October 2012

A recent case has flagged some of the difficulties involved in covering both sides’ positions when it comes to negotiating earn-out provisions in a business sale, and the importance of the words which parties use in their agreements.

Background

Earn-out provisions are common in two situations:

• the business is a ‘people’ business, where the buyer cannot be too sure that the same level of business will continue once the seller has left, even if he remains involved for a handover period;
• the business is a new technology business with no or limited sales history, making it hard to value the goodwill.

In both cases, the actual value to the buyer will only become known with hindsight, so the parties agree an ‘earn-out’ whereby the purchase price is increased (often substantially compared with the up-front payment) depending on future performance; and the seller will want to ensure that the buyer doesn’t do anything to reduce the chances of the seller earning his earn-out.

In a people business, the seller will want to keep some control of things, by staying involved during the earn-out period.

In a technology business, the seller may well not be involved but will want to ensure the buyer does what it can to meet the earn-out targets.

The buyer on the other hand will want to retain flexibility as to how it develops its business, including the business it has bought.

In either case, it can be quite difficult to negotiate a sensible balance which covers each side’s interests. Quite detailed provisions are often needed, and you have to be quite careful with the words you use. I prefer to see deals being structured in as clean and simple and ‘win-win’ a way as possible, so that things are likely to work well without the need for imposing excessive legal protections. For example in a recent deal I was involved with, acting for the seller, the buyer proposed an earn-out based on the seller receiving two times the target business’ net profits in the first year – certainly not a ‘win-win’ deal, and we managed to replace it with a much more sensible one.

The Acolyte Biomedica case (Porton Capital Technology Funds and others v 3M)

This recent high Court case dealt with the sale of a new biotechnology business – a diagnosis tool (BacLite) used to detect the MRSA superbug. It sheds some light on how hard the buyer needs to try to commercialise the technology it has bought (and so maximise the possible earn-out for the seller).

The sale was in early 2007, and involved  an up-front consideration of £10.4m plus an earn-out equal to the net sales of BacLite in 2009. Both parties had estimated that this would be over £22m. The maximum earn-out was capped at £41m.

The sale agreement included provisions requiring the buyer (3M) to commercialise BacLite before and during the earn-out period. It had to ‘actively market’ it in certain markets, such as the USA and the EU; and it had to seek regulatory approvals ‘diligently’ in the USA and elsewhere (it had already received regulatory approval in the EU). It also said that 3M couldn’t cease to develop and market BacLite without the sellers’ written consent, which the sellers could not unreasonably withhold.

Unfortunately, 3M encountered unexpected difficulties in that it had poor results in the US with clinical trials; sales in the EU were worse than it had expected; a new NHS review in the UK resulted in widespread MRSA screening which helped cheaper lower quality alternatives; and the economic crisis led to a cost-cutting review across the whole of 3M’s healthcare division. By mid-2008 3M had had enough and asked the sellers for their consent to close the Baclite business down, offering them a termination payment of just over US$1m. The sellers refused to consent, so 3M closed the business down anyway.

‘Diligently’ doesn’t necessarily mean ‘carefully’.

The sellers argued that the obligation on 3M to act ‘diligently’ in seeking US regulatory approvals meant it had to use reasonable care. 3M had actually deviated from what they had done with their successful EU trials. The court agreed with 3M that an obligation to act ‘diligently’ didn’t mean you had to use reasonable care; you just had to act with reasonable application, industry and perseverance. ie you had to try quite hard, but you didn’t need to be too careful about how you went about it! No, I’m not too sure how you draw the line on this either…

The court said that 3M had used reasonable care anyway, so it wouldn’t have made a difference.

‘Actively market’ – how active is ‘active’?

The court said that 3M’s obligation to ‘actively market’ didn’t mean it had to act in an uncommercial way. For example there was little point in marketing Baclite outside the EU until US regulatory approvals had been obtained.

What’s reasonable from one party’s point of view doesn’t have to be what’s reasonable from another party’s point of view.

The court agreed with the sellers that by closing the business down 3M had ceased to ‘actively market’ BacLite and to diligently seek US regulatory approvals. The court also agreed that it hadn’t been unreasonable of the sellers to refuse to consent to 3M closing down the business – the factors in deciding what was reasonable from the sellers’ point of view in withholding consent were not the same as those considered by 3M in deciding to cease actively marketing BacLite. The sellers could put their own interests before the buyer’s. It would therefore seem that there is unlikely to be much point including a clause in an earn-out requiring the sellers’ consent to the buyer’s actions, unless it is more clearly worded.

Part of the problem was that the sellers were out of the loop, and couldn’t easily understand where things were going wrong when EU clinical trials had already gone so well and both sides had originally envisaged things would be much more successful.

The court therefore ordered 3M to pay damages, but only of US$1.3m. The sellers probably ended up out of pocket after the costs of the trial.

(Case: Porton Capital Technology Funds & Ors v 3M UK Holdings Ltd & Anor [2011] EWHC 2895 (Comm)  7 November 2011)