Earnouts: Recent Delaware Cases Highlight Important Drafting Considerations

Earnouts in acquisition agreements are commonly used to bridge valuation gaps between a buyer and a seller. The buyer agrees to pay additional consideration to the seller if the acquired business achieves specific post-closing milestones, and the seller often negotiates certain contractual assurances with respect to the buyer’s post-closing operation of the business, typically defining the “efforts” the buyer must undertake to support achieving the milestones.

The Delaware Chancery Court recently issued three decisions interpreting generally seller-favorable “outward-facing” efforts standards and generally buyer-favorable “inward-facing” efforts standards, as well as addressing a buyer’s earnout-related claim for fraud by the seller.¹ “Outward-facing” efforts standards tend to be seller-friendly because they look to an industry standard or industry participant(s) as a point of comparison when evaluating a buyer’s efforts, whereas “inward-facing” efforts standards tend to be buyer-friendly because they compare a buyer’s past practices in similar situations when evaluating its efforts.²

Seller-Favorable “Outward-Facing” Efforts Standards

In an opinion delivered on September 5, 2024, Vice Chancellor Morgan Zurn ruled in favor of Shareholder Representative Services LLC (“SRS”) in its capacity as representative of the former securityholders of Syntimmune, Inc. (“Syntimmune”), finding that Alexion Pharmaceuticals, Inc. (“Alexion”), the buyer, was liable for breach of the merger agreement for its failure to use commercially reasonable efforts to achieve certain earnout milestones.³ 

The merger agreement provided for earnout payments when Syntimmune achieved certain post-closing milestones for its developmental-phase drug ALXN1830 and required Alexion to support achieving those milestones by using “the efforts and resources typically used by companies like Alexion, developing a product like ALXN1830, taking into account factors typically considered by such companies.”⁴ Following the closing, Alexion deprioritized the further development of ALXN1830 in response to the COVID-19 pandemic in order to maintain its “10 by 2023” promise to investors, i.e., its commitment to launch ten products by 2023 (ALXN1830 not being among them). Alexion was then acquired by AstraZeneca, which decided to terminate the ALXN1830 project to create synergies after a Phase 1 trial had shown potential safety risks (albeit inconclusive).

The court compared Alexion’s decisions with regard to ALXN1830 to those of a “hypothetical typical company of Alexion’s size, working on a project like ALXN1830 at a similar stage of development, considering the factors such a company would typically consider, up until the point of being contrary to prudent business judgement.”⁵ While it found that Alexion’s focus on “10 by 2023” was an idiosyncratic corporate initiative that a hypothetical company would not have taken, it questioned whether that initiative or COVID-19 caused the breach, which had led to trial delays in any event. However, it also held the pursuit of merger synergies by AstraZeneca to be an “idiosyncratic corporate objective,” explaining that a hypothetical typical company would not have abandoned ALXN1830 at a still viable stage, noting that Alexion’s competitors were continuing the development of similar products. Accordingly, the court awarded approximately $130 million in damages to SRS, which corresponded to the value of the breached earnout milestones.

Buyer-Favorable “Inward-Facing” Efforts Standards; Fraud in the Inducement

In an opinion delivered on July 29, 2024, designated Vice Chancellor Meghan Adams dismissed claims by Fortis Advisors LLC (“Fortis”) as representative of the former stockholders of Companion Medical, Inc. (“Companion”) against Medtronic Minimed, Inc. (“Medtronic”) for breach of the earnout provisions in the merger agreement pursuant to which Medtronic had acquired Companion.⁶ The merger agreement required Medtronic to make earnout payments when Companion achieved certain post-closing milestones for insulin pen products. The agreement stipulated that in achieving the milestones Medtronic could act in its “sole and absolute discretion. . . in accordance with its . . . own business judgment” and that it retained “no liability for any claim, loss or damage arising out of any decisions or actions affecting whether the contingent milestone payments become payable,” except that Medtronic was prohibited from “tak[ing] any action intended for the primary purpose of frustrating the payment of any such contingent milestones.”⁷ Fortis alleged, among other things, that Medtronic’s delays in introducing new sales people and commencing a marketing program caused the failure to meet milestones. The court classified the alleged delays as omissions by Medtronic rather than actions, and thus not implicated by the covenant.⁸ Further, the court reasoned that even if such omissions qualified as actions, Fortis had failed to establish that they occurred with the primary purpose of frustrating the occurrence of the milestones. The court noted that Medtronic did not treat the Companion products differently than any other Medtronic assets.

In an opinion delivered on September 4, 2024, Vice Chancellor Lori Will ruled in favor of Fortis in its capacity as representative of the former stockholders of Auris Health, Inc. (“Auris”), finding that Johnson & Johnson (“J&J”), the buyer, was liable for breach of the merger agreement for its failure to use commercially reasonable efforts to achieve certain earnout milestones. ⁹ The agreement provided for earnout payments upon Auris achieving certain post-closing regulatory milestones for a surgical robotics product that it was developing. It required J&J to use “commercially reasonable efforts” to advance the achievement of the milestones, thereby treating it consistent with J&J’s “usual practice with respect to priority medical device products,” to support certain regulatory milestones, and to avoid making decisions based on the earnout.¹⁰ The court found that J&J breached its efforts covenant when after closing it pitted Auris’ device in a competition against one of its own similar developmental products for purposes of competitive assessment.¹¹ The competition distracted the Auris team’s focus on the device’s development. In addition, after the Auris device won the competition, J&J merged the two developmental teams, further delaying Auris by the integration. The court held that these actions, among others, led to the failure of the milestone to be met and that J&J had expected this, but “viewed the resulting delays as beneficial since it could avoid making the earnout payment.”¹² As a result, the court awarded Fortis approximately $923.5 million in damages, which corresponded to the value of the breached earnout milestones.

The court also found that J&J had committed fraud on Auris when making certain statements during the negotiation of a milestone involving regulatory clearance using a J&J-developed catheter.¹³ J&J had stated that “there was a high certainty” of achieving the milestone and that J&J viewed the milestone as “an effective upfront payment,”¹⁴ thereby failing to disclose that a patient in a clinical study using the catheter had recently died, thus putting achievement of the milestone in doubt.¹⁵ The court found this omission to be “an active concealment of material facts,”¹⁶ thereby making J&J’s statement misleading because the milestone “was not remotely certain to be met.”¹⁷ The court noted that in the agreement, Auris had not disclaimed reliance on extra-contractual representations.¹⁸ Consequently, the court awarded Fortis approximately $79.8 million in damages, which corresponded to the value of the fraudulently induced earnout milestone.

Takeaways

• Parties negotiating efforts clauses in earnout provisions should define “efforts” in choosing from a sliding scale of behavioral standards.
  • Inward-facing efforts standards are buyer-friendly because they compare the consistency of a buyer’s past practices in similar situations when evaluating its efforts.
    • The standard used in the Medtronic case is the most buyer-friendly, requiring no action from the buyer and merely prohibiting any action intended for the primary purpose of frustrating the payment of any such contingent milestones.
    • The standard used in the J&J case is still buyer-friendly because it permits a buyer to compare its past practices in similar situations when evaluating its efforts.
  • Outward-facing efforts standards such as the one used in the Syntimmune case are generally seller-friendly because they look to an industry standard or other industry participants as a point of comparison when evaluating a buyer’s efforts.

• Buyers should include anti-reliance language in acquisition agreements to avoid potential fraud claims. Absent such language, by which the seller affirmatively disclaims reliance on any extra-contractual representations by the buyer, a seller might bring a fraud claim if a milestone is not achieved, alleging having been induced to agree to such milestone by a buyer’s incomplete or misleading statement.

For more information about these cases, please contact Chuck Samuelson, Alexander Rahn, or Wayne Yu.