Earn - Outs - A Bug's Life

In the case (*) which led indirectly to the demise of former defence secretary Dr. Liam Fox, the High Court ruled earlier this month on the alleged breach of the provisions of an acquisition earn-out arrangement. The case was brought by private equity group Porton (together with the MoD and others) against the Minneapolis-based giant 3M of Post-it note fame. Earn-outs (where part of the purchase price is dependent on future financial performance of the target) are a common M&A deal structure in high growth businesses and none more so than in the life sciences sector which provided the backdrop to this case.

Background

● 3M acquired Acolyte Biomedica in 2007 in a deal worth £10.4m on closing with an earn-out (based on net sales of products) of up to £41m. Acolyte had developed technology known as “BacLite” which was used for detecting the anti-biotic resistant super-bug MRSA. BacLite had been approved for sale throughout the EU and was expected to be attractive to hospitals (it had already been sold to a small number in the UK) on the basis that it was comparatively cost effective and efficient.

● The sellers (who accounted for c.60% of the equity of Acolyte) and 3M had different views on the business’s valuation and the sellers, reluctant to leave the future success of their business to a hand-shake, negotiated various protections in the sale and purchase agreement obliging 3M:

- to “actively market” BacLite in the US, EU, Canada and Australia

- to “diligently seek” regulatory approval for sale (in the US and Canada)

- not to close down the BacLite business without the consent of the sellers – that consent not to be unreasonably withheld

● Things didn’t go to plan. Within 9 months of completion:

– the 3M executive charged with leading the BacLite business left

– clinical trials in the US produced disappointing results leading to 3M halting further studies

– in the UK (the one market where sales had been achieved) the government announced the introduction of MRSA screening for all elective hospital admissions from 2008 with the consequence that the sheer volume of tests would lead hospitals to buy the cheapest product (making the BacLite product much less attractive)

The claims

● Amid growing concerns at the spiralling development costs of BacLite and the perceived challenges of obtaining further regulatory approval, 3M approached the sellers with a view to closing down Acolyte. Predictably the sellers declined and demanded the maximum earn-out payment (£41m) on the basis that 3M had breached the contract as it had neither “actively marketed” the product nor “diligently sought approval”. Predictably (perhaps) 3M demurred and instead counter-claimed that the sellers were in breach of contract by unreasonably withholding their consent to the closure of the business.

The judgment

● After a lengthy and doubtless expensive trial the court concluded:

- 3M had breached the contract (3M had pulled the tests for commercial reasons rather than – as 3M effectively claimed - for fears it wouldn’t cut the regulatory mustard)

- the sellers had not unreasonably withheld their consent to the proposed closure (the burden was on 3M to prove the sellers were unreasonable – the sellers were entitled to have regard to their own interests in maximising the earn-out payment and not required to balance their interests with those of 3M)

- damages of $1.3m were awarded (on the basis that expert evidence indicated net sales of $2.1m for the relevant earn-out period - $1.3m being the proportion representing the claimants’ 60% stake in the BacLite business)

The moral of the story

● The case lays bare the inherent conflicts of buyer and seller which earn-outs can create while simultaneously being the supposed tool to reconcile them. The challenge is to align interests as far as possible on both the micro as well as the (easier) macro level.

● Both 3M and the sellers claimed victory – 3M had ended up paying $1.3m (c.£800k) instead of £41m - the sellers were “delighted … have been vindicated in our attempt to force 3M to face up to its responsibilities”. Pyrrhic victories?

● So what are the lessons for prospective buyers and sellers entering into an earn-out? Come and ask us….

(* Porton Capital Technology Funds & others v 3M UK Holdings Limited &  Another. The case was allegedly discussed at the infamous meeting between Dr. Fox, Adam Werrity and Harvey Boulter (owner of Portman Group) at the Dubai Shangri-la hotel ultimately exposing Mr. Werrity as Dr. Fox’s unofficial adviser and triggering a possible blackmail suit which could yet see the former defence secretary appear as a witness in a US court)