Earn-outs are a common feature of acquisitions in the biomedical sector. The value of businesses in the sector is commonly dependant on the successful development, testing, regulatory approval and launch of a product, or range of products, in one or more territories. So, when US multinational 3M offered to acquire a company called Acolyte, it was no surprise that an earn-out was part of the deal.
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 combined a lower price (as compared with the fastest test products) with a higher speed of result (as compared with the cheapest available products). BacLite had been developed and tested to the point at which it was approved for sale throughout the European Union and had actually been sold to a small number of hospitals in the UK.
3M believed that BacLite might also be sold successfully in other major markets, such as the rest of the EU, the USA, Canada and Australia
It accordingly offered, through a UK subsidiary, to acquire Acolyte for an initial price of £10.4 million. But the sellers could also receive up to almost four times that amount if sales of BacLite during 2009 reached up to £41 million. 3M clearly thought that handing over an entire year's revenue from BacLite was a price worth paying for the product.
Of course, all those involved knew that the earn-out 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 agreements from 3M as follows:
- that 3M would "actively market" BacLite and would "diligently" seek regulatory approval for its sale in the USA, Canada and Australia;
- that 3M would 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;
- that appropriate training and customer support materials would be developed; and
- that the Acolyte business would not be shut down 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.
The deal was completed in February 2007. But almost at once, things began to go wrong. First of all, the 3M executive with lead responsibility for taking BacLite forward left the company. Secondly, 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 seemed to be because:
- one of the key elements of the test process had been changed, in the belief (incorrect, as it turned out) that BacLite would not gain US Food and Drug Administration clearance in its original form; and
- US laboratory procedures were often slightly different to those prevailing in the UK, especially in relation to the storage of samples (temperature and length of storage) and incubator temperature (even a couple of degrees' difference was sufficient to affect the results).
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 evidence showed that, by March 2008, executives at the highest levels within 3M were becoming concerned at the ever-growing costs of developing BacLite when seen against the difficulties of achieving further regulatory approvals and sales. By the end of that month, testing and approval for launch in the US and Canada had been put on hold and some of the EU sales team were re-assigned to other products. However, the expert evidence at trial led the court to conclude that approval could have been obtained (on the basis of testing of BacLite in its original format and with more stringent laboratory procedures) for product launches in Canada by October 2008 and the US by February 2009.
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 one million US dollars. This was refused, the sellers demanding the maximum earn-out payment of £41 million in exchange for consent to cease business. 3M contended at trial that this refusal meant that the sellers were unreasonably withholding their consent, in breach of the original 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.
This left the court with the unenviable task of determining which side was in the right. This required a trial lasting for almost a month in total, with around 20 witnesses, including experts, mountains of written evidence and a 65-page judgment. The court concluded that:
- from March 2008, 3M was no longer diligently seeking regulatory approval in the US and was therefore 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; and
- 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.
The court was then left, on the basis of expert evidence, to reach its best estimate of what actual sales of BacLite would have been if 3M had kept its side of the bargain. The sellers were awarded just over two million US dollars, more than double 3M's original offer, but well short of the £41 million which the sellers had, no doubt, already decided how to spend.