By James M. McKnight, Mintz Levin
Your PE firm owns a small but growing life-science company with pipeline products and emerging technologies. A big strategic company offers you a fat purchase price and you jump at it.
You go into sell mode. After months of negotiations and diligence, the purchase price still stands at a higher multiple than you could expect from other bidders, but the strategic has whittled down your closing-date payout with earnouts and special holdbacks. It’s too late to turn back.
Earnouts are increasingly popular, with SRS Acquiom reporting that some 70% of life-science deals use them. So are special stand-alone indemnification holdbacks, where the buyer retains a portion of the purchase price, separate and apart from the standard indemnification for representations and warranties. In life sciences, they are often used for IP litigation or when FDA or other regulatory problems are uncovered in diligence.
If you feel stuck at this point, what can you do?
The price is right. (Or is it?)
Every dollar of a special holdback means one less dollar in your investors’ pockets at closing. A large strategic buyer comes armed with data to back up its argument for shifting a generous portion of the purchase price to the earnout or special holdback. Be prepared. Have your own legal arguments about why the risk is low, as well as your own data to counter their projections.
You should also consider representations-and-warranties insurance to replace all or part of a special holdback.
Clean up the mess now
Caught in the M&A vortex, you are consumed with negotiating the sale agreement, finalizing financials, responding to constant diligence requests, coping with employee anxiety, and more. It’s tough, but you should resolve as many earnout and special indemnification issues before closing as possible. Delegate point people to work with your deal lawyer. Clean up regulatory problems or settle litigation on your terms.
According to SRS Acquiom, most post-closing earnout disputes involve perceived lack of progress or changed business plans. Post-closing operational covenants can help. A strategic buyer will object to covenants limiting its freedom. But you should at least come to an understanding on your specific concerns during the drafting process.
Most large companies will agree on some level of information sharing post-closing. Designate a person to receive information from the buyer and keep track of progress.
Special holdback language can be tricky. For example, what is the definition of a claim for which holdback amounts may be retained pending resolution rather than returned to the seller? Definitions vary but they usually include “threatened” litigation. Is a mere threat enough to constitute a claim?
A related pitfall is the timing of holdback releases, especially if “claims” giving rise to retained amounts go away or the risk diminishes. Think all this through carefully with your deal lawyer.
Plan now for future disputes
The best way to protect your interests is prenegotiated dispute resolution. Designate a mediator – whether an investment banker, accountant or consultant – from the start. Make sure the mediator has experience with life-science deals.
You often see prenegotiated dispute resolution with earnouts but not so much with special indemnities. It should apply to both.
In conclusion, you face the same risk with an earnout or special holdback – that a strategic buyer will not do everything it should to achieve milestones or resolve claims efficiently, especially if the only downside is return of less cash to you.
As a result, protections such as prenegotiated dispute resolution, together with careful drafting, are crucial to a good outcome.
For over 25 years, James McKnight, a member at Mintz Levin in New York City, has represented both acquirers and targets in mergers and acquisitions and financing transactions in a wide range of industries. For the past decade, his practice has focused on the medical-device industry, including acquisitions and sales on behalf of private equity investors and the day-to-day representation of various medical-device companies. He can be reached at JMMcKnight@mintz.com
Update: The 7th last paragraph has been amended to reference “the buyer” instead of “the seller.”