In life sciences/medical technology transactions, buyers and sellers often use milestone-based and sometimes royalty-based contingent consideration to compensate sellers for assets that are in various stages of development from clinical- to development-stage to product commercialization.[1] In licensing transactions, there is an established secondary market through which licensors may monetize their rights to future royalties by selling their rights to receive those future royalties to a third party. Similarly, sellers (particularly financial investors) in private M&A transactions are increasingly seeking the right to be able to monetize their rights to contingent consideration by requesting royalty-like earn-out streams and requesting a right to sell the potential future payments to a single third-party purchaser. However, giving the target stockholders the right to an earn-out raises significant issues for the buyer of the development-stage asset with regard to the US securities laws because the contingent consideration will likely be treated as a “security” of the buyer, requiring the buyer to comply with the federal securities laws and subjecting the buyer to liability for non-compliance. Therefore, buyers should be cognizant of these securities law considerations and some of their practical implications.
If the right to be paid contingent consideration is transferable, that right will likely be considered a “security” of the buyer under long-held SEC guidance. In general, under a line of SEC no-action letters on earn-outs and contingent value rights, there is a multi-factor test used in analyzing whether the contingent consideration is more like a contract or a “security,” with transferability being the most significant factor. If the contingent consideration is considered a “security,” any offering of the security must comply with the federal securities laws. Importantly, because the contingent consideration will be considered a security of the buyer, and not of the target company, the onus of complying is on the buyer and the buyer will have liability under securities laws for any misstatements and omissions in offering documents as well as inadequacies in the offering process.
Private placement
Giving a seller the right to monetize an earn-out right may be untenable for a buyer due to securities law requirements. As with any security, the offering or sale must either be registered with the SEC or issued pursuant to a registration exemption, most typically in a private placement that is premised on issuances being made to mostly sophisticated, or “accredited,” investors (in reliance on the safe-harbor provisions of Regulation D under the Securities Act). If there are too many unaccredited investors among the target’s consideration recipients (which may include option-holders or participants in a carve-out plan who are entitled to participate in earn-out payments), the buyer may structure the deal to cash-out the unaccredited investors in order to stay within the safe-harbor provisions of Regulation D. However, where there are too many unaccredited investors, parties may be unwilling or unable to pay the present cash value of the future earn-outs to the unaccredited investors (which would require a valuation of the future earn-outs).
Disclosure
Even if an exemption is available, there is a need to provide detailed disclosures of the offering, especially if unaccredited investors will be receiving the security (i.e., earn-out rights). Two points in time are important from a disclosure perspective: first, the security will be issued to sellers at the closing of the private M&A transaction, requiring the buyer to provide disclosure to the sellers prior to the closing; and, second, when the sellers transfer the contingent consideration rights, the buyer may have liability for disclosure provided to the transferee.
Disclosure at closing
Where a buyer issues stock as contingent consideration, simply incorporating the buyer’s SEC filings (or in the case of a private buyer, providing an offering document from a recent financing round), along with minimal disclosure regarding the target company, may be sufficient to satisfy disclosure requirements to the sellers receiving the buyer’s stock. The amount of special disclosure regarding the target company will be a function of the target company’s materiality to the combined business.
For contingent consideration that is a security, the relevant disclosure will relate to product or business that the buyer is acquiring rather than the buyer’s existing business. Thus, the offering document must focus on the target’s business, risk factors and other facts and circumstances material to the realization of the contingent consideration. In preparing an adequate offering document, the buyer will need to rely on the target company’s officers and employees to assist in the preparation of adequate disclosure. As a private company, the target is unlikely to have prepared a detailed description of its business (or its materials are not adequate for SEC-compliant disclosure), which could delay closing.
Subsequent transfer
Each time a seller transfers its rights to the contingent consideration, it is undertaking a secondary sale of the buyer’s securities. The acquisition agreement should include safeguards to provide the buyer with advance notice of a proposed transfer and strong consent rights over the offering process and disclosure provided to the transferee.
While a single transfer could be a significant administrative and financial undertaking for the buyer, multiple transfers would be more troublesome. To curb this, the buyer may seek to limit all the sellers to one transfer (with each seller having the right to opt-in) and to require the sellers to reimburse the buyer for its fees and expenses.
Risk mitigation
A buyer cannot shift primary liability under securities laws to the sellers. However, while by no means perfect, the buyer can negotiate for indemnification from the sellers for losses incurred in connection with the offering and sale of the security (both to the sellers and to a subsequent transferee).
The buyer may propose a special escrow to cover such losses and to limit the sellers’ transfer right to a period that ends sufficiently in advance of the end of the escrow term so that the parties will know whether issues are likely to arise. Note that an escrow may not be practical in transactions where contingent consideration triggers will not be achieved for years after closing (i.e., acquisitions of pharmaceutical products with clinical, regulatory and/or net sales milestones). Parties may wish to factor in the risks of not having an escrow in these circumstances into the negotiation of the indemnity or other economics of the deal.
Another risk of transfer is that the buyer may be dealing with a third party with which it may not be familiar. The buyer should consider the extent to which any obligations to use efforts to achieve triggers and provide information rights and reports will run to a transferee or if the transferee may make claims directly against the buyer.
As we continue to observe increasing requests by sellers to monetize their earn-outs rights through transfer rights, we encourage both parties to consider as early as possible, the securities issues noted above, among other things, in order to help manage expectations and avoid unexpected delays, costs and disagreements in executing the transaction.
[1] While earn-outs are much more common in life sciences deals than in other types of deals, a meaningful percentage (14%) of non-life sciences deals involving private companies had an earn-out. Of these deals, the value of the earn-out payments was considerable, on average representing nearly half of the deal’s total potential consideration. See 2017 SRS/Acquiom M&A Deal Study.
Mutya Harsch
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