September 10, 2020

Life Sciences M&A trends: earnout clauses, general outlook, and a few drafting tips

This article has been also published on the EACCNY website on September 10, 2020.

Earnout payments are a common and widely used tool for pricing targets operating in the life sciences, although there are various nuances depending on the specific sub-sector (biotech, pharma, med-tech, and so on). Indeed, earnouts can be a powerful mechanism in an industry where the evaluation of a target can be quite complex due to things like long R&D phases, clinical trials, and market access to products, especially in the biotech and pharma sectors, with all the connected risks. At the same time, if on the one hand the earnout construct offers a good way to balance evaluation risks fairly between buyer and sellers, on the other it entails major drafting and negotiation complexities and quite often leads to post-closing litigation for many reasons.

We’ll start with a brief overview of the SRS Acquiom 2019 Life Sciences M&A Study (you can download the study by clicking here) (the “Study”)[1], which provides very interesting insights into deal terms, milestone achievement, and other data from private-target Life Science M&A transactions from 2008 to 2019, then provide few drafting tips aimed at minimizing the risks of litigation.

1. Nothing new under the sun: earnouts are very popular

As it is well-known by the stakeholders of the industry, according to the Study, earnouts have appeared in a significant percentage of deals in each Life Science sector over the last decade, particularly since 2015. Notably, earn-outs have been the norm in biotech/pharma deals (around 80% of deals), frequent in medical devices (70%), common in diagnostics and research technologies (50%), but rarer in other industries (15% to 20%).

Compared to other industries, upfront value does not deviate much, but there is usually a substantial earnout addition, especially in the biotech/pharma field. On average an earnout is worth about double the payment at closing.

How often are earnouts paid and what is the value at stake?

The answer to this question depends on several aspects, such as the Life Sciences sub-sector (e.g., biotech/pharma, medical devices, diagnostic/research) and phase of development (preclinical, phase 1, phase 2, or phase 3) of the products in the target’s pipeline. Indeed, particularly in the biotech and pharma industry, parties tend to structure the payment of earnouts so that they are subject to the achievement of non-financial events (or a mix of financial and non-financial parameters), such as product development milestones (e.g., success or start of a certain phase of a clinical trial), regulatory filings and approvals (e.g., issuance of marketing authorization in certain countries), execution of a material agreement of partnership, cooperation, and so on.

In terms of statistics, according to the Study, milestones have been achieved on average at a slightly higher percentage in the medical devices and diagnostic/research sector (i.e., 38% of the analyzed deals) as compared to biotech/pharma deals (33% of cases), but the biotech/pharma deals are potentially more remunerative than those for medical devices and diagnostic/research (potential payment up to $8.9B in biotech/pharma versus $4.1B in medical devices and diagnostic/research deals).

Furthermore, earnouts are mostly paid by the second and third anniversary of the closing date for both medical devices and biotech/pharma.

With respect to phase of development, the Study shows that the rate of paid events as a percentage of the total amount of analyzed milestones tends to decrease proportionally in each progressive phase of development (% Events Paid/Total: 60% in preclinical, 44% in phase 1, 30% in phase 2, 29% in phase 3).

2. Earnout disputes and renegotiations

Earnout clauses are frequently disputed: 31% of the analyzed deals generated disputes, and 53% of the deals have been renegotiated with consequent substantial delays in payment.

Furthermore, of the $4.3B earnout potential from disputed milestones, only $986MM has been paid: $786MM was paid after a renegotiation and the remaining $200MM without prior renegotiation. If paid, disputed milestones were paid one year later on average than undisputed milestones (3.2 versus 2.2 years).

Disputes typically arose from unclear milestones and relevant parameters, changes to accounting principles, integration of the target into a buyer’s business, delays in the agreed timeline, or change of strategy.

3. A few drafting tips

Disputes may be avoided by providing a detailed and structured plan. For example:

  • clearly and plainly define financial and non-financial milestones, as applicable, using objective and measurable parameters (e.g., in case of marketing authorization, define the product, its indications, technical specifications, regulatory authority, and so on), methods of calculation, duration, and payment formula;
  • provide a certain degree of flexibility in order to clear the way to addressing changes of strategy, delays, and other issues that may arise as a result of equivalent or even better results (in the biotech/pharma space the development of a new drug is a long and complex exercise and the underlying strategy may change along the way based on the results of clinical trials, the status of the relevant market and competing products, and so on);
  • if the parties agree on multiple milestones over time, consider and possibly regulate catch-up or claw-back mechanisms;
  • take into consideration and properly regulate whether the seller will have any role in the management of the target post-closing, since this clearly changes the balance between the parties with regard to assessing achievement of milestones: e.g., if seller is no longer involved in management after closing, the agreement should provide a certain degree of diligent efforts to be made by buyer to achieve the milestones. Reference to the “commercial reasonable effort” standard may be too broad; hence, the parties should agree on a more specific definition of “commercial reasonable effort” (e.g., allocation of a certain amount of resources for the development of a product, a precise timeline for starting clinical trials, and so on);
  • consider adding restrictive covenants on post-closing management of the business (e.g., the obligation to manage the company consistently with past practice and apply the same accounting principles throughout the earnout period) and regulate post-closing integration of the business into the buyer’s group;
  • regulate post-closing cooperation duties and information rights: e.g., buyer should provide periodic updates, allowing the seller to monitor the status of the milestones;
  • define an appropriate dispute resolution clause, tailoring it to reflect the type of milestones at stake and what technical expertise may be required to address potential litigation;
  • moreover, carefully tailor the earnout construct and milestones with an eye to the actual business of the target, the relevant market, and the industry.


If you are interested in M&A transactions and trends, read our notes on the ABA 2019 European Private Target M&A Deal Points Study by clicking here.

[1] The 2019 Life Sciences M&A Study analyzes the following topics: (i) deal terms from 227 deals, including 163 deals with earnouts; (ii) earnout achievement and other post-closing experience from 131 deals that have been closed more than one year and have earnouts with significant data available (this includes 112 deals that have at least one milestone due by mid-2019 and representing a potential earnout of $13B); and data by industry sector, upfront value, closing year, and product stage.

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