Originally published in the December issue of PLC magazine.
There may be a sting in the tail
The recent High Court decision in Porton Capital Technology Funds and others v 3M UK Holdings Limited and another shows that agreeing to an earn-out as part of the purchase price for a business does not always produce the desired result ( EWHC 2895 (Comm)) (see box "What is an earnout"). Expectations on both sides may often be far too high.
The case also illustrates the dangers of relying on the common contractual compromise of "consent not to be unreasonably withheld".
What is an earn-out?
An earn-out is a means of ensuring that buyers do not overpay for (and sellers do not undersell) businesses that may be diffi cult to value upfront. Part of the purchase price is paid on completion of the acquisition, with the balance dependant on the future performance of the target business.
An earn-out is often used as a management incentive where owner-managed businesses are sold and the managers continue to work in the business following the sale.
Earn-outs are a common feature of acquisitions in the biomedical sector. The value of businesses in the sector is often dependant on the successful development, testing, regulatory approval and launch of a product in one or more territories.
Acolyte had developed a product for detecting the presence of the antibiotic-resistant "superbug", MRSA, in hospital patients. The product, called "BacLite", was expected to be attractive to hospitals, as it produced faster results than the cheapest competing products but cost less than the fastest test processes. BacLite had been approved for sale throughout the EU and had actually been sold to a small number of hospitals in the UK.
US multinational 3M believed that BacLite might also be sold successfully in other major markets, such as the rest of the EU, the US, Canada and Australia. It offered, through a UK subsidiary, to acquire Acolyte for an initial price of £10.4 million. The earn-out offered further consideration equal to 100% of revenue from worldwide sales of BacLite during 2009, to a maximum of £41 million (less incentive payments to the sales force).
All those involved knew that the earnout payments might ultimately be far lower than the maximum and were dependant on BacLite's success. The sellers were not prepared to leave that success wholly to chance and negotiated terms in the sale agreement that 3M would:
- "Actively market" BacLite and would "diligently" seek regulatory approval for its sale in the US, Canada and Australia.
- Devote the same marketing and other resources to BacLite as to its other medical products and remunerate its sales team on the same basis as other product teams.
- Not shut down the Acolyte business without the sellers' consent, "which shall not be unreasonably withheld".
3M, for its part, insisted on a provision stating that it was not obliged to operate its business in a manner that increased the earn-out payments.
Almost immediately after completion, things began to go wrong. Clinical trials in the US produced consistently much less accurate results than the trials carried out by Acolyte in the UK before the acquisition. This was against a background of very substantial expenditure by 3M in setting up new manufacturing facilities, and in product development and sales efforts.
The one market in which sales had been achieved was the UK. However, the UK government announced in October 2007 that it would introduce MRSA screening for all elective hospital admissions in 2008. This was likely to lead hospitals to buy the cheapest products because of the sheer number of tests that would be needed, making BacLite's "mid-range" product far less attractive. The market for BacLite was in danger of disappearing entirely.
By the end of March 2008, testing and approval for launch in the US and Canada had been put on hold and some of the EU sales team were reassigned to other products.
In July 2008, 3M made the first approach to the sellers for consent to shut down Acolyte in exchange for a payment of just over $1 million. This was refused, and the sellers demanded the maximum earn-out payment of £41 million in exchange for consent to cease business.
3M contended that this refusal meant that the sellers were unreasonably withholding their consent, in breach of the sale agreement. The sellers countered that 3M was in breach of that agreement because it had neither "actively marketed", nor "diligently" sought the relevant regulatory approvals for, BacLite.
The trial lasted for almost a month in total, with around 20 witnesses, including experts, mountains of written evidence, a 65-page judgment and (no doubt) very substantial costs.
The High Court concluded that:
- From March 2008, 3M was no longer diligently seeking regulatory approval in the US and was thus in breach of the sale agreement.
- From various dates between June 2008 and February 2009, 3M had ceased active marketing of BacLite in the EU, the US, Canada and Australia, also in breach of the sale agreement.
- The sellers had not unreasonably refused consent to shut down Acolyte; they were not required to balance the costs incurred by 3M against their interest in receiving the maximum possible earn-out payment. It was for 3M to prove unreasonableness (for example, that the refusal was due to some ulterior motive) and it had not done so.
In the absence of the sale agreement, it might have been a reasonable commercial decision, on the facts, for 3M to close down Acolyte, but that is a different issue to the question of whether or not it was unreasonable for the sellers to withhold consent to the closure.
The court was then left to reach its best estimate of what the actual sales of BacLite would have been had 3M kept its side of the bargain. The sellers were awarded just over $2 million, more than double 3M's original offer, but well short of the £41 million which the sellers had originally hoped for.
The decision highlights the uncertainties for both buyers and sellers of agreeing to an earn-out. In agreeing the financial parameters, it is crucial to consider how realistic the underlying sales or other financial projections are, and what might happen to the market in any interval between the date of sale and the earn-out kicking in to change the picture. The buyer should check that it is not locked in to continuing indefinitely with an obviously struggling business, regardless of the costs of doing so. Both parties should ensure that they are properly protected from any underhand manipulation of the business that would affect the amount payable.
The decision also illustrates that while "consent not to be unreasonably withheld" is a compromise that has allowed numerous contract negotiations to be closed, it sets a challenge in which the party alleging unreasonableness will have to prove it. Although it may be difficult to find an alternative consent wording acceptable to all parties, they should at least consider if there are any specific circumstances in which consent either cannot be refused or is deemed to be given.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.