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Earnouts are particularly popular as a tool for bridging valuation gaps in life sciences deals. This Hogan Lovells memo provides an overview of some of the key considerations for buyers in those deals when negotiating their obligations under an earnout provision. This excerpt addresses the alternative standards that may apply to the efforts that will be required of the buyer to achieve earnout milestones, and the considerations that should be kept in mind when negotiating them:

Efforts levels come in many flavors: a more buyer-friendly approach may permit a buyer to take any action, including terminating a product line at the center of an earnout milestone, regardless of the impact it would have on achievement of the earnout; a more seller-friendly approach may grant a seller board participation rights (as a voting member, advisor, or non-voting observer), information rights to monitor the company’s development, or veto rights over certain actions (such as terminating a key employee or changes to a clinical trial); and variations in the middle may require that a buyer use “diligent efforts”, “reasonable efforts”, or “commercially reasonable efforts” (and other variations thereof) during the post-acquisition period. There are many varietals of compromises that can be negotiated between the parties depending on the sensitivities at issue.

As we have described in detail elsewhere, many jurisdictions have their own case law interpreting the levels of efforts required to carry out the standards that are often used in purchase agreements. This case law can vary and often does not delineate a meaningful distinction between such standards, regardless of any perceived hierarchy among practitioners. Unsurprisingly, interpretation of the efforts clause used is a common source of post-acquisition disputes among parties.

The memo says that in order to avoid judicial interpretation of these standards, if the parties desire an efforts standard to be articulated in an acquisition agreement, that standard should be defined contractually in a way that reflects their intent with respect to regulatory and commercialization obligations. It goes on to point out that the parties often need to choose whether to apply an objective standard that looks to industry practice or a subjective one that looks to the buyer’s or the seller’s past practices with respect to similar assets. Because courts are more willing to consider extrinsic evidence of the buyer’s or the industry’s past practices when the parties define the required efforts, a thoughtful approach here will make it more likely that the contract will be interpreted as the parties intended.

– John Jenkins