Earnouts in M&A Transactions: Recent Decisions From Delaware

In 2024, Delaware courts issued multiple instructive decisions on earnout provisions in life sciences M&A transactions. These decisions underscore the following key points:

• Earnout and milestone provisions often lead to post-closing disputes—clear, precise language with input from regulatory and financial functions, as applicable, is paramount.
• Acquirors can be liable for targets' earnout obligations, which emphasizes the need to evaluate a target's potential earnout obligations and the efforts a target has used to achieve those obligations as part of diligence efforts.
• Buyers should maintain records of their commercial reasons for taking actions relating to acquired programs that are subject to earnout payments.
• When crafting earnout provisions, carefully consider the level of efforts, if any, which a buyer must use in seeking to achieve milestones and explicitly provide whether a buyer, in meeting the applicable standard, can consider its own self-interest.
• Well-drafted and clear earnout dispute resolution procedures that employ an independent party as an "expert" and that are intended to be final and binding upon the parties will be enforced.
• If you intend for fee-shifting, be explicit.

Himawan v. Cephalon[1]

Key Point: While a buyer's broad discretion in development decisions to achieve regulatory milestones for a drug product was bound by the requirement to act commercially reasonably, measured objectively, the buyer's decision to cease drug development was commercially reasonable, given the low probability of achieving approval, the costs of development, and the low probability of profitable commercialization.

Cephalon Inc. ("Cephalon") acquired Ception Therapeutics, Inc., a company whose sole asset was an antibody called Reslizumab ("RSZ"). RSZ showed promise in treating two separate conditions—inflammation in the lungs and in the esophagus. Separate earnout payments were tied to regulatory approvals for each of the lung treatment and esophagus treatment. Post-acquisition, Cephalon retained "complete discretion with respect to all decisions" regarding how to operate the acquired business, subject to Cephalon's obligation to use a defined standard of commercially reasonable efforts ("CRE") to develop and commercialize RSZ for each separate condition. The CRE standard was measured by reference to a "company with substantially the same resources and expertise as [Cephalon], with due regard to the nature of efforts and cost required for the undertaking at stake." Teva Pharmaceutical Industries Ltd. acquired Cephalon during the earnout period and, agreeing with Cephalon's earlier determination that the esophagus treatment had dim commercial prospects, focused on pursuing the lung treatment. Former investors in Cephalon filed suit, claiming breach and seeking up to $200 million in unpaid milestone payments related to the esophagus treatment.

The court stated that the merger agreement's definition of CRE imposed an objective standard on the buyer to develop the assets that allowed the buyer to eschew further development where circumstances reasonably indicated, as a business decision, that development not go forward. As the contractual definition of CRE was explicitly with due regard to the nature of efforts and cost required for the undertaking, the court determined the buyer could take into account any milestone payments, any opportunity costs, the likelihood of achieving regulatory approval, and the probability of profitable commercialization in assessing whether to proceed with further development. If a reasonable actor faced with the same restraints and risks would go forward in its own self-interest, the buyer would be obligated to do the same. But if, after taking account of development costs and the milestones, the buyer was not expected to achieve a commercially reasonable profit, it could abandon development. Based on the facts presented, and taking into account the buyer's likelihood of receiving regulatory approval, actions taken in pursuit of development, the costs expended, and the low probability of profitable commercialization, the court found after a bench trial that the buyer used commercially reasonable efforts to develop RSZ. In January 2025, the Delaware Supreme Court affirmed the decision.

Fortis v. Medtronic[2]

Key Point: A purchase agreement that applies an unusually buyer-favorable standard, granting the buyer significant discretion in meeting milestones and only restricting actions taken with the primary purpose of avoiding earnout payments, imposes very limited obligations on the buyer.

Medtronic Minimed, Inc. ("Medtronic") acquired Companion Medical, Inc., which developed "smart insulin pen" products. The merger agreement provided for a $100 million earnout payment tied to the achievement of sales and net revenue milestones. The development, marketing, commercial exploitation, and sale of the products was to be exercised by Medtronic in accordance with its own business judgment and in its sole and absolute discretion, even if Medtronic's proposed actions would have an impact on the payment of the earnout amounts. Medtronic was restricted only from taking "any action intended for the primary purpose of frustrating the payment of [earnout amounts]." The merger agreement also contained a mutual anti-reliance provision.

The court held that, unlike instances where a buyer covenants to use some level of efforts to achieve the milestone, Medtronic secured itself sole discretion to take actions it knew would frustrate the milestone, so long as the action had some other primary purpose. The court ultimately dismissed the claim on a motion to dismiss, holding that the plaintiff failed to plead any facts that directly related to Medtronic's purpose in taking the at-issue actions. Importantly, however, the court acknowledged that the plaintiff could have used circumstantial evidence of an action's purpose to support its claim and would not have been limited to direct evidence of Medtronic's primary purpose for taking various actions—it had just failed to do so.

Fortis v. J&J[3]

Key Point: A subjective standard committing a buyer to use commercially reasonable efforts consistent with its "usual practice" with respect to "priority medical device products of similar commercial potential at a similar stage in the product lifecycle," taking into account 10 specified factors, gave the buyer some discretion as to the efforts it would undertake, so long as those actions were consistent with the buyer's customary actions with respect to those devices. However, the requirement that the efforts be expended "in furtherance of achieving each of the regulatory milestones" meant that the buyer could not use the specified factors to change the acquired business' development strategy to maximize commercialization, product differentiation, or short-term profitability at the expense of achieving the milestones, in particular when it did not employ the same development strategy for its similar priority medical device. The court awarded significant damages—approximately $1 billion—to compensate for the failure to meet the earnout obligations.

Johnson & Johnson ("J&J") acquired Auris Health, Inc. ("Auris"), which had developed a surgical robot to diagnose and treat lung cancer ("Monarch") and another surgical robot innovating laparoscopic and endoscopic procedures ("iPlatform"). The merger agreement provided for up to $2.35 billion in earnout payments tied to achievement of two commercial and eight regulatory milestones. J&J was required to use a subjective CRE standard to achieve each of the regulatory milestones, taking into account 10 listed factors. CRE was defined by the usual practice of J&J and its affiliates with respect to "priority" medical device products of similar commercial potential and at a similar stage in product lifecycle to the acquired assets. J&J was specifically prohibited from taking into account the cost of any earnout payment, and the merger agreement did not specify that J&J had complete discretion over decisions relating to the acquired business.

Following a bench trial, the court held, among other things, that J&J's efforts toward the iPlatform regulatory milestones were not commercially reasonable and J&J had failed to act in good faith and with diligence to achieve the agreed-upon goals. This was especially evident when compared to J&J's efforts for its only other priority medical device at a similar stage in product lifecycle—an internal orthopedic robotically assisted surgical device ("Velys"). In particular, the court determined that iPlatform was not developed using an industry standard minimally viable product development strategy, while Velys was. In addition, J&J subjected iPlatform (but not Velys) to a comparative assessment with another internal robotic surgery system ("Verb"), which hindered iPlatform's development, drained resources, and did not bring it closer to regulatory approval. The court determined that these actions were "the antithesis of the commercially reasonable efforts expected for a 'priority' device." Moreover, integrating iPlatform with Verb after iPlatform prevailed in the assessment, which J&J predicted would be highly disruptive, knew would negatively affect iPlatform's development schedule, and anticipated would frustrate the regulatory milestones, was inconsistent with its obligation to use commercially reasonable efforts to achieve the regulatory milestones. Lastly, creating an employee incentive program with targets different from the milestones in the merger agreement (including longer timelines than the milestone payment obligations) negatively impacted employees' motivation to work on iPlatform and deprioritized the milestones, contrary to J&J's usual practice for a priority device. This is juxtaposed with J&J establishing cash bonuses for employees advancing the competing Velys program. However, the court found that J&J's efforts toward the Monarch platform regulatory milestones, even though they were flawed and may have prompted unintended delays, were not commercially unreasonable.

SRS v. Alexion[4]

Key Point: An objective standard tied to "typical" companies established for the use of commercially reasonable efforts to achieve milestones does not permit a buyer to take into account its particular initiatives and goals.

Alexion Pharmaceuticals, Inc. ("Alexion") acquired Syntimmune, Inc., a company developing a monoclonal antibody ("ALXN1830"), with up to $800 million in earnout payments tied to the achievement of eight milestones. Post-acquisition, Alexion had sole discretion over business operations, subject to Alexion's obligation to use a defined standard of CRE to achieve each of the milestones. The CRE standard was measured by reference to typical biopharmaceutical companies similar in size and scope to Alexion for the development and commercialization of similar products at similar stages, taking into account 11 factors, including profitability. Because the merger agreement did not explicitly allow Alexion to consider its own efforts and cost (unlike in Himawan, discussed above), the court found that Alexion could consider only "typical factors considered by typical companies" and not its own self-interests. AstraZeneca plc ("AstraZeneca") acquired Alexion during the earnout period and launched a full portfolio review of ongoing Alexion drug programs in furtherance of delivering $500 million in recurring synergies from the acquisition. As a result of this review, AstraZeneca paused (and eventually terminated) further research into the ALXN1830 program.

The court found that language comparing efforts to those "typically used by biopharmaceutical companies" and "typically considered by biopharmaceutical companies" in the CRE definition meant that Alexion's efforts should be measured against an abstract and aggregated industry standard. Using such a hypothetical company approach, the court held that Alexion's deprioritization of ALXN1830 as a result of an idiosyncratic corporate initiative to launch 10 products by 2023, while competitors were all moving forward with similar products, and its decision to terminate the ALXN1830 program as a whole, were a breach of its obligation to use CRE to achieve the remaining milestones. In particular, the court stated that "the preponderance of the evidence supports the conclusion that the decision was influenced, motivated by, or driven by AstraZeneca's pursuit of merger synergies." These short-term financial objectives were inconsistent with the long-term development commitments required by the purchase agreement.

AM Buyer v. Argosy[5]

Key Point: Where an acquisition agreement specifies that disputes regarding the earnout statement be resolved by an independent accountant, whose determination would be final and binding, a party has a high burden in challenging the independent expert's determination of the earnout on the basis of manifest error. Absent a fee-shifting provision, parties likely will have to split costs associated with challenging any such expert determinations, so long as such disputes have a basis in fact and law.

AM Buyer, LLC ("AM Buyer") acquired certain companies from Argosy Investment Partners IV, L.P. ("Argosy") with an earnout payment based on Earnout Period EBITDA. A detailed dispute resolution provision required factual disputes to be resolved by an independent accountant whose findings will be "final, conclusive and binding … other than [for] fraud or clear and manifest error." AM Buyer disputed the earnout payment statement, and the independent accountant issued a final report addressing 12 disputed items, concluding that an earnout payment was owed. AM Buyer filed suit, claiming the accountant's report was not binding on the parties, that the report exceeded the scope of the accountant's authority, and that the accountant's decision was manifestly erroneous and should be set aside.

On summary judgment, citing language that the "findings and determinations of the Independent Accountant as set forth in its written report shall be deemed final, conclusive and binding upon the Parties," the court held that the accountant's written report was indeed final and binding on the parties. The court further held that the accountant did not exceed its scope of authority when it resolved certain factual disputes connected to the earnout dispute. Lastly, the court found that the ability to weigh documents one way or the other is within the province of the expert and does not constitute "plain and obvious error." In ordering AM Buyer to make the earnout payment, the court held that AM Buyer had not breached the purchase agreement by failing to pay the earnout payment while it challenged the accountant's report in court. The court also declined to invoke an indemnification provision that required AM Buyer to indemnify Argosy for failures to perform a covenant, because AM Buyer had not breached its obligation to pay the earnout payment and because the agreement did not contain a fee-shifting provision entitling the successful party to any fees and costs expended in connection with the dispute.

The recent Delaware court decisions on earnout provisions in life sciences M&A transactions highlight the need for careful consideration of how earnout provisions are structured, the importance of regulatory analysis, and the critical role of clear and precise drafting to ensure provisions are measurable and enforceable to mitigate disputes post-closing. In particular, these cases underscore the importance of outlining CRE standards, establishing dispute resolution procedures, and considering potential fee-shifting mechanisms. Buyers must balance discretionary business decision-making with their contractual obligations to exert agreed-upon efforts toward achieving earnout milestones. Buyers should maintain clear records, understand potential obligations, and ensure dispute resolution procedures are well-defined to prevent costly litigation. As these cases continue to shape M&A practices, it is evident that earnout provisions must be crafted with precision and foresight, considering both the business realities and the legal standards that may be applied.