The increasing popularity of earnouts in biotech M&A

Introducing the ‘earnout’

Against the backdrop of lower M&A deal volumes and a challenging IPO market, earnouts are becoming increasingly common in transactions. As a short introduction to the concept, an ‘earnout’ is a sale mechanism used to make part of the consideration payable for a business contingent on the business achieving or satisfying certain milestones. While earnouts can be used in all forms of M&A, an earnout used in connection with a public company sale or acquisition may be structured as a contingent value right (CVR), giving sellers a right to receive a share of future revenues arising from the commercialisation of particular assets eg, through out-licensing. CVRs may be transferrable and carry the right for to be settled in cash and/or securities.

Earnouts are typically enshrined in the main purchase agreement (and potentially a separate instrument or certificate if structured as a transferable CVR) and are distinct from traditional completion mechanisms used to adjust a purchase price at the completion date (such as locked box or completion accounts mechanisms).

This article takes a brief look at earnouts and how they are typically employed in biotech M&A transactions, before considering a few risks associated with the structure.

What is the purpose of an earnout?

The purpose of an earnout is to manage the risk in pricing a business – effectively the risk that a business’s value is different from the buyer’s expectations (whether that’s better or worse). Their relevance to biotech M&A – a sector where future success (and therefore value) is dependent on the outcomes of clinical trials, regulatory approvals and royalties – is easy to see. 

As may be expected, earnouts are mechanisms typically sought by a buyer. However, sellers can benefit from the structure as well. As a US Court once summarised, an earnout reflects “a disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time” (Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009)). Effectively, by using an earnout, a buyer may be encouraged to invest in a business before its full potential has been achieved, in turn allowing a seller to realise at least part of their investment and the business to benefit from additional cash and/or resource (depending on the nature of the buyer). 

How does an earnout work?

As above, the transaction purchase agreement will set out the earnout mechanics and confirm that a proportion of the consideration will be deferred and paid in the future against the achievement of pre-agreed metrics. 

These metrics broadly fall into two categories – financial and non-financial. Which metrics are appropriate will depend on the sector, whether a company is early or late stage, and whether the buyer is a financial buyer (such as a private equity house) or a trade buyer. 

Typically, earnouts in biotech transactions (and CVRs generally) will focus on objectively ascertainable milestones which may be associated with lead product candidate development – for instance, a required approval or clinical trial outcome or launch event being achieved. On the achievement of a milestone, the buyer will pay the amount of cash withheld against that milestone. However, these milestone payments can be married to, or solely focused on, other financial metrics, such as the generation of a specified revenue stream over a period of time. Naturally structures and metrics vary on a deal-by-deal basis so it’s important to approach each transaction on its own merits.

As an aside, from a seller’s perspective, it's worth noting that a financial buyer (for instance a private equity house) is more likely to have a focus on financial metrics (eg, revenue or turnover), while a strategic or trade buyer may well want to focus on non-financial metrics (such as project milestones or pipeline conversion) to align the target group’s interest with the wider commercial interests of the new group.

What are the commercial considerations?

If you ignore the obvious dichotomy of aspiration when it comes to payment of the earnout (in that a seller wants a full consideration to be paid up front and a buyer would prefer not to pay the earnout down the line) it could be argued the parties’ interests are actually relatively aligned – the seller wants to achieve a full value for the business and a buyer wants it to realise its potential.

However, in reality, it’s certainly not that simple and an earnout will be a big focus in negotiations for both parties. For instance:

• From a buyer’s perspective, achieving the maximum performance of the business will be of paramount importance. A buyer may want to integrate the business into its existing group, apply group-wide accounting policies and drive efficiencies by using existing products and service lines. Each of these could have the impact of making the earnout difficult to track or reduce the likely achievement of financial targets.
• Conversely, from a seller’s perspective, achieving the earnout will be paramount. This is a subtle difference, but one that will mean a seller will want to ensure the business is not going to be fundamentally changed once it has been taken on, that business opportunities are not diverted, and that any financial metrics used to calculate the earnout are tracked on the same basis they have been previously. 

Striking the right balance between these competing interests will be key. During negotiations the buyer should ensure that its strategies for the company post-completion are not disrupted by the earnout and that the accounting policies to determine any financial metrics are pinned down, while the seller should ensure the sale agreement includes protections as to what the buyer can and can’t do with the business and its products during the period and that any revenue streams are identified in appropriate terms. 

Are there any tax implications?

Assuming that the seller is an individual, at the date of writing, the seller will expect their earnout to be taxed as a capital gain. However, as earnouts often run parallel to a seller’s continued engagement by the business, care needs to be taken to ensure an earnout is not treated as employment income, resulting in higher rates of tax for the seller (or possibly the business), and an employer’s NIC liability for the business. Typical ‘red flags’ include earnouts that are linked to a seller’s continued employment or personal performance, earnouts being paid to one seller on different terms to others, and sellers receiving less then market remuneration for their continued roles.

A detailed analysis of the tax pitfalls of an earnout is beyond the scope of this note. The HMRC has, however, published some helpful guidance and we are, of course, happy to explore this on any transaction with the parties involved.

Final thoughts

Earnouts are a great structure that can help bridge a valuation gap between a seller’s expectations and a buyer’s concerns. However, as Vice Chancellor Laster went on to observe in Airborne Health, the risk is that an earnout simply converts today’s disagreement over price into tomorrow’s litigation over the outcome.

With this in mind, both parties to a transaction need to take the time to fully explore and understand the implications and structure of any earnout to be employed in their transaction. When doing so, they should not forget the earnout’s underlying purpose – that from the buyer’s perspective, an earnout should be motivational and not destabilising, and from the seller’s perspective, an earnout should reasonably achievable.