- A View From London - Earn Outs: Seller Protections Under the Microscope
- June 26, 2012 | Authors: Andrew Bell; Henrietta Walker
- Law Firm: Greenberg Traurig Maher LLP - London Office
In the recent case of Porton Capital Technology Funds & Others v 3M UK Holdings Ltd & Another  EWHC 2895 (Comm) (“Porton”) the UK High Court was asked to examine a buyer’s compliance (or otherwise) with the terms of a sale and purchase agreement governing the payment of contingent consideration (“earn-out”) agreed between the parties. In reaching its decision, the court touched on a number of key issues regarding the use of earn-outs in commercial contracts, and provided a clear confirmation to commercial parties and their legal advisers that such provisions should be “handled with care”.
An earn-out can be a useful tool for procuring that a buyer does not overpay for (and a seller does not undersell) a business which is difficult to value at the point of sale. In such circumstances, the parties may agree that part of the consideration payable by the buyer will be paid upfront, with the remainder to be determined by reference to the target business’s ongoing performance during an agreed period of time following completion (the “earn-out period”). Performance under an earn-out is most commonly assessed by reference to profits of the target business during the applicable earn-out period, but, where relevant, may also be assessed by reference to net assets or other quantifiable financial or commercial measures.
This mechanism for deferring the quantification and payment of consideration has become increasingly common in M&A transactions in recent years, in large part as a result of the volatile and uncertain trading conditions faced in markets around the globe. In particular, earn-outs have become especially common where the target business has a short track record but significant growth potential, as is often the case in the bio-medical sector (see brief synopsis of the facts of Porton set out below).
In some senses, it could be argued that the interests of the buyer and seller are aligned under an earn-out: each party wishes to ensure the continued trading success of the target business, in the case of the buyer, to maximise profits going forward, and, in the case of the seller, to maximise the amount of the earn-out payment at the end of the earn-out period. However, behind the veneer of alignment between the parties, lies an essential tension, which, if weighted too far in the direction of either party, can cause the transaction to descend into conflict (as was the case in Porton).
The natural tension inherent in an earn-out arrangement derives from two competing objectives:
- on the part of the buyer, to ensure that it can operate and integrate the target business free from fetter and that the mechanism by which the earn-out payment is determined is defined by reference to ‘ordinary course of business’ performance; and
- on the part of the seller, to ensure that the buyer is not able to take steps in the running of the target business which could have a detrimental effect on, or artificially reduce, the amount of the earn-out payment.
Sellers’ Earn-Out Protections
Given the inherent tensions within an earn-out arrangement, it is common practice for the buyer and seller to negotiate certain parameters for operation of the target business during the applicable earn-out period. This is of particular relevance to sellers who are also part of the existing management structure of the business, and who agree to divest their day-to-day management responsibilities to the buyer at the point of completion.
Such operational parameters or “seller protections” will often seek to:
- oblige the buyer to take specified positive steps during the earn-out period to maximise the profits of the target business, such as agreeing to provide adequate working capital, sales and management resources; and
- restrict the buyer from taking certain action(s) that could have the effect of frustrating or artificially reducing the profits of the target business (and thus the seller’s earn-out payment), such as agreeing deferred payment schedules with customers or accelerating costly investment.
In essence, these seller protections are intended to prevent the performance of the target business being artificially altered during the earn-out period. However, by allowing such protections to be introduced into an earn-out provision, a buyer may potentially be opening itself up to obligations which could require ongoing performance in circumstances which it would normally consider to be commercially unviable. This is the backdrop to the Porton case.
Porton Case: Background and Decision
In February 2007, 3M UK Holdings Limited (“3M”) agreed to acquire the entire issued share capital of Acolyte Biomedica Limited (“Acolyte”) under a sale and purchase agreement (“SPA”) which contained provision for an upfront consideration payment of £10.4 million and a deferred consideration earn-out payment (which was capped at a maximum of £41 million). The claimants, which included Porton Capital Technology Funds, each owned shares in Acolyte which, in total, amounted to 60.4 percent of the shareholding acquired by 3M.
The earn-out was to be determined by reference to Acolyte’s net sales during 2009, which would be solely driven by the performance of its only product, “BacLite,” which was being developed for use in detecting the antibiotic-resistant “superbug”, MRSA.
At the point of completion, BacLite had only been tested and approved for sale in the European Union (with actual sales only having been made to a small number of hospitals in the UK). However, 3M saw big potential in the product and the business (as part of its existing expansion into the field of medical diagnostics), and set its sights on further expansion into new sales territories in the US, Canada and Australia. In these circumstances, the parties agreed to the inclusion of an earn-out mechanism to determine part of the consideration payable to the sellers.
The SPA provided that the earn-out would be set within certain parameters, and in particular required that during the earn-out period 3M would:
- “diligently” seek regulatory approval for the sale of BacLite in the US and Canada;
- “actively market” BacLite in the US, EU, Canada and Australia; and
- not shut down the Acolyte business without the sellers’ written consent (not to be unreasonably withheld or delayed).
Within a short space of time following completion of the SPA, the fortunes of Acolyte and the BacLite product began to change for the worse: a key executive left the business; clinical trials in the US produced markedly less accurate results than the comparable trials conducted in the UK (which led 3M to believe that continued expenditure on running trials in the US would be ultimately futile, as it appeared unlikely that the product would be given approval in its current form); and the UK government announced that it would be introducing uniform MRSA screening for all elective hospital admissions in 20081 (which would lead to hospitals seeking the cheapest products available, effectively pricing BacLite out of the market) - all of which occurred in the context of significant investment which had already been made by 3M towards setting up facilities for testing and manufacturing the BacLite product (in particular in the US).
In December 2008 - after a series of failed attempts by 3M to seek the sellers’ consent to the closure of the Acolyte business2 (on the grounds of lack of commercial viability) and having already ceased taking steps to obtain regulatory approval in the US and Canada - 3M took the decision to terminate the business. The claimants launched proceedings against 3M (and its US parent) alleging breach of the SPA resulting in the loss of their 60.4 percent share in the net sales of BacLite under the earn-out which would have occurred during the year 2009 had the Acolyte business not been terminated.
Finding in favour of the claimants,3 the High Court found as follows:
- Obligation on 3M to “diligently” seek regulatory approval. The court held that, absent any express intention of the parties for a particular standard to be achieved, the obligation to “diligently” seek regulatory approval imposed a standard of “...reasonable application, industry and perseverance.” In the circumstances and on the basis of the evidence put forward, the court held that it had not been futile for 3M to continue to pursue clinical trials in the US and Canada in order to obtain regulatory approval, and, as such, 3M had not been entitled to weigh up the commercial benefit and/or costs of seeking such approval when taking the decision to cease product testing. 3M had therefore been in breach of its obligation to “diligently” pursue this obligation when it ceased taking steps to seek regulatory approval for BacLite in the US and Canada during 2008.
- Obligation to “actively market products.” The court held that 3M’s marketing efforts required more than simply taking some active steps to market the BacLite product. To be compliant with the terms of the SPA, such efforts needed to be “...characterised by action.” Again, on the evidence presented, the court found that 3M’s marketing efforts in respect of the US, Canada, EU and Australia - which were largely confined to dealings with existing and interested customers — had at various points during 2008 become in breach of the obligation in the SPA on the basis that the actions taken by 3M ceased to be ‘characterised by action.’
- Obligation to obtain sellers’ consent (not to be unreasonably withheld) to shut down the Acolyte business during the earn-out period: The court held that, on the facts, the sellers were acting reasonably in refusing to grant consent to 3M to shut down the business in 2008, on the basis that, amongst other things, the sellers had a reasonable expectation that if the business were to continue the earn-out payment would be higher than the £1.07 million offered by the buyer in exchange for consent to terminate. The sellers were therefore entitled to have regard to their own interests in keeping the Acolyte business trading so as to maximise the potential earn-out payment (and that this did not require the sellers to balance their own commercial interests with those of 3M).
Implications of Porton
The judgment of the High Court in Porton therefore sets out some important guidance to sellers and buyers considering the inclusion of an earn-out within their proposed transaction, with the key considerations being that:
- where a buyer is obliged to pursue a specific aspect of performance during the earn-out period “diligently” or in a diligent fashion, such obligation will not permit the buyer to weigh up the commercial benefit or costs to it in pursuing — or ceasing to pursue — the required aspect of performance in circumstances where the prospect of a successful outcome remains;
- in respect of any obligation on a buyer to “actively” market, or undertake some other type of performance, the steps taken by the buyer in order to comply must be characterised by positive “action” (as such term is commonly understood);
- in taking the decision to withhold or grant consent (where this is expressed to be “not to be unreasonably withheld or delayed”) to a particular action at the request of the buyer under an earn-out, a seller is entitled to have regard to its own commercial interests in seeking to maximise the potential earn-out payment, without being required to balance this against the commercial interests of the buyer - just because a decision may be ‘reasonable’ for a buyer to take, it will not be automatically unreasonable for a seller to withhold its consent to the taking of such decision. The inclusion of the commonly used words “not to be unreasonably withheld or delayed” in an earn-out may not provide the degree of comfort that buyers and their advisers have previously thought;
- a right to “buy out” a specific seller protection (e.g. in the event an acquired business is no longer tenable) cannot be implied absent a specific contractual right to do so - it may therefore be preferable for a buyer to seek agreement from the seller to the inclusion within the sale and purchase agreement of a mechanism allowing the buyer to free itself from an earn-out obligation by payment of an agreed amount of compensation, without the need to obtain the seller’s consent; and
- in more general terms, commercial parties and their advisers must in each case:
- carefully consider the extent of their respective rights and obligations during the earn-out period in light of the potential risks inherent in the particular transaction and business;
- not assume (without express drafting) that a decision of the buyer with regards to the ongoing operation of its business will not breach earn-out restrictions simply because it is reasonable and rational from a commercial perspective; and
- ensure that any seller protections are drafted and recorded in clear, express and unambiguous terms.
It is clear that earn-outs are, at least for the foreseeable future, likely to be a regular fixture in M&A transactions. It is therefore of central importance that parties to such transactions are aware of the inherent tensions and uncertainties that accompany earn-outs (particularly in the current financial climate), and that, in particular, buyers are advised to critically examine the nature, scope and extent of any protections offered to the seller under an earn-out, especially where such protections are intended to apply for any material length of time.
1 Previously this process had been at the discretion of individual hospitals / NHS trusts.
2 3M offered the sellers £1.07 million in compensation for any such agreement to terminate the business.
3 The claimants were ultimately awarded £1,299,808 - being 60.4 percent of the amount which, on the evidence available, the court determined the aggregate net sales of BacLite would have been during 2009 but for the breach of contract by 3M.