Earnout Provisions in Pharmaceutical Transactions: Key Challenges and Strategies to Mitigate Risk
December 07, 2023
The pharmaceutical industry operates within a dynamic and complex landscape for reasons including market volatility, innovation and uncertain approval timelines for drugs. Owing to the challenges associated with this sector, start-ups and small companies often look to sell their businesses or drugs at a relatively early stage, when compared with other sectors, to larger, more established companies that are better equipped to go to market. The number of biotechnology and pharmaceutical sector M&A deals nearly quadrupled between 2000 and 2022. Although many sectors saw growth in the number of such deals during the same period, this increase dwarfed other major industries like banking (where the number of deals grew by nearly one-third) and energy and power (where deal volume grew by a little more than two-thirds). According to research firm Global Data, in 2Q23 alone, the pharmaceutical industry saw 228 deals worth more than USD50 billion.
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As heightened activity levels have combined with innovation and the search for increased returns in a challenging economic environment, parties entering deals require sophisticated and complex contracts and structuring arrangements. In these more difficult times, parties seek to bridge valuation gaps and align incentives by establishing earnout provisions, through which sellers reap economic rewards when the sold business performs as well as forecasted or better.
However, these earnout provisions carry inherent risks, whether driven by an unpredictable regulatory landscape, industry dynamics or market forces. The fallout from things not going according to plan can be meaningful and ranges from litigation to regulatory intervention. Professional and financial services firm SRS Acquiom reports that of the deals it has helped facilitate, biotechnology and pharmaceutical earnout milestone achievement rates have dropped from 34 percent in 2021 to 22 percent in 2023, while unpaid potential earnouts under dispute have grown by 50 percent.
Here, we examine these provisions and provide a high-level overview of some of the risks they present. We also touch on structuring and other considerations for dealmakers to minimize risks and best capture the desired economic results.
In an earnout, transacting parties agree on specific payout terms at a future date. But those arrangements are vulnerable to unpredictable outcomes as well as the potential for gamesmanship. Taking some of these in turn:
- Regulatory Factors: Unforeseen safety concerns can emerge during an approval process and new legislation can create unexpected hurdles for drugmakers. Drug approval timelines can be uncertain due to the required input of numerous stakeholders, stringent approval guidelines and the need for quality data. Furthermore, during a black swan event like the COVID-19 pandemic, when regulators are forced to prioritize according to need, timelines can be increasingly unpredictable.
- Overall Market Conditions: While drugmakers are subject to strict regulation and approval processes, they must also navigate the landscape of competitive business, including companies that may emerge quickly. New market entrants can present competitive challenges, and as the market evolves, pricing structures can change quickly in the United States and abroad, potentially causing a significant impact on businesses with an actual or desired cross-border footprint. One example is the Chinese government intervention in 2019, when a centralized procurement program required hospitals to buy in bulk and price became the determining factor, meaning brand name drugs or any business that was differentiated by factors other than price suddenly lost significant market share. These types of developments in major markets can significantly impact projected revenue that would otherwise be undisrupted.
- Macroeconomic Conditions: In the current macroeconomic environment, from interest rate rises and inflation to energy and labor costs and even global conflict, there is increased unpredictability compared to the median years, particularly for businesses that have financed recent growth with debt or M&A. Aymen Mahmoud, co-head of London finance, restructuring and special situations for law firm McDermott Will & Emery, notes that limited capital due to macroeconomic pressure is impacting buyouts and causing disparity between buy-side and sell-side expectations, "bridging that gap either structurally with an earnout or with some other form of capital will be an even more key consideration for parties to M&A transactions in the short and medium term.” Amid these challenging economic headwinds, businesses may need to be financially and operationally restructured. Indeed, pharmaceutical companies accounted for nearly a quarter of bankruptcies between 2019 and 2022.
The uncertainty stemming from these situational risks is not the only challenge that drugmakers face. In M&A, the integration of firms can produce novel risks, particularly as large pharmaceutical businesses are often bought by trade buyers, meaning they are integrated into existing large pharmaceutical businesses rather than through a private equity model structured specifically for that acquisition. Merging two firms can result in delays, disruptions and the loss of key personnel, all of which can impact development timelines and sales, particularly in a market driven by significant growth in carve-outs. It is critical to have the right teams in place to oversee integration effectively.
One difficult consideration in the structuring of earnouts is the misalignment of incentives. Executives in the target business are likely incentivized to indicate high-level performance, which may not be sound from an accounting standpoint and increases the scope for gamesmanship. On the sell side, there may be a desire to show increased revenues, and buyers should scrutinize sudden upticks in performance prior to a sale. For buyers, there may be a desire to downplay performance, adjust discounts or pricing structures or adjust sales efforts to avoid a payout, and for management executives, the opposite dynamic can exist given their own compensation structures.
Risk Mitigation Strategies
Despite the risks associated with earnout provisions, there are many ways to mitigate risk and ensure that risk is fairly allocated. Before looking at true mitigation, the first question should be allocation. For example, who is properly positioned to accept the macroeconomic risk associated with debt financing or geographic conflict? After moving past the question of allocation, which is driven mostly by bargaining power, data-driven strategies can be meaningfully implemented to reduce unpredictability.
Comprehensive diligence can be transformative for a buyout process; assessing the target company, market conditions, competitive landscape and pipeline gives insight into market evolution in the post-earnout era. Comprehensive diligence guards against asymmetric information, enables the development of better-negotiated protections and creates more informed expectations for the feasibility of reaching key milestones. For example, when a buyer commissions a commercial due diligence report, they benefit from receiving detailed information regarding the market, including anticipated regulatory changes, disruptors and holistic views from customers and other stakeholders that can serve to validate their investment thesis while also identifying any risks or information gaps.
Firms can also improve their understanding of the wider market by building collaborative relationships with other parties. Communication and regular data sharing can be highly effective in reducing risk and proactively addressing challenges, leading to better outcomes for both parties while reducing the likelihood of disputes.
As the above strategies suggest, data is key for companies entering a deal. Those entering a deal cannot control the future, but they can use data to make better judgments about the other party and current and future risks that may arise from a transaction. Earnouts play a critical role in bridging the value gap in an uncertain deal environment, so Harris Siskind, partner and global head of transactions at McDermott Will & Emery, notes that buyers and sellers “should exercise caution in crafting earnout provisions, which can range from a very simple top-line revenue-based earnout to a highly complex EBITDA-based earnout that discounts for future add-on acquisitions and is dependent on a multitude of factors.”
Knowing that earnouts are subject to uncertainty is important, but it does not render those provisions unworthy of consideration. Are they any worse than agreeing on an up-front price that is unfair and based on the same assumptions that the earnout is based on? Likely not. As with all facets of buyouts and integration, understanding the risks allows for better preparation and, therefore, a better outcome.
We have demonstrated the usefulness of earnouts in bridging valuation gaps, particularly in the current environment. We have also noted the additional risks, which might be heightened by the approach in a particular geography to warranties and indemnities in M&A. In markets subject to structural unpredictability, such as the pharmaceutical industry, parties agreeing to earnout provisions can be exposed to risks ranging from uncertain drug market performance to integration challenges and misleading data. As with any business risk, the approach to risk management means that buyers and sellers can benefit from these provisions in a thoughtful way where everyone wins.
December 07, 2023
Senior Managing Director, Leader of Commercial Due Diligence
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