Closing the Value Gap Using Earnouts in Life Sciences M&A

This article specifically focuses on the role earnout provisions play in transactions in the life sciences industry and follows our broader article on the utility of earnout provisions in M&A transactions: Closing the Value Gap: Examining the Utility of Earnout Provisions in M&A Transactions, which focused on the general use of earnout provisions and their typical structures.

Earnout Provisions and M&A in the Life Sciences Industry

Earnout provisions are particularly prevalent in transactions within the life sciences industry. Uncertainties related to product development, complicated regulatory regimes and rapidly changing market conditions frequently create value gaps between what a buyer and seller see as a fair purchase price for the target business. These factors, together with the opportunity to retain key talent and align incentives, make the life sciences sector particularly suited for the use of earnout provisions in purchase agreements to bridge valuation gaps.

Earnout provisions give buyers and sellers the power to make a portion of the purchase price contingent on the occurrence of certain future events, such as whether a business receives a specific regulatory approval or if a patient trial achieves desired results. Industry data from 2021 to 2023 shows that earnouts were employed in approximately 91% of private biotech and pharmaceutical deals during that period, alongside 59% of private medical device acquisitions and 47% of private diagnostics and research technologies transactions.^[1] In comparison, just 21% of non-life sciences deals featured an earnout provision during the same timeframe.^[2]

Earnouts have been a staple in transactions within the life sciences industry, and their prevalence is expected to continue for the reasons described above as well as the looming “patent cliff,” with patents for a variety of core biopharmaceuticals set to expire by 2030.^[3] This patent expiry reality is expected to expose many leading biotech companies to increased competition from generic medicines, putting US$236 billion in annual revenue at risk between 2025 and 2030 in the United States alone, with more than 190 existing pharmaceuticals losing patent exclusivity worldwide.^[4] This represents an estimated 46% in revenue decline for the world’s largest pharmaceutical companies over the next decade.^[5] In response, major players in the industry are expected to rely heavily on strategic acquisitions to drive growth, with earnouts anticipated to play a continued role in structuring deals and managing the associated risks.^[6]

Unique Features of Earnouts in Life Sciences M&A Transactions

In most industries, earnout provisions are drafted in a relatively straightforward manner: the parties agree to certain clear and objective post-closing metrics (e.g., revenue targets) that, if met within an agreed-upon time period, trigger additional payments by the buyer to the seller. While earnouts can be made more complex to suit specific transaction needs in any industry, it is not unusual for earnouts to be particularly intricate in M&A deals within the life sciences industry.

Many earnout provisions in life sciences M&A are characterized by the following:

Non-Financial Metrics: Acquiring a life sciences company before it obtains regulatory approvals for its key assets is a high-risk move for buyers. Since pharmaceuticals and medical devices typically cannot be sold without specific governmental or industry authorization, and since regulatory approvals are often binary decisions, regulatory approvals often serve as a main milestone in these transactions. Earnouts are also frequently tied to target-generated R&D goals reflecting, among other things, the uncertainty of product development. This is not to say that commercial milestones don’t have any role to play in life sciences M&A transactions – they comprise approximately 40% of total earnout metrics in bio/pharma transactions.^[7] That said, commercial milestones only appear in approximately 26% of all bio/pharma transactions.^[8] This contrasts with other sectors, where earnouts are typically structured entirely around financial metrics such as gross profit or EBITDA.^[9]

Term of Earnout Periods: In life sciences M&A, it is increasingly common to include milestone-based earnouts, with payments tied to specific achievements at various points in time, such as the successful completion of different stages of clinical trials.^[10] While earnouts in the life sciences sector are typically structured to span several years, the majority of earnout milestones are concentrated within the first three years after the deal closes. This trend aligns closely with broader M&A patterns. However, according to SRS Acquiom’s Life Sciences M&A study, 35% of all earnout milestones were achieved more than 36 months after closing, and 7% were achieved more than six years after closing.^[11]

Consideration: In life sciences M&A, earnouts often represent a significantly larger portion of the total purchase price compared to other industries. For example, between 2021 and 2023, mean earnout potential per deal reviewed by SRS Acquiom accounted for 62% of the total possible consideration in private biotech and pharmaceutical deals, and 35% in deals involving private medical device, private diagnostics or research technologies.^[12] These transactions often hinge on the future success of product development and regulatory milestones, which in turn drives the reliance on earnouts comprising a material portion of life sciences M&A purchase prices.

Considerations for Structuring Earnouts in Life Sciences M&A

Buyers’ strategic priorities can shift from one transaction to the next. In one circumstance, a buyer may look to acquire the entire target company, gaining ownership of all its assets, including product candidates and research projects. In other circumstances, a buyer may be interested in a very particular range of the seller’s already successful products, especially if they are linked to a key platform technology. Or, the buyer may only be interested in acquiring one or two clinical-stage products, with many of the early-stage products or research programs receiving minimal or no immediate value. As a result, earnouts are often tied to very specific milestones in R&D and regulatory approval (e.g., Phase 1, Phase 2 trials).^[13] These factors make earnouts a critical and highly negotiated part of many transactions in this industry.

As a result of most life science M&A earnout milestones being tied to non-financial outcomes that are difficult to predict, there can be tension between buyers and sellers during the post-closing period regarding whether the buyer is making sufficient efforts to achieve the applicable earnout milestones within the agreed-upon time period. Since the buyer controls the asset(s) after the acquisition, they hold the power to influence whether the earnout milestones are met. Sellers, therefore, often push for buyers to commit to making substantial efforts to ensure the earnout is achieved and may negotiate post-closing covenants and other obligations that address this concern. This makes the nature and extent of the buyer’s obligations to work toward meeting the earnout milestones a key point of negotiation (and potentially a critical point of tension between the parties post-closing).^[14]

The level of effort a buyer may agree to commit post-closing toward achieving earnout milestones can vary significantly depending on the transaction. For example, a buyer-friendly agreement may not require the buyer to take specific actions, or may permit actions – such as discontinuing a product line crucial to earnout milestones – regardless of their impact on the seller’s potential earnout payment. Conversely, a seller-favourable agreement may impose onerous obligations on the buyer, such as committing significant resources to meet earnout milestones, or granting the seller broad oversight – through board involvement, access to performance data, retention rights over key products or technologies, and measures to ensure key employees remain in place to support earnout success. Earnout provisions are typically set up to ensure that the buyer makes a genuine effort to meet specific future targets.

However, a variety of particular disputes may still emerge between buyers and sellers post-closing, often relating to the following:

Ambiguity in Requirement to Achieve Milestone and Meaning of “Best Efforts”: Terms like “best efforts” or “reasonable efforts,” when relating to the buyer’s obligation to run a purchased business in a manner that can achieve a certain milestone, are often open to interpretation based on the actions of the parties and the drafting of the provisions themselves. The distinction between the two terms is that a higher threshold of effort from the buyer is required to meet the “best” threshold.^[15] What the buyer sees as reasonable might later seem inadequate to the seller, resulting in a potential dispute that often hinges on fact. That said, when clearly defined, the standard of effort required in an earnout can be informative, and at times determinative, in a court’s analysis of whether a party met the standard which was required of it by the earnout. This point can be further complicated by the expectations of the parties, based on their prior experience with the interpretation of the various standards to be applied to meeting earnout milestones, which expectations must be tempered against the actual meaning of these standards under the governing law of the purchase agreement.

Buyer’s Control: The buyer’s control over key decisions post-closing, such as marketing strategies, investment levels or even product discontinuation, can directly affect whether earnout targets are met. If the seller believes the buyer is taking actions that hinder the earnout’s success, disputes can arise absent fulsome drafting in the applicable purchase agreement.

Shifts in Business Strategy and Market Dynamics: Buyers must assess how acquired assets fit into their existing operations and long-term goals, while also accounting for the steps needed to reach performance milestones. This is particularly challenging in the life sciences industry where regulatory approvals for commercialization are constantly changing and therefore uncertain. The buyer may choose to pivot the business or product line if they believe it will benefit the company in the long term. This creates obvious tension between the buyer and their desires to operate the business post-closing in the way that the buyer sees fit versus the seller’s objective to maximize the payment associated with the earnout.

Achieving Earnout Milestones

Despite the potential for significant future payouts, earnout milestones in life sciences M&A can be difficult to achieve and generally have a low success rate.^[16] While earnouts are a common tool in the industry to help both buyer and seller reach an agreement, the unique challenges inherent to the industry, such as scientific and technological uncertainty, lengthy timelines and rigorous regulatory hurdles, can make these milestones generally harder to reach compared to other sectors where earnout targets may be more predictable. For instance, recent data from SRS Acquiom revealed that only 22% of milestone events were achieved in 2023, with just 16% of overall earnout potential realized in the bio-pharma industry.^[17] Of the US$7.5 billion in commercial milestones due in 2023, less than US$1 billion was paid out. Further, across 252 earnout deals in the broader life sciences sector, representing a combined potential payout of US$72.8 billion, around 6% of that amount – or roughly US$4.7 billion – was actually paid to sellers.^[18] In comparison, 59% of milestones in earnout provisions in M&A transactions (excluding life sciences deals) were either partially or fully paid out.^[19]

Conclusion

Earnouts offer a clear pathway for managing risk in M&A in the life sciences industry; however, potential challenges in determining whether certain milestones have been met underscore the need for careful drafting and negotiation. In light of this complexity, it is important to account for lengthy and uncertain timelines and to craft agreements that balance flexibility with clearly defined, outcome-based metrics.

The Capital Markets Group at Aird & Berlis LLP will continue to monitor matters related to earnout provisions in life sciences M&A transactions. If you are a business owner, seller or potential buyer considering an earnout as part of an M&A transaction involving a life sciences business, or if you have questions about effectively using earnout provisions in such transactions, please contact the authors or a member of the group.

[1] SRS Acquiom, “2023 Life Sciences M&A Study” (2023) at page 20: SRS Acquiom 2023 Life Sciences Report.