and timing of research and development efforts; decisions on product introductions, promotions and discontinuations; or decisions on whether to extend credit to potential customers.
While a broad disclaimer may be effective in protecting a buyer from claims based on an implied covenant of good faith and fair dealing, it may be met with considerable hostility from the seller. A seller faced with a buyer's attempt to disclaim any obligation related to earn out or milestone payment provisions may become suspicious about the buyer's commitment to achieving the earn out objectives or milestones. The seller may respond with a long list of obligations that it wants the buyer to undertake. While the parties eventually may reach a reasonable accord on the appropriate level of the seller's obligations, negotiations may be longer and more contentious than if the parties had considered appropriate seller covenants related to the earn out or milestone payments at the onset.
Too often when negotiations do occur over the extent of a buyer's obligations to facilitate the achievement of earn out targets or milestones, the focus is on a general standard of efforts. A draft transaction document offered by a buyer that includes no obligations for the buyer related to earn out provisions may prompt the seller to propose that the buyer promise to exert "best efforts" to permit the seller to achieve the maximum earn out. The buyer may respond that "best efforts" is too much to ask for, but that it is willing to make "reasonable commercial efforts" to achieve the objectives that will lead to earn out or milestone payments. The negotiations may end at that point.
Although transactional lawyers frequently argue over "best efforts" versus "commercially reasonably efforts," courts do not have clear standards for either level of effort. If both standards are used in the same agreement, a court may recognize that a lower standard of effort is intended for "commercially reasonably efforts" than for "best efforts." However, if only one of the standards of effort is specified in an agreement, courts are left to their own devices to determine what level of efforts should be expected under the circumstances of the transaction.
Tailoring Earn Out Protective Provisions
Appropriate buyer obligations will vary considerably from transaction to transaction based on the nature of the assets or business being acquired and the specific provisions of the earn outs or milestone payments.
Buyer covenants often include that the buyer will maintain a certain dedication of resources to support sales of products subject to an earn out or continue development efforts related to technology that is the subject of a milestone payment. A buyer's management may see such obligations as an imposition on its discretion and may want to negotiate for an escape clause that terminates the obligations under certain circumstances, such as a general downturn in the business of the buyer.
Depending on the nature of the seller, it may also be appropriate for a seller's representative to be appointed and provided with information from time to time related to the earn outs or milestone payments. A seller's representative may also need to be consulted before the buyer takes specific actions that could have an impact on the earn outs or milestone payments.
The parties should also consider the consequences of the buyer breaching its obligations related to earn outs or milestone payments. The seller's initial positions may be that every breach should result in an automatic payment of the earn out or milestone amount to the seller. Often, however, another remedy will be more appropriate. For example, a buyer's failure to meet a specified level of development expenditures related to a potential product that is the subject of a milestone payment may lead to an extension of the deadline for achieving the milestone. Similarly, discontinuation of a product line that is subject to an earn out could lead to extrapolation of the product line's prior sales to earn out periods following such termination.
Anticipating earn out and milestone payment covenants, and the consequences of their breach, at the time the earn outs and milestones themselves are being negotiated may improve the contingent consideration provisions themselves. For example, contemplating how the termination of products in a product line may impact an earn out based on the revenues of that product line may lead the parties to consider how new products or subsequent acquisitions that impact the product line should be treated for purposes of the earn out.
The suggestion to consider buyer covenants in connection with earn out or contingent consideration provisions should not be interpreted as meaning that every disclaimer of such an obligation is inappropriate. On the contrary, thoughtful consideration of appropriate buyer obligations should include consideration of appropriate buyer authority that should be expressly retained. For example, in the context of revenue-based earn outs, express recognition of the buyer's right to retain discretion over whether to grant credit to customers and how to set product pricing generally would seem appropriate.
Consider Obligations and Consequences Early in Acquisition Process
Earn outs and milestone payments are common features in medical technology acquisitions. They may become even more popular as a means of dealing with valuation difficulties during the current economic uncertainty. However, parties to acquisition transactions that conclude their negotiation after simply identifying the earn out or milestone conditions and the amount of the related payments miss an opportunity to eliminate further uncertainly from the transaction by clearly identifying the obligations and rights of the buyer with respect to the earn out or milestone conditions.
Not every earn out or milestone payment conflict can be anticipated and obviated, and clearly there are time and cost constraints that apply to negotiating elaborate covenants related to contingent consideration. However, by considering appropriate obligations and their consequences at the time earn out or milestone payments provisions are negotiated, the provisions themselves can be improved and the potential future conflicts can be reduced.