This article explores strategies to mitigate risk in life sciences acquisitions. It discusses how buyers can use contingent consideration and option structures to gain access to potentially valuable assets without paying "full price" before the real value of those assets is known. It also provides an update on the feasibility of using representation and warranty insurance (RWI) to protect against compliance risks and other liabilities arising out of the target's pre-closing operations.

In more detail

Contingent consideration

Earn-outs can reduce the risk for buyers in private life sciences M&A transactions by making a portion of the purchase price contingent on the future performance of the target. This is useful, in particular, for R&D-stage assets whose value depends on future regulatory approval, or young commercial assets whose sales potential is currently uncertain.

An earn-out can only effectively mitigate risk if it functions as intended by the buyer. Earn-outs often end up the subject of litigation, in particular as to whether the buyer complied with its contractual efforts requirement. In earn-out transactions, buyers often commit to using "commercially reasonable efforts" or "good faith efforts" to achieve the milestones or performance metrics that will trigger or maximize the earn-out payment. The buyer needs to make sure this efforts covenant accurately captures what the buyer is actually willing to do from a business perspective.

Unfortunately, the common ways of describing these efforts requirements are far from precise. Courts have determined that "reasonable efforts", "commercially reasonable efforts", acting in "good faith", etc. have roughly equivalent meanings. They all basically mean that the buyer took reasonable steps to carry out the relevant activities. Buyers and sellers often disagree about what this means in practice in any given scenario.

A buyer increase the odds that its earn-out functions as intended by carefully detailing what triggers the earn-out payment and what actions the buyer needs to take to try to achieve those triggers. For example, is it the efforts that the buyer devotes to its comparable R&D programs? Is it the efforts that most similarly situated pharmaceutical companies use for pipeline products of similar market potential? Is the buyer allowed to consider the future earn-out payments in deciding whether it is reasonable for a buyer to continue seeking an earn-out trigger? In recent cases, courts have given effect to these kinds of specific and detailed provisions, thereby ensuring that buyers received the benefit of the limitations on their efforts obligations that they negotiated for. Courts have also rejected interpretations of efforts clauses that require buyers to use greater efforts than sellers bargained for in the relevant agreement, even if this could disadvantage sellers. This means that careful drafting can enhance the risk mitigation benefits of earn-outs for buyers.

Option structures

Option structures are another strategy that buyers can use to avoid paying "full value" for an asset before it is derisked. For example, a large pharmaceutical company may pay a biotech for the right, but not the obligation, to acquire the biotech or one of its products in the future, e.g., after completion of a phase II clinical trial or receipt of regulatory approval for a product. The buyer is typically required to exercise (or decline to exercise) the option once this future event has occurred and then pay a pre-negotiated acquisition price. This benefits the biotech, which can use the consideration from the option grant to fund product development, and the large pharmaceutical company, which secures the right to acquire the product if it proves to be effective (but without committing to a full acquisition until there is a lower risk of failure at the clinical trial stage or inability to obtain regulatory approval).

While option structures can be mutually beneficial to buyers and sellers, they require careful planning and structuring in order to effectively mitigate risk for buyers:

• If the option is to acquire a specific product, and not a company as a whole, the parties should clearly delineate which assets are "in-scope" at the time of the buyer receives the option. Several years may pass between option grant and acquisition, and the selling company may develop or acquire assets that are unrelated to the target product during that time. The buyer needs to ensure the seller cannot keep assets that may be necessary or useful for the exploitation of the target product.
• The buyer should ensure that it will have the requisite equityholder support for the transaction at the time of option exercise. The buyer should consider obtaining support agreements from the equityholders at the time of the option grant and requiring that future incoming investors sign support agreements before acquiring equity. Alternatively, creative structures can also be used to simplify these equityholder concern issues – for example, requiring the target company to issue the buyer a "golden share" that allows the buyer to force redemption of all other equityholders upon option exercise. The optimal strategy needs to be evaluated on a case-by-case basis, taking into account, e.g., the jurisdiction of the target and the characteristics of its investor base.
• Option payments can be a substantial investment for the buyer. The buyer can seek to protect this investment by requiring that the target company use specified efforts to achieve the milestones that would inform whether the buyer is willing to exercise the option. The buyer may also seek additional, more detailed covenants as to how the target company operates prior to option exercise (to the extent permissible under applicable antitrust laws).

Representation and warranty insurance

While contingent consideration and option structures can mitigate the risk of a target's primary regulatory or commercial objectives not being achieved, they do little to address risks associated with other issues in the target's business that are discovered after the acquisition is complete – such as failures to comply with laws, intellectual property infringement, or misstatements in financials. These risks can be challenging to cover when acquiring a biotech or a private equity portfolio company, as the sellers are typically looking to exit with limited or no continuing liability.

Outside of life sciences, RWI is commonly used to cover post-closing losses in transactions where the sellers demand a clean break with no post-closing liability. For many years, the prevailing wisdom was that RWI was not a viable option for life sciences transactions because carriers viewed life sciences deals as too high risk. More recently, an increasing number of buyers in both pharmaceutical and medical device deals have successfully obtained RWI policies with robust coverage, including with respect to key risk areas such as intellectual property, FDA regulatory compliance, product liability, product warranty claims and product recalls. While insurers apply heightened scrutiny to these riskier areas when underwriting coverage for life sciences deals, solid RWI coverage is potentially available to buyers who are willing to "do their homework" in diligence.

While a real market for life sciences RWI coverage exists, the buyer's experience may nonetheless be different in a life sciences deal than in a deal in another industry. Brokers typically see substantially lower market interest on life sciences deals. This means fewer quotes for the insured to choose from and less opportunity to play carriers against one another to improve their terms. The nature of the life sciences industry puts pressure on the carrier's ability to diligence, and appetite to insure, critical, high-risk areas, such as patents and product liability. The buyer should discuss this with prospective carriers before picking one and commencing underwriting. In addition, premiums on life sciences deals are typically above-average, particularly for pharmaceuticals and high-risk medical devices. The buyer should take this into account in its deal model, particularly if the seller is not willing to split the cost.

Conclusion

Life sciences acquisitions present unique risks, but these risks can be effectively mitigated with the right strategies. Contingent consideration can reduce the risk of overpaying for an asset. Options can reduce the risk of taking full responsibility for an asset of uncertain potential. And, RWI can protect against post-closing losses arising out of previously unknown pre-closing issues. Careful implementation of these strategies can go a long way in making your next life sciences acquisition a success.